When the global financial crisis began the
Chinese government stimulated the economy. It worked. Chinese banks took on
risk, and the economy continued to grow. But in recent months China’s
investment climate has gotten out of control
In the shadow banking sphere banks have increased sales of
trust and wealth management products, which promise high returns and are often
invested in questionable assets, such as white liquor or luxury apartments in
impoverished regions. Because the products are sold by banks, customers are
often unaware that these products are not ultimately backed by the government.
While the China Banking Regulatory Commission (CBRC) has tried to rein in these
sales by forbidding bank sales of trust
products, in reality trust companies continue to sell their wares.
Wealth management products continue to be sold by a number of companies, and
customers, attracted by unusually high returns, are often blithely unaware of
what they are investing in.
So on 17 June the People’s Bank of China acted. The Bank
increased interbank interest rates while at the same time strategically
injecting liquidity into institutions that would be most affected by the
liquidity tightening. China’s interbank lending ‘crisis’ was actually engineered
by its central bank. The central bank’s website said that it needed to
manage liquidity risks that have resulted from credit expansion, including
investment risks taken by local governments, excessive property investment, and
lending within the shadow banking sphere. Banks, trusts, real estate trusts,
and local governments are thus overleveraged, often on weak foundations.
The shadow banking sector certainly needs to be deleveraged. But
whether monetary policy is the best method to accomplish this is questionable.
Monetary policy, which controls liquidity in the financial economy, is a broad
sword: it cuts down risky investment but it also constrains lending to
businesses which need funding for everyday activities. But deleveraging through
regulation has been shown to be ineffective — there is so much shadow banking
activity occurring that the CBRC is unable to enforce its regulations. So
officials have turned to monetary policy as a means of reining in all types of
speculative activity. Although this is not a practical long-term solution since
it is not targeted toward risky lending practices (long-term policy should
include the creation of a more effective risk-monitoring mechanism), in the
short run it is the only viable option.
Shadow banking poses enormous risks to China’s
economy. As in the US subprime mortgage crisis, shadow banking products
are leveraged off risky assets that will almost certainly fail. Now the
government is caught in an awkward position. Although it has stated it
will not back shadow banking loans, systemically important financial
institutions will almost certainly have to be bailed out if the shadow banking
system fails.
Shadow banking is also closely connected to lending to the
real economy. With recent credit tightening, manufacturing and small business
activity has slowed even further. China’s new credit-tightening policy comes as
demand for China’s manufactured goods abroad has slowed due to the ongoing
crisis, and fiscal stimulus has come to an end. It will surely impact economic
growth.
This has quite unpleasant ramifications on the ground, but
consider this: if the US Federal Reserve had tightened monetary policy to
target risky lending before the subprime crisis arose, the global crisis might
have been stopped at its source. No doubt there is real and financial pain in
China right now, but perhaps some moral credit is owed to the Chinese
leadership for deflating asset bubbles before they burst. Recent experience
tells us that a sudden leverage deflation after a very long expansion would be
far more painful and prolonged.
Sarah Hsu is Assistant Professor of Economics at the State University of New York. Asia Sentinel
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