A Chinese bank staff member counts stacks of 100-yuan notes at a bank in Huaibei, east China's Anhui province, on Aug. 17, 2012. AFP/AFP/GettyImages
Summary
China's leaders are looking to balance steady, incremental reforms of the state-controlled banking sector with the need for stability and strong central oversight of the system. Recently released statistics from China's National Audit Office point to the growing imbalances plaguing China's financial system and highlight the need to stabilize credit expansion and reform the relationship between local governments, state-owned enterprises and state-owned banks. These are critical components of Beijing's ambition to move toward a more sustainable model of economic growth.
Analysis
The need for reform has been echoed in the weeks following the Communist Party's November Third Plenary session, at which President Xi Jinping and his colleagues pledged to allow market forces to play a decisive role in the allocation of resources -- and in particular, capital -- throughout the Chinese economy. In the past year, numerous reform proposals and guidelines have emerged from the State Council (China's Cabinet), the China Banking Regulatory Commission and the National Development and Reform Commission. These measures have been aimed at stimulating competition in the sector, curtailing banks' involvement in shadow lending markets and reducing local governments' and state-owned enterprises' reliance on debt to fuel growth and remain solvent.
Beijing's Financial Reform Measures
On Jan. 8, the China Banking Regulatory Commission announced it will soon require "systemically important" state-owned banks to disclose off-balance sheet assets on a quarterly basis. Two days earlier, the State Council circulated internally a set of guidelines titled "Document 107." The guidelines called for tighter oversight of state-owned banks' involvement in shadow lending activity and urged trust companies -- private asset managers that in recent years have become key intermediaries between banks and shadow lending markets -- to cease involvement in credit-related businesses. Also on Jan. 6, the Banking Regulatory Commission said it will allow the establishment of three to five privately owned banks in 2014, a move designed to expand ordinary consumers' access to credit (so far, banks under consideration appear to be connected to specific companies like Taobao, a popular e-commerce platform). This move will also begin the long process of chipping away at the state-controlled banking sector's monopoly on formal lending.
These announcements came just days after the National Development and Reform Commission said it would expand a fledgling municipal bond program in an effort to give local governments alternative means of raising capital (thus limiting their reliance on bank loans and financing vehicles, a key constraint in recent years on further financial sector reforms). Local government bond issuance -- for years allowed on a trial basis in certain provinces -- is a long-awaited means of providing local governments with more budget stability and accountability.
Finally, recent financial reforms follow moves by the country's central bank in June and in December 2013 to discourage banks from engaging in overly risky lending by refraining from providing immediate liquidity assistance during cash crunches in interbank loan markets. The central bank hopes that by temporarily withholding funds from these markets -- on which banks rely increasingly to meet their quarterly payments, some of which go to investors in bank-managed shadow lending tools like wealth management products -- it can scare some discipline into the state-owned banking sector. At the same time, in both the June and December instances, the People's Bank eventually succumbed to the banks' demands for liquidity assistance, signaling its fear for financial stability in the event that it should tighten liquidity. The central bank, having expanded money and credit supply drastically over the past five years, recognizes that these periodic cash crunches reflect serious systemic risks in the major banks and shadow lending sector.
These actions and proposals fit into a larger financial reform patchwork aimed at improving transparency and more effectively evaluating the nature of the projects being financed and the creditworthiness of borrowers while still maintaining a strong degree of central government coordination and oversight of the system. For many reasons, this will be an exceedingly difficult task in the years to come.
Debt, Reform and Stability
On Jan. 6, a report from China's National Audit Office showed that local governments across the country owed more than 17.9 trillion yuan ($2.96 trillion) in outstanding loans as of June 2013, an increase of nearly 70 percent from 2010, when a similar audit was conducted. On the same day, U.S.-based bank JPMorgan Chase estimated that from 2010 to 2012 the size of China's shadow lending market doubled, reaching around 36 trillion yuan ($5.95 trillion) and accounting for 27.8 percent of all debt added in China since the end of 2010.
Add to these conditions the likelihood of even slower economic growth in 2014 and the impact of rising capital, labor and other input costs on businesses' bottom lines, and it seems almost certain that this year will see greater volatility and instability in the Chinese banking sector than in previous years. China may not suffer a nationwide financial crisis this year, but isolated defaults by local governments, state and private enterprises and state-controlled banks will become more common, with important implications for popular (and investor) confidence in the Party leadership.
This is the backdrop against which China's leaders seek to reform the banking sector. As the November Third Plenary session highlighted, the Communist Party is well aware of the need to improve efficiency in the way Chinese banks allocate capital. But doing so involves many moving parts, none of which can be dealt with entirely in isolation. To ease the country's financial imbalances, Beijing must, in a coordinated fashion, begin to rein in credit growth, provide deposit insurance and allow for higher interest rates on corporate loans and consumer deposits. The government must also formalize shadow lending, remove and restructure bad government and corporate debts, provide local governments with more sustainable sources of revenue, and stimulate competition among state-owned banks by allowing more private and foreign capital into the sector (which, in turn, entails tactically loosening the country's capital account and currency controls).
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Managing each of these various reforms in turn requires myriad incremental adjustments. Unless these are carried out in tandem with each other and with reforms of the fiscal relationship between central and local governments, each is liable to trigger a domino effect of defaults by local governments, enterprises and banks. For example, unless local governments are able to raise capital through higher tax revenues or long-term debt programs like municipal bonds, reining in formal credit expansion will only spur borrowers to rely even more heavily on shadow loan markets. This in turn would raise the risk of financial contagion when borrowers -- and the banks they borrow from -- are unable to make regular payments to their investors. Similarly, without installing deposit insurance, it is very difficult to experiment with liberalizing interest rates, which will drive different banks to compete and expose weaker banks to the risk of deposit losses and default.
The complexity and interconnectedness of these challenges in part explains central authorities' approach to reform thus far. Rather than strike directly at the system's core constraints, Beijing has chosen a more cautious, roundabout approach, looking to different government agencies to make incremental adjustments until, theoretically, a fail-safe foundation is laid and the final reforms (such as interest rate liberalization for consumer bank deposits) can be enacted effortlessly. It is not an ideal approach, for it means that many of the system's core problems will persist for many years to come. But what this approach sacrifices in speed, it gains in stability. For the Communist Party, the alternative -- a bold reform program like Soviet Russia's perestroika -- likely would lead to greater instability.
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