Quality not quantity as China deleverages

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The top-down structural reform of China’s commercial banks is beginning to show results, but the real economy is still overleveraged, requiring further action, writes Zhang Yanling, Former Executive Vice President, Bank of China

While China has been adjusting its model of economic growth, on the international stage three issues regarding its commercial banks have received broad attention. The first is the cash shortage of June 2013, when both short-term interbank interest rates and the Shanghai interbank offered rate (Shibor) suddenly spiked to record levels. Second, in 2013, 42 state-owned enterprises recorded losses totalling ¥72.6 billion ($11.8 billion), while the 17 biggest banking enterprises in China earned ¥1.23 trillion ($200.7 billion) in profits. The third issue is the large volume of non-performing loans in the commercial banking system; by June 2014, non-performing loans reached ¥694.4 billion ($113.2 billion), having increased for 11 straight quarters.

Still, the performance of China’s economy is one of the best in the world. But, from these data and events, it is clear that the task of reform is going to require considerably more effort. Commercial banks are at the centre of China’s banking system. Building commercial banks that can control risk affects the management of systemic risk in the overall financial system. Due to the special relationship between the commercial banks and the government in China, any discussion about how to make China’s commercial banks better must begin with a discussion about how to create a better financial ecosystem, and how to better run and manage the commercial banks as banks.

‘Cash shortage’ warning
China is undertaking economic reforms and deleveraging. Its goal is for assets to circulate in the banking system to flow towards the real economy. This is a top-down structural reform that has only just begun to take effect. During the cash shortage of 2013, the People’s Bank of China refused to inject capital into commercial banks that were short on funds, which caused the overnight interest rate to shoot from 2.1 per cent in early May to above 13.4 per cent on 20 June. The banks were unprepared. Since then, the commercial banks have improved their management of liquidity and risk.

The goal of this action was to discipline the shadow banking activities of commercial banks. In 2014, it has already made a big impact. In the first quarter of the year, China’s total social financing was ¥5.6 trillion ($913.4 billion), a decrease of more than ¥561.2 billion ($91.5 billion) from the first quarter of 2013. New bank lending as a proportion of total social financing increased by 9.1 per cent year on year, while trust lending (a form of shadow banking) fell 8.4 per cent. This demonstrates that the government moved effectively to standardise and control the shadow banking activities of commercial banks.

High leverage, local-government debt issues and policy reform
In reality, it is hard to say that the commercial banks have made no mistakes, but these problems are probably inevitable. Responding to government easing policies after the 2008 global financial crisis, commercial banks provided massive lending support for various infrastructure projects through local-government financing vehicles.

The increased lending of the commercial banks supported China’s growth after the global downturn, and China has been the driver of global growth since the financial crisis. The growth slowdown and a low rate of return on these projects produced a chain reaction. In order to finally solve the problem of shadow banking, commercial banks need to return to lending that serves the real economy, while at the same time resolving the difficulties caused by the local-government financing vehicles. On 21 May 2014, the government initiated a pilot programme for local-government bonds issuance by allowing Shanghai, Beijing, Qingdao and Shenzhen, among other selected provinces and cities, to issue local-government bonds within a certain limit.
This pilot programme attempts to resolve the local-government debt problem in three ways. First, it severs the local debt’s implicit guarantee from the central government. Second, it gives local governments the authority to raise their own funds and to take on their own risk. And third, setting the duration of the local-government bonds at five, seven and ten years, when currently only three- and five-year durations are available, solves the problem of the mismatch between bond durations and long-term investment projects.

Targeted macroeconomic management and deleveraging
Even though these measures are starting to bear fruit, because such a large amount of credit previously flowed into long-term infrastructure investment projects, the problem of overcapacity in numerous industries such as steel, cement, glass, chemicals and coal remains. The real economy is still overleveraged. Commercial banks must coordinate with the People’s Bank of China to solve these existing problems, such as deleveraging overcapacity industries while continuing to proactively contribute to employment, improved quality of life and sustainable economic growth.

The central bank has initiated two rounds of targeted cuts in the reserve requirement ratio and one round of targeted interest-rate cuts. It allowed county-level rural cooperative banks, commercial banks and financial institutions to lower the reserve requirement ratio under certain conditions. This was intended to improve financial support to the agricultural sector, rural areas and farmers, an underserved sector responsible for a large number of crucial jobs.
The first targeted interest-rate reduction was implemented through the Pledged Supplementary Lending (PSL) plan. It will provide more than ¥1 trillion ($163.1 billion) to the China Development Bank to rebuild shanty towns and help improve conditions for those living in poverty.
The yield on one-year AA-rated urban-construction investment bonds has fallen to 5.3 per cent from a rate of 7.4 per cent in early 2014. The seven-year urban-investment bond yield has fallen to 6.7 per cent from 7.9 per cent. The two-week Shibor has fallen from 5.2 per cent early in 2014 to about 3.5 per cent, indicating that deleveraging measures have started to take effect.

China’s economy under the ‘new normal’
These targeted changes reflect the ‘new normal’ of China’s macroeconomic management efforts. In the medium term, as China takes the initiative to deleverage, it will guide the economy away from a path that once emphasised quantity towards one that emphasises quality.
China is moving from being a manufacturing power to an innovation power. The commercial banks will do their part to provide support and be an active and crucial participant in the reform process, fostering the growth of the real economy.

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