This is the right approach to direct greater bank lending to China’s best and most credit-worthy small businesses. A more efficient loan market will improve the overall returns for private equity investors, as it will lower the cost of capital, during early phases of growth, for the best SMEs.Â
China’s Monetary Paradox
ByÂ PAUL CAVEYÂ |Â From today’s Wall Street Journal Asia
China yesterday did what many economists expected it to, and cut both the lending rate and the reserve requirement on banks. The move is intended to serve as a classic monetary stimulus as China faces its biggest economic test since 1978. But a different, paradoxical, strategy might be better: a stimulative tightening.
On the face of it, China’s problems don’t look all that unusual in the region. Real export growth has slowed to around 10%, although the turmoil overseas suggests this is about to get much worse. The bigger problem is the domestic real estate market, the other main driver of Chinese growth, with sales contracting more than 50% in recent months. China is at risk of its first real simultaneous downturn in external and domestic demand growth since 1996.
The solution in a normal economy would be an interest rate cut. Indeed, Beijing yesterday cut the lending rate to 6.9% while also reducing bank reserve requirements by 0.5 percentage points (exact requirements vary by bank size), both moves intended to boost liquidity. The underlying structural cause of these economic problems is unique to China, however. Despite 30 years of economic reform, the most important price in the economy — the price of money — is still controlled.
The undervaluation of the yuan, which can be inferred from the tremendous build-up of foreign exchange reserves, has sparked overseas calls for revaluation. Beijing has responded, allowing the yuan to appreciate 8% or so this year. That rise has only encouraged further inflows, however, so Beijing has held interest rates low to avoid exacerbating the inflow problem. Combined, these policies are the classic recipe for a bubble. The liquidity inflow creates an excess supply of money, and low nominal interest rates — 7.2% at the moment, well below nominal GDP growth of 20% — create the excess demand.
Beijing’s response has been to cap loan growth through regulation. Banks have been ordered not to lend, instructions which in particular this year have been backed up with sterilization, the government’s soaking up of excess yuan. Bank lending growth is now around 15% a year. That’s a big number in absolute terms, but not in the context of China’s rapid growth. The stock of outstanding credit has fallen relative to the size of the economy, closing in on 100% of GDP now from 125% of GDP in 2003. In the same period credit in the U.S. has ballooned to almost 180% of GDP — not even including the liabilities of the super-leveraged financial sector.
At first blush it looks like China’s banking straightjacket has protected the banks from themselves and the economy from the banks, in contrast to events elsewhere. The problem is that these policies are preventing banks from developing the risk management and other skills needed to make them self-supporting commercial institutions.
It is the government that decides how much lending occurs. Within what are effectively credit quotas it would in theory make sense for the banks to lend to companies that have the best ability to repay. In practice, though, there is little value in being too choosy. Banks can fulfil their quota with profitable firms by lending to pretty much any company that walks into the bank on Jan. 1 each year. In this environment, it is likely that the banks lend almost exclusively to the customers they are most familiar with.
One consequence is that smaller start-ups in the private sector find it harder to get credit, despite relatively low interest rates. This is why it is so important for Beijing to raise rates to replace the banking straightjacket, the regime of administrative measures and sterilization that has controlled lending growth so far. Under this new policy, credit growth would be controlled via the price rather the quantity of money. Only then will China’s banks begin to learn how to judge risk, and thus wean themselves away from state-owned enterprises and start lending to the more dynamic private sector.
This transition would have huge economic consequences. Most evidence suggests the small private firms are the most productive in China, and are also the most employment-intensive. Their development is stunted because credit rationing denies them money from the banks. Instead, they are pushed to the informal credit market, where interest rates can be as high as 40%. Indeed, even a borrowing rate in the formal banking sector of 15%, more than double the current rate, would be low for the army of small and medium-sized enterprises.
Which is why a nominal tightening via an interest rate hike wouldn’t necessarily be a tightening in practice at all, if banks in the meantime are released from their straightjacket of administrative controls and sterilization. By encouraging banks to think for themselves and thus potentially giving smaller enterprises access to relatively more affordable bank credit, a policy of easing by tightening might end up being just what China needs.
Mr. Cavey is head of China economics at Macquarie Capital Securities.