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July 29, 2013

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Home » Opinion » China Knowledge

Lower growth rate helps economy as useless investment will end

July 29, 2013, Monday | Print Edition

On June 19, US Federal Reserve chairman Ben Bernanke announced that the US central bank planned to end its five-year quantitative easing program later in 2013, when the US economy is expected to pick up.

 

The Fed’s intentions reverberated around the globe, as prospects for higher US interest rates and the end of easy money prompted capital outflows from China and other emerging markets. Indeed, Bernanke’s speech helped catalyze a surprising liquidity squeeze in China — one that signals more change to come in that country’s financial system and carries broad implications for the global economy.

 

On June 20, China’s overnight interbank lending rates — the rates at which banks borrow from each other — spiked to their highest levels ever: The seven-day repurchase rate reached a record 12.45 percent, closing at 11.62 percent, triple the year’s average of 3.85 percent, according to Bloomberg.

 

China’s central bank, the People’s Bank of China (PBOC), declined to inject liquidity to calm the markets. On June 24, the Shanghai Composite Index witnessed its biggest decline in four years and continued to drop the following day until the PBOC said that it would infuse more money to stabilize the system.

 

Gradually, an explanation emerged: The central bank allowed the squeeze on bank credit to rein in irresponsible bank lending to the so-called shadow banking industry.

 

With trillions of dollars in reserves and money supply growing at 15.8 percent during the last year, China has no real liquidity shortage.

 

Yet, small- to medium-sized enterprises are starved for capital, while bank loans fund speculative shadow banking wealth management products and questionable local government-backed projects instead, according to Xinhua, China’s official news agency.

 

The PBOC’s hard-line approach was a wake-up call, signaling that China’s new leadership under President Xi Jinping and Premier Li Keqiang is preparing to undertake potentially significant structural reform of the economy, replacing fast growth — driven by low-cost, state-directed investment — with slower growth driven more by market forces, private sector enterprises and consumption.

 

With the PBOC’s attempt to rein in credit overexpansion, analysts are now lowering expectations that China will reach this year’s 7.5 percent GDP growth target, already below the average annual 10 percent rate of the last 30 years. Yet, slower but more sustainable Chinese growth can be positive for China and the world.

 

“The rest of the world has accepted for so long the inevitable rapid Chinese GDP growth, that we need to adjust expectations,” says Wharton management professor Marshall Meyer. “Even if growth rates go down, it’s for the better, because useless investment will cease.”

 

In a November 2012 paper, the International Monetary Fund concludes that China needs to lower its investment by 10 percentage points of GDP to ensure its most productive use. The cost of the high investment has been borne by households, estimated at almost 4 percent of GDP per year, the paper notes.

 

Meanwhile, small- and medium-sized enterprises — often the engines of economic growth — face high costs of capital, because low-cost bank lending is available only to large state-owned enterprises.

 

In the shadows

 

Shadow banking, or lending that takes place beyond China’s regulated banking industry, illustrates some of this phenomenon. In a popular practice, shadow bankers raise funds from investors through wealth management products (WMPs), often offering 6 percent annual interest, compared to ordinary bank deposits carrying a low, government-set 3 percent rate.

 

The shadow bankers, in turn, lend the proceeds from WMPs to small- to medium-sized enterprises or local government projects otherwise unable to get bank loans. The problem: WMPs are short-term, often maturing in three or six months, but are funded by these longer-term loans. To pay off investors when the WMPs come due, WMP lenders borrow from banks, which get their funds through the interbank lending market. The Chinese liquidity shortage in June was the PBOC’s attempt to squelch the growth of WMPs.

 

Yet, shadow banking itself is not necessarily bad for China and may actually serve to apply “back-door pressure to liberalize the financial system,” says Pieter Bottelier, senior adjunct professor of China Studies at the Johns Hopkins University School of Advanced International Studies.

 

“My conjecture is that authorities are deliberately allowing dual pricing in the financial market to make it easier to abandon controlled interest rates once 80 percent of the market is at free market prices,” he says. But with only about 50 percent of financial market intermediation at uncontrolled prices, it may take some time, he adds.

 

Adapted from Knowledg@Wharton, http://knowledge.wharton.upenn.edu. To read the original, please visit: http://knowledge.wharton.upenn.edu/article.cfm?articleid=3313

 

 

 

 

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