(Version in 中文)
One of my all-time favorite movies is “The Third Man” starring Orson Welles and Joseph Cotten. It is a British film noir from the 1940s. Perhaps the most striking part of the movie is the shadowy cinematography, set in post-World War II Vienna. Strangely, it springs to mind lately when I have been thinking of China.
Many China-watchers looked on in awe in 2009 as the government’s response to the global financial crisis unfolded, causing bank lending as a share of the economy to expand by close to 20 percentage points in less than a year. This, subsequently, led to a lot of hand-wringing about the consequences of those actions and the eventual credit quality problems that China would have to confront and manage.
However, around the same time, a less visible phenomenon was also getting underway. One that, like Orson Welles’ character in the movie, resided firmly in the shadows. Various types of nonbank financial intermediaries—some new, some old—were gearing up to provide a conduit through which China’s high savings would be tapped to finance the corporate sector. The available data on this is terrible—the central bank’s numbers on social financing are the only credible and comprehensive public source, but even that gives only a partial picture.
Talking to people in China, and looking at what numbers are available, one cannot help but have an uneasy feeling that more credit is now finding its way into the economy outside of the banking system than is actually flowing through the banks.
The means by which such “lending” is being provided is wide-ranging and dynamically evolving.
Certainly many are aware of the high volumes of bankers’ acceptances—off-balance sheet short-term credit—being used of late. Over the past couple of years, trusts and entrusted lending vehicles (China’s own particular form of asset securitization) have also taken off. Then there is the world of informal lending: loan sharks charging high interest rates to those poor souls that are rationed out of regular channels of intermediation. The recent narrative from Wenzhou has certainly excited many.
But the shadows stretch even beyond these tales.
In the 12 months to June, over RMB 600 billion poured into China from short-term lending by nonresidents to Chinese corporations. Financial leasing companies have expanded, providing services that look a lot like credit by another name. The corporate bond market has blossomed, perhaps reaching RMB 1 trillion in new issuance for this year. There is an unknown volume of inter-corporate lending passing from one large company to another. And finally, some nonbank institutions have entrepreneurially moved into the lending space, providing loans to large corporations as a way to boost their profitability.
These developments are worrying for four broad reasons.
- First, that’s an awful lot of credit. New bank credit alone is likely to be over 20 percent of GDP this year. This is already a very high number. However, if a similar amount (or more) is finding its way into the economy through channels outside the regulated banking system, this would add up to a huge amount of credit stimulus. This high level of credit, in turn, is facilitating a continued upward trajectory for investment which is fast approaching 50 percent of GDP.
- Second, the regulatory oversight for these various intermediaries is likely to be nowhere near as effective and comprehensive as it is for the banks. We have seen this in many other countries—deposits and lending migrate out of the banking system because life is just easier there without those pesky regulators asking awkward questions about how risks are being managed. It often doesn't end well.
- Third, if nonbank channels of intermediation develop at a faster pace than the banking system is reformed, the shift of resources out of the banks and into the shadows will progressively start to undermine the health and stability of the banks themselves.
- Finally, and perhaps my largest concern. The rapidly expanding nonbank system is actively undermining China’s ability to exercise macroeconomic control. This, in large part, reflects the structure of the current system. China uses monetary tools like interest rates and reserve requirements sparingly and, instead, relies heavily on quantitative limits on bank lending to switch on and off the credit taps and manage the pace of economic growth. These bank-by-bank credit quotas create enormous incentives for intermediaries to find other ways to lend. By not actively using interest rates and price incentives to choke of the demand for loans, China is far too reliant on controlling the supply of credit. The more intermediation that takes place outside banks, the tougher it is to enforce the credit policy that is essential in guiding the trajectory of the economy.
Thankfully, China’s regulators are trying to pursue the problem. Last year they moved to require a large share of trusts to be brought back onto bank balance sheets and, more recently, the bank regulator has issued instructions to the banks to stop moving loans off their books and repackaging them into wealth management products.
Despite these efforts, this risks the regulatory authorities perpetually being one step behind the financial innovators, always patching up the last hole in the system.
What is needed instead, as we have argued for some time now, is a careful reexamination of the whole monetary and financial framework. Policies that restrain credit through administrative means are becoming increasingly difficult to sustain. It is only going to get worse. This has been the experience of every other country that has tried to exercise macroeconomic control this way. China, admittedly, has held the system together exceptionally well for many years and it is never wise to bet against the government’s ability to diagnose and successfully resolve problems as the economy develops and becomes more sophisticated.
That does not alter the fact, though, that China is now facing a clear choice: pursue financial and monetary reform on a timetable that is driven by careful, pre-emptive, and concerted policy planning. Or, face the possibility that change will evolve in an uncoordinated and disorderly way, with innovation and disintermediation outpacing supervisory capabilities and revealing regulatory gaps along the way.
At the end of The Third Man, Orson Welles emerges from the shadows and, unfortunately, promptly meets an untimely end at the hands of Joseph Cotten. It would be a major setback for China, and the global economy, if the long and proven track record of spectacular Chinese growth were to be undermined by waiting too long to make progress on financial liberalization and reform.