HONG KONG — China’s financial system is in danger of becoming too big to bail out.
Official bank lending has more than doubled since the global financial crisis, growing nearly twice as fast as the overall economy. The even bigger problem, however, appears to come from the rise of a shadow banking system that has allowed a number of companies and individuals, often with political connections, to borrow from state-controlled banks at low interest rates and relend the money at much higher rates to private businesses desperate for credit at almost any price.
Now, in an effort to wean the banks and the economy off their addiction to such risky practices, Beijing has pledged to deliver what amounts to the country’s most sweeping financial overhaul in decades. Markets will play the “decisive” role in directing the economy, policymakers promised last month after a key plenum meeting of the Communist Party leadership. Interest rates are to be liberalized, cross-border investment will be welcomed, and regional and bureaucratic protectionism will be curtailed, they declared.
But already, even relatively modest government moves are producing turbulence in money markets; China’s central bank recently was forced to back off, at least temporarily, to avoid putting too much stress on the banking system and potentially drawing an angry reaction from powerful vested interests in China accustomed to paying very little for their loans.
“It’s been pretty clear since June, and especially clear since the plenum, that the new crowd is interested in tightening monetary policy and letting interest rates rise,” said Arthur Kroeber, the Beijing-based managing director of GK Dragonomics, an economic research firm.
China has experimented twice this year with much higher, market-driven interest rates. As with a similar experiment in June, the central bank allowed rates late this month to soar to unsustainable levels. Instead of regularly scheduled open-market operations, the bank tried unconventional methods of guiding money markets.
That approach involved the central bank’s turning to posts on China’s Twitter-like social messaging service, Sina Weibo, to chasten banks to “make rational adjustments to the structure of their assets and liabilities, and improve their liquidity management using a scientific and long-term approach.”
But as in June, the experiment did not last long. China’s central bank, People’s Bank of China, provided a direct injection of fresh money after the market pushed seven-day interest rates to nearly 10 percent, double their earlier level. The central bank’s action eased pressure on the financial system and quelled fears of an immediate credit crisis. But rates remain elevated, and the bank may have only postponed the moment of reckoning for a few months.
A complex and loosely regulated network of financial go-betweens has sprung up to profit from repackaging and reselling China’s new mountains of debt, turning loans into investment products. Such products have become popular among ordinary investors in China, because they pay much higher interest rates than deposits in savings accounts, where rates are capped by the government to protect the state-owned banking system from competition.
But loosely regulated financial businesses can make a dicey business model, as Wall Street learned in 2008. And they pose a particular threat in an economy where growth is slowing, as it has been in China for the last three years.
“The final users of the money will not be able to earn returns high enough to repay the money and promised interest,” said Yu Yongding, a senior fellow at the Institute of World Economics and Politics of the Chinese Academy of Social Sciences and a former member of the monetary policy committee at China’s central bank. “The chains of lending and borrowing can be long, just like the securitized subprime mortgages. The result can be devastating.”
The big risk for China’s cosseted banks is not necessarily bank runs of the sort seen in the early 1930s in the United States, with depositors lining up to withdraw money before a bank can fail. The Chinese authorities have made clear that they will not tolerate disorderly closures of banks and have reportedly over the years rushed cash to banks that faced sudden withdrawals.
Instead, the greater worry has been what some experts describe as “a walk on the banks” — depositors steadily removing their savings from banks after losing enthusiasm for deposit rates that have long been set by regulation. Banks in China have been able to stay profitable while lending at low rates only because the government has required all of them to pay even lower rates for deposits. Savers have had few alternatives to banks until very recently: Real estate prices are already stratospheric relative to incomes, the weakly regulated and highly speculative domestic stock markets are widely distrusted and shadow banking businesses are periodically reined in by the government.
While policymakers say they are worried about upsetting the delicate mechanisms of the current banking system, public criticism continues to grow, even within China’s elite. That suggests further market-oriented experiments could be coming soon.