But why is shadow banking still all the rage, despite thehostile regulatory environment?
In the past two to three decades, China has implemented anextremely inflationary monetary policy. Since 1986, for example,its money supply has grown at a compound annual growth rate of 21.1per cent, and its bank loan balance by 18.2 per cent. Of course,Chinese citizens have not become richer as fast, and much of thegrowth is merely a monetary illusion.
Why did credit grow so fast for so long? Apart from a robusteconomy, the reason has been the regulated and negative realinterest rate. Due to financial repression, demand for loans hasbeen artificially boosted, as bad investments become feasible onsubsidised credit. Indeed, it has been a vicious cycle.
First, the fast growth of loans worsens inflation, which weakensthe purchasing power of money. To facilitate the same amount ofbusiness, corporate China needs more credit. And as more credit isreleased into the economy, the purchasing power of money shrinksfurther. I call this an iterative escalation of credit andinflation. There is a constant shortage of credit no matter howfast credit grows. The reason? Bank loans are impossible to refuseas they are heavily subsidised. Homebuyers and speculators knowthis all too well.
The Chinese government frequently talks about prudent monetarypolicy but does not really have the political will to tightencredit for fear of job losses and a recession. Even in April, thebroad money supply (M2) has grown at 16.1 per cent compared to thesame time last year. That is a very high rate on a high base. Chinais still inflating rapidly despite repeated declarations of creditcontrols by government officials.
The results of financial repression are visible everywhere, fromindustrial overcapacity to excess real estate construction, and theunstoppable growth of shadow banking.
Over time, the Chinese statistics (particularly on inflation)have lost credibility among citizens. Despite high inflation thatis widely believed to be somewhere between 5 and 10 per cent ayear, Chinese depositors are paid an average of 2 per centinterest. Naturally, they want better deals. While many have chosento speculate on property, others have embraced shadow banking,including microcredit and wealth management products. Afterconsistently deflating for two consecutive decades, the domesticstock market remains very expensive, with banking stocks being thepossible exception.
Negative real interest rates on bank loans constitute a subsidyfor borrowers. Unfortunately, access to finance is neither equalnor fair. State-affiliated companies and well-connectedprivate-sector borrowers take the bulk of funds for loans, leavingvery little for small businesses. The underprivileged have toresort to the curb market, involving trading outside the officialstock markets, pawnshops, microcredit firms and high-cost fundsarranged by trust companies.
In other words, China's shadow banking is a reflection of thefinancial repression. The high interest rates prevalent in shadowbanking activities are a result of the low rates in the formalbanking sector.
Financial repression has accentuated the uneven playing fieldfor the two types of borrowers. Normal bank loans carry a 6 percent annualised interest rate, while the shadow banks typicallycharge 15-30 per cent per annum.
If Beijing really wants to help small businesses, or deflate theproperty bubble, it should raise interest rates steadily. As aresult, the growth rate of money supply will decline to 7-8 percent within two to three years. Yes, this will risk an economicrecession, but a recession may be exactly what is needed to avoidthe next global financial crisis. This time, unlike in 2008, thecrisis will be made in China.
China's iterative escalation of credit and inflation has severesocial consequences, too. Ordinary savers are punished, and areleft further and further behind by the rising prices of assets suchas property. If President Xi Jinping wants Chinese people torealise their own "China dream", he must tame the credit monster.Shadow banking is only the shadow, not the monster waiting in theshadows.
Joe Zhang was chairman of Wansui Micro Credit Company inGuangzhou from 2011 to 2012, and is author of a new book, InsideChina's Shadow Banking: The Next Subprime Crisis?
China's private sector still in the shadow of the state
In an essay published eight years ago (Financial Times;October 5, 2005), I said that China's private sector was in theshadow of the state.
I can make the same argument today with one significantdifference: the state sector's dominance in China has grownconsiderably in the last eight years.
The last decade has almost completely undone the reforms of thetwo previous decades.
The consensus in the West is that China's state sector iscorrupt, inefficient and ideologically inferior, so it must belosing ground against private enterprise which is steadily chippingaway at the communist, state-backed old guard.
That is just not the case.
Nicholas Lardy, in a recent Bloomberg Brief piece,compared the financial performance of China's state sector with theprivate sector. Citing the National Statistics Bureau, his numberswere predictable: last year, the state sector return on assets(ROA) was merely 4.6 per cent and well below the private sector's12.4 per cent.
I think those numbers are biased and wrong.
The biggest components of the state sector are the banks, whichaccount for almost half of the domestic stock market valuation, andabout half of the total net profit of all the listed companies.Other big components in the stock market, or in the unlisteduniverse for that matter, are state-controlled big insurancecompanies, big oil corporations and telecommunicationsoperators.
Chinese banks have an average return on equity (ROE) of about 20per cent – twice the level of their global peers. Insurancecompanies do well in general, and telecoms operators enjoyexorbitant privileges. How can the state sector underperform theprivate sector in financial terms?
Of course, you can argue that the banks' profits are entirelydue to the government's control of interest rates. That is a trueand fair assessment, but the fact remains that the state sector hasa much higher ROE than the private sector.
Lardy's use of ROA is meaningless because banks by definitionare highly-geared business and their ROAs are low in nature (around2-3 per cent). The nature of the banking business is such that youcannot usefully compare bank ROA with other sectors. ROE is theappropriate benchmark.
The other problem with Lardy's comparison is that tens ofthousands of private sector companies go bankrupt, or voluntarilyclose each year. Once that happens, they exit from the statistics.So there is a 「survival basis」. But you do not hear any state-ownedenterprise being shut down.
The playing field is unfair and aligned against the privatesector.
Moreover, there are many hybrid joint venture companies in Chinathat blur the distinctions between the two sectors.
Finally, the state sector takes on many social functions, andtheir existence and activities provide a positive spillover effectfor the whole economy and society.
While liberal commentators may disagree with this, the statesector is designed to achieve more than just financial ratios.
Utilities, (power, water, natural gas and public transportation)for example, where the state sector dominates, are not charged atfull price because of affordability and other social reasons. Thatdrags down their financial returns, but the financial ratios do notreflect their efficiency.
It is wrong for liberal economists to say that the dominance ofthe state sector goes against the public's wishes.
In China, the public wants more, not less, involvement by thestate sector. The public wants a bigger state sector to tackle themany challenges China faces, even if many of these challenges areby-products of the state sector (inequality, overpopulation andpollution).
Even the recent third plenum does not mention the privatesector, a point Lardy acknowledges.
The official data shows that the government tax revenue as apercentage of gross domestic product almost doubled from 12 percent a decade ago to 22.3 per cent last year. This is almost awholesale reversal of the economic liberalisation of the previoustwo decades.
But Western economists do not mention this uncomfortablefact.
The state dominates strategically important sectors – essentialinfrastructure and sectors with pricing power – while the privatesector is left to fight it out in fiercely competitive sectors suchas low-end manufacturing, retail, service industries and (some)real estate.
The writing is on the wall: the score of the past decade's matchof the private sector versus the state sector in China is 「privatesector - zero」 and 「state sector - one」.
Joe Zhang is a corporate adviser based in Hong Kong, and theauthor of Inside China's Shadow Banking: The Next SubprimeCrisis?
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