Children in kindergarten always expect plenty of candy.
The teacher thinks it’s a better idea to distribute the candy directly herself, but some enterprising kids trade candies among themselves. Some children have a theory that when they run out of candy, the kindergarten will dole out more. So when their stockpile begins to run out they sit in the front row, with open hands.
This is a fable for the financial market, and is what Zhang Xiaohui, director-general of the Bureau of Monetary Policy at the People’s Bank of China (PBOC), told commercial bankers in a meeting on 21 June. She pointed out that the financial market deludes itself into thinking there is unlimited cheap money and criticised commercial banks for having more interest in borrowing and lending with each other than in serving the real economy. Some commercial banks believe that, with the slowdown of economic growth, there will be a new round of stimulus policy, so they have tried to move faster than their competitors by expanding credit as quickly as possible. But Zhang warned the overstretched lenders to stop their bad habits immediately.
Zhang’s speech was made right after the panic in the Chinese inter-bank market on 20 June. There had been less liquidity in the market since mid-May, but the financial market didn’t worry. They believed the central bank would bail them out. After all, it has happened before. Whenever the financial market gets tired and hungry, ‘Mother Central Bank’, as the PBOC has come to be known, is there to offer some nourishment. But times are changing. All of a sudden the loving mother was telling her kids they had to fend for themselves. Even when liquidity was sucked out of the market and short-term interbank rates were pushed to record highs, with banks charging each other 25 per cent for overnight money, the central bank refused to lend a hand.
I have some sympathy for the PBOC. China’s financial institutions have been spoiled. After the global financial crisis, in order to save China from an economic crisis, state-owned enterprises and local governments were encouraged to borrow as much money as they wanted and squander it on real estate or reckless infrastructure projects. Now, the party is over.
But how strong can the central bank be? On 24 June, four days after the interest rate hike, the Shanghai Composite Index suffered its worst one-day percentage loss in nearly four years, plunging 5.3 per cent, while the Shenzhen Composite Index dived 6.1 per cent. The central bank quietly changed its tune and injected liquidity. Ha, what a familiar story: this time I will forgive you, and next time I will not.
This is more a lesson for the mother, not her children. First, Mother Central Bank did the right thing at the wrong time. It should have paid more attention earlier to the rapid expansion of China’s shadow banking system — which deals in off-the-books wealth-management products and trust products — and to mounting local government debt. Now, as the growth rate keeps falling, the central bank has less and less room to manoeuvre. If it further tightens monetary policy the real economy will become the real victim, because high interest rates encourage risk-taking speculation and the manufacturing sector would be squeezed out.
But if it does nothing, something else could go wrong. Now there is only a liquidity shortage: what if some small banks or other financial institutions have a liquidity crisis? Even if this happens, the Chinese government can quell the panic by reacting quickly and decisively. What if some wealth management products or local bonds default? Well, if the default is on a minor scale and the situation can be controlled, it may help to let them fail to send a message to the rest. As the old Chinese saying goes: kill the cock to warn the monkey. But the danger is that the shadow banking system connects commercial banks to local governments, real estate developers, export companies, and retired people who have bought risky wealth-management products. The collapse of a few products could trigger a chain reaction.
Really there is not much that the monetary authority can do. The pains felt by the financial markets are symptoms of the real economy. Why does money keep flowing into the real estate sector? Because the future of the manufacturing sector is gloomy. Labour costs are increasing dramatically. External demand is still sluggish. Small- and mid-sized companies are short of liquidity ahead of the large state-owned enterprises.
Rather than behave like a teacher in a kindergarten full of greedy children, the Chinese government should learn from the legend of Great Yu. About five thousand years ago there was an enormous flood. Great Yu’s father, Gun, was ordered by the emperor to control the flood. Gun did nothing but build a lot of dams to stop water. Finally the dams were inundated, giving rise to a fiercer flood. Great Yu chose another approach. He dredged the rivers and channelled the flood into the sea. This is what the Chinese government should do. It must let all the money out by liberalising the service sector, including health care, finance, transportation and communication. It should open up the economy to both foreign investors and domestic private investors, which would help start-ups and small and mid-sized enterprises. Finally, it should spend more on public goods to make people feel more secure and willing to spend more. Then the flood in the financial market will disappear, flowing out into the ocean.
He Fan is Deputy Director at the Institute of World Economics and Politics, Chinese Academy of Social Sciences. He is also Deputy Director at the Research Center for International Finance, Chinese Academy of Social Sciences.