China: The Cocaine of Cheap Money

A lot of people have asked me to write about the recently “leaked” CBRC report on dodgy local government debt. Here is what the article in Monday’s Bloomberg had to say about it (and note especially that delicious second paragraph):

Mainland banks may struggle to recoup about 23 per cent of the 7.7 trillion yuan (HK$8.81 trillion) they have loaned to finance local government infrastructure projects, according to a person with knowledge of data collected by the nation’s regulator.

About half of all loans need to be serviced by secondary sources including guarantors because the ventures cannot generate sufficient revenue, said the person, who declined to be identified as the information is confidential. The China Banking Regulatory Commission has told banks to write off non-performing project loans by the end of this year, the person said.

Commission chairman Liu Mingkang said last week that borrowing by the local government financing vehicles may threaten the banking industry. The mainland’s five largest banks, including Agricultural Bank of China, plan to raise as much as US$53.5 billion to replenish capital after the sector extended a record US$1.4 trillion in credit last year.

Many analysts seemed to have been surprised by the report, and over the past few days we’ve seen a veritable flurry of “half-full’ interpretations of the numbers, but I would suggest, based on my pretty extensive experience in emerging markets, that we should assume the real problem is worse than the initial evaluation. It almost always is.

Not everyone agrees. In an article in today’s People’s Daily, the CBRC was at pains to play down the risks:

The China Banking Regulatory Commission (CBRC) said on Tuesday that nearly one-fifth of the bank loans disbursed to local governments are questionable, but will not cause any systemic risks to the banking sector.

….”These questionable loans won’t necessarily turn sour, as most of them have eligible collateral or a secondary source of repayment,” a CBRC spokeswoman told China Daily on Tuesday.

Maybe. I agree that these loans won’t pose a risk to the banking system, but that doesn’t mean that there won’t be huge losses. It just means that the losses will be covered by the household sector. For years I have been arguing that without liberalizing interest rates and pushing through governance reform, there won’t be meaningful reform in the domestic financial system. It isn’t even conceivable to me that a combination of rapid credit growth, socialized credit risk, severely repressed interest rates, and serious lack of transparency could ever have led to anything other than large-scale capital misallocation and rising debts.

So of course there are problems in the banking system, and of course there is a lot of debt piling up in all sorts of unexpected places, and of course bit-by-bit we will get more information, like this leaked CBRC report. Victor Shih’s report earlier this year on hidden local government financing was another supposed “shocker”, and at first widely dismissed, until little by little his very ugly numbers were confirmed (and he thinks his numbers are probably understated).

There’ll be more

I am sure this will not be the last scary report to come out in the coming years. Yesterday, for example, Reuters had this to say:

Shanghai banks are facing rising default risks on loans to real estate developers after the central government took steps to cool the sector, a senior banking official said in remarks published on Tuesday. Yan Qingmin, head of the China Banking Regulatory Commission’s (CBRC) Shanghai bureau, said more property loans were categorised as “special mention” in the second quarter, indicating developers’ weakening capacity to repay the loans.

And there’ll be still more, but rather than dive into what the latest releases might mean to bank capital and bank risk, I wanted to discuss a related topic that is especially relevant in the context of burgeoning of government and bank debt: local interest rates. Is China going to raise interest rates this year?

The ADB seems to think so. According to an article last week in Bloomberg:

Chinese policy makers may raise interest rates this year to cool price pressures, an economist at the Asian Development Bank said, even as slower growth compels analysts to dismiss higher borrowing costs in 2010.

“I don’t rule out the possibility that China may raise rates this year,” Srinivasa Madhur, senior director of the ADB’s Office of Regional Economic Integration, which compiles the lenders’ economic forecasts, said in an interview in Tokyo today. “China needs to speed up monetary normalization, preferably by a combination of currency appreciation and interest-rate adjustment.”

The very smart Andy Xie has been calling almost desperately for China to raise rates to head off deeper trouble. He argues that loose monetary and credit policy is driving wasteful investment, especially in the real estate sector.

