China: Market Mechanisms need Official Help

Last July, the People’s Bank of China removed controls on the lending rate and began liberalizing savings rates. This aggravated the volatility of money market rates. It is becoming clearer to PBOC officials that even the successful functioning or market mechanism require an important official role. 

PBOC Governor Zhou told a conference in Beijing last week that a new mechanism is being contemplated that would help anchor money market rates. The new mechanism would be similar to a rate corridor that some other countries and regions use (e.g. ECB, Turkey). The PBOC will drain or inject funds if the money market rate deviates “too much” from the midpoint. 

Officials are concerned that as the current state-directed system is phased out, that money market rates will become more volatile and makes it more difficult for banks and companies to manage their liquidity. The 7-day repo rate is a benchmark of short-term borrowing costs. Last June it spiked to almost 11% and 14% in September and 15% in January. In late April, it spiked over 7%. Today it jumped almost 85 bp to 4.0% 

The PBOC’s Q1 monetary policy report, published in early May, recognized the value of a corridor-like mechanism. The central bank is looking for a framework to “effectively guide and adjust market rates.” It would boost transparency and allow greater consistency in PBOC operations. It would provide officials with a greater capacity to prevent or minimize credit crunches.

Separately, the PBOC and other government regulators announced new measures to rein in China’s so-called shadow banking. The current approach is too fragmented to be effective. The emphasis seems to be on the securitization process, or the packaging of loans into complex structures that effectively allow some participants, like trusts, to circumvent official regulations. Although there were at least 18 new regulations outlined, the most important seemed to be the additional capital provisioning that could rise to as much as 100%, depending on the nature of the assets of the investments. 

While not banning shadow banking activity, the new regulations are thought to curb its profitability. Bank has used off-balance sheet activities to get around the 75% loan/deposit rate of their balance sheet activity. Maximizing capital usage was its competitive advantage, and this is what is being addressed by the new measures.

It is estimated that this off-balance sheet activity grew by 50% from 2009 to CNY9 trillion by the end of last year. Officials in the high income economies have found that financial intermediaries will seek out new ways to bypass regulations on capital requirements. It is unlikely that Chinese financial institutions will prove to be an exception. 

If these new rules and regulations are going to be effective, it likely will aggravate the tighter credit conditions being experienced in part of the economy that officials have identified as suffering from excess capacity. Often, as we have seen with mortgage lending, official attempts to crack down on undesirable practices have a greater impact than anticipated. On the other hand, if the new measures are not effective, Chinese officials will face more difficult choices in the future.