But if he believes rates are indeed going to rise this year, I think he is in the minority. Most other economists seem to think China will not raise rates. Their reasoning has to do, for the most part, with inflation expectations. Those who think inflation is heading up – the minority – believe Beijing will be forced to raise interest rates in order to rein in price rises, whereas those who think inflation has peaked – probably the majority – believe that Beijing will not raise interest rates.

I used to be more of an inflation hawk, but as I explain in a June 15 entry, I now suspect that there is a mechanism in place that automatically limits the inflationary impact of rapid monetary expansion. But whether or not I am right, I wonder anyway if the relationship in China between inflation and interest rates is not a lot more complex than the arguments about the interest-rate response to inflation imply.

In the US, raising interest rates may be a reasonably effective way to head off inflation because it is likely to reduce aggregate demand faster than it reduces supply. I would argue that there are three main ways it would do this.

Will higher rates stop inflation?

First, interest rates hikes are associated with declining real estate and stock markets, and through the wealth effect a rate hike would reduce US consumption by making Americans feel poorer. Second, a rate hike makes consumer financing more expensive and so reduces the desire to borrow for consumption. Finally, a rate hike reduces corporate borrowing for investment purposes, and so also reduces aggregate demand in the short term, even if it reduces aggregate supply over a longer term.

None of these mechanisms work to nearly the same extent in China, and in fact one of them is likely to have the opposite effect. Starting from the last, the aggregate amount of corporate borrowing from banks in China has little to do with interest rates and nearly everything to do with the loan quota. Since credit for most borrowers is largely socialized, interest rates have little bearing on the decision to borrow and invest.

Second, unlike in the US there is very little consumer financing in China – so raising its cost will have a negligible effect on total consumption. Finally and most importantly, as I have argued in my April 20 blog entry, the wealth effect of an increase in interest rates in China is the opposite of what it is in the US. Raising interest rates will actually increase household wealth, and so increase consumption, not reduce it, although this growth in consumption is likely to happen slowly.

So although I agree with most observers that if inflation should surge, the PBoC is more likely to raise the lending and deposit rates, I wonder if this is likely to be an effective instrument for heading off inflation. As I understand the Chinese growth model, slow wage growth (relative to productivity growth), an undervalued currency, and low interest raters have been mechanisms for repressing consumption growth by slowing the growth in household income relative to GDP. Reversing any of these, which is necessary to achieve rebalancing, will allow both household income and household consumption to grow more quickly.

But while it is one thing to wonder whether the PBoC should raise lending and deposit rates, it is another thing altogether to wonder whether the PBoC actually can raise them, at least enough to matter. I am not sure they have much room to raise rates even if they wanted to.

One of the problems with a severely repressed financial system, especially one with rapid credit expansion, is that there tends to be a huge amount of capital misallocation supported by borrowing, and in an increasing number of cases it is only the artificially-reduced borrowing costs that allow these investments to remain viable. I worry that even if the PBoC wanted to raise rates, it would not be able to do so without exposing how dependent borrowers are on artificially cheap capital.

Take the most obvious example, the PBoC itself. The central bank officially has about $2.5 trillion in reserves. This by the way almost certainly understates its true position but let’s ignore that for a moment. The PBoC has funded this position with an equivalent amount of RMB liabilities, which makes it very vulnerable to changes in the value of the currency.

Rate addiction

In fact there were strong rumors last year that the PBoC was technically insolvent as a consequence of the 20% increase in the value of the RMB against the dollar during the 2005-08 period of currency appreciation. Weirdly enough, although the numbers are huge, it has proven difficult to convince anyone that the PBoC is not the richest institution in the world, and that it is actually very vulnerable to big losses (although I notice that Sovereign Trends’ Terrence Keeley, in an OpEd in the Financial Times Tuesday, seems also to have done the numbers).

The problem for the PBoC occurs not just because of the currency mismatch but also because it needs repressed funding costs to keep it profitable. How much do the PBoC foreign currency assets earn? I would guess probably between 3% and 4%, maybe less. The RMB funding cost, on the other hand, is roughly between 1.5% and 2.5%. This leaves the PBoC with a net positive carry of between 1% and 2%.

If the RMB appreciates by as little as 2% a year, in other words, the PBoC runs a negative carry on its assets. Every further 1% increase in interest rates, or additional 1% rise in the value of the RMB, then, erodes its capital by at least $25 billion (annually, if it happens through an increase in interest rates).

Let’s assume, for example, that over the next two years we see a combined appreciation and interest rate increase of 10% (let’s say a 2% increase in interest rates and a 4% annual appreciation), which is, in my opinion, the absolute minimum that China must do to slow down the worsening domestic imbalances. Assuming no change in the rate earned on reserve assets, which in fact may decline, this means that the PBoC’s net indebtedness would rise by over $250 billion, or roughly 5% of the country’s GDP.

These kinds of number quickly add up. And of course it is not just the PBoC that has this addiction to repressed interest rates. Many years of very low cost borrowing has created a huge dependency on low interest rates among SOEs, local governments, and other creditors of the bond markets and the banks (not to mention the banks themselves), all of whom are directly or indirectly funded by long-suffering households.

As I discussed in an entry several weeks ago, repressing the interest rate is the equivalent of granting hidden debt forgiveness. It is probably a safe assumption that an awful lot of borrowers depend heavily on this hidden debt forgiveness to remain solvent, and would be unable to repay if rates rose to anywhere near a reasonable level (at least 400-500 basis points, I would guess, if we wanted to eliminate the overinvestment and repressed consumption consequences of financial repression).

In that case any attempt to raise interest rates to levels high enough to reduce China’s investment misallocation and to allow households to raise their consumption levels would come, in the short term, with a massive rise in bankruptcies and in government debt levels. If nothing else the PBoC is probably under huge pressure from local governments not to raise rates.

The cocaine of cheap money

All this might sound like I am effectively recommending that the PBoC continue to repress interest rates, but of course repressed interest rates are what caused the problem in the first place. To continue to do so simply makes the underlying problem worse, by piling on even more non-viable debt. Rather than suggest that the PBoC must keep rates low, what I am really arguing, I guess, is that this is a very difficult trap from which to escape.

What can the authorities do? If Beijing raises interest rates quickly, debt and bankruptcy will surge and growth will collapse – although the eventual rebalancing of the economy might happen much more quickly.

If they don’t raise interest rates, they can keep growth high for a while longer, but the amount of reserves and misallocated capital will continue rising, making the eventual cost of raising interest rates even higher. The risk is a Japanese-style stalemate in which for many years the authorities are forced to keep rates too low because they simply cannot countenance the alternative, and during this time consumption growth continues to struggle.

Finally, if they raise interest rates slowly, they will slow growth while still suffering many more years of worsening imbalances, until rates are finally high enough to begin reversing the imbalances. But for this strategy to work, they would need a very, very accommodative external sector – China’s domestic imbalances require high trade surpluses until they are finally reversed.

So there’s the dilemma: they’re damned if they do and damned if they don’t. So far the authorities do not seem to be seriously considering raising interest rates, and my guess is that if the US successfully pressures them to revalue the currency, they will be even less likely to do so.

In fact they may do what they did the last time the currency revalued – engineer a reduction of real interest rates and a rapid expansion of credit. This will counteract the contractionary effect of revaluing the currency – competitiveness lost because of a higher currency will be counterbalanced by competitiveness gained by lower costs of capital.

This of course will also put more upward pressure on the trade surplus, allowing China to continue to use the external sector to absorb excess capacity. Of course it will also sharply increase the asset misallocation problem – as Japan demonstrated after 1985 when, in response to the appreciating yen, they reduced interest rates and expanded credit.

So interest rate policy has to choose between rising bankruptcies or rising misallocation of capital. Even ignoring political pressures, this isn’t an easy choice. And it will require a great deal of sympathy and cooperation from abroad.

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