Former Economics Editor of the NZ Herald

Brian Fallow: Carefully uncaging Chinese tiger


Beijing's process of financial liberalisation will release a torrent of capital into markets around the world.

The People's Bank of China headquarters in Beijing. With the freeing of financial markets, the absence of social safety nets could be a scary prospect for elderly Chinese. Photo / AP
The People's Bank of China headquarters in Beijing. With the freeing of financial markets, the absence of social safety nets could be a scary prospect for elderly Chinese. Photo / AP

China has embarked on a process of financial liberalisation and the sheer numbers involved mean it will have profound implications across the region.

"We know it will happen, we know it will be large, what is very difficult to predict is exactly how it will play out," three of ANZ Bank's most senior economists say in a report, Caged Tiger: The Transformation of the Asian Financial System.

They point to the striking disparity between the spectacular growth of China's real economy and its share of world output and trade on the one hand, and its relatively underdeveloped - one might say stunted - and insular financial system on the other.

But the Chinese authorities are committed to changing that.

The head of its central bank, Zhou Xiaochuan, said this month that he expected deposit interest rates to be liberalised "within a year or two".

At present deposit interest rates are capped, at levels which often deliver very small, even negative returns after inflation. The ugly name for this is financial repression but it has served to keep the cost of capital, for approved borrowers at least, low.

It has also inevitably encouraged speculative investment in property, and a copious flow of funds into the less regulated shadow banking system.

More broadly China's leaders have committed to moving towards allowing markets to play a "decisive role in the allocation of resources" and towards opening the capital account.

Governor Zhou's New Zealand counterpart, Graeme Wheeler, says opening the capital account, as New Zealand did in the 1980s, is one of the boldest reforms a government can undertake.

"You are basically saying to every producer in that economy, 'If you want to attract savings either from domestic or foreign savers, and capital is free to move, you have to compete against international firms in terms of of productivity and innovation and all of that'," Wheeler says. "It is a hugely powerful reform."

The ANZ economists say the present system, shared by a number of Asian countries, of capital controls and a managed exchange rate, has left trillions of dollars worth of savings "trapped" in official foreign exchange reserves and recycled, traditionally at least, into the rest of the world through purchases of US treasuries and other Governments' bonds.

Reforms which allow Chinese savings to be allocated instead by investors' quest for yield will release a torrent of capital into all sorts of markets around the world.

"The outstanding stock of Chinese foreign direct investment into other countries was around US$500 billion in 2012. This could rise towards US$10 trillion in 2030."

And they reckon Chinese private portfolio flows into global bond and equity markets could increase by US$1.3 trillion a year for the five years following the opening of the Chinese financial system.

To echo US Senator Everett Dirksen's famous comment: a trillion here, a trillion there, pretty soon you're talking real money.

"The cost of capital in markets outside of the United States and Europe is likely to fall as they benefit from increased portfolio flows," the ANZ economists say.

On the other hand to the extent it triggers a portfolio switch out of the Government debt of the US and other major western economies it could put upward pressure on global interest rates.

Which would be the stronger effect in New Zealand's case is a moot point.

If the opportunities are big, so are the risks, the ANZ economists warn.

"The international experience with financial system deregulation and capital account liberalisation is replete with examples of capital flow surges creating wide current account deficits, asset price bubbles and large banking system losses."

Remember the sharemarket crash of 1987 and the bailout of the Bank of New Zealand?

"The transition from an economy operating with a relatively rigid and closed financial system to one that allows capital to flow freely between asset markets and across borders is often associated with financial instability. China is facing these issues right now.

"The strains and stresses its industrialisation and urbanisation have put on the banking system run the risk of leaving the banking sector stymied with bad debts, undermining the efficient allocation of capital within the economy into the future."

A particularly wary eye is cast these days on China's shadow banking system.
National Australia Bank economists in a recent note define a shadow bank as a financial institution that provides services similar to those of a traditional bank but lacks the regulatory oversight or supervision that traditional banks receive.

"In most cases, shadow banking activities are completely legal. However the lack of regulation means that tracking the characteristics of loans - such as their size, interest terms and maturity dates - and the flow of funds can be much more difficult."

As an illustration of that opacity, the most recent estimate of the size of China's shadow banking system the NAB economists quote, from the US bank JP Morgan last January, is 47 trillion renminbi (or nearly $9 trillion).

That is three times the estimate the ANZ economists offer.

But even at the JP Morgan level it is comparatively modest by international standards, ranking between Japan and Germany, when measured against the size of the economy.

The concern is rather about the speed with which it has been growing, by 75 per cent in just three years on JP Morgan's estimate.

"In part, the growth in shadow banking ... reflects credit rationing imposed by Chinese authorities to slow bank loans and address overheating in some sectors of the economy such as real estate," the NAB economists say.

It is attractive to small and medium sized enterprises, which face significant disadvantages in both access to and cost of finance when compared with larger state-owned enterprises, and offers savers higher returns than are available under traditional deposits.

One risk is the misalignment of investment horizons - short terms on the funding side but financing long-term things like local governments' infrastructure projects.

Another is moral hazard. The rarity of defaults creates the risk that these savings products are seen as safer than they are.

But if the Chinese Government's commitment to "allowing the market to play a decisive role in the allocation of resources" means anything it must include allowing enterprises to fail - freeing up resources like workers and factory space - and allowing investors and lenders to lose their money.

Defaults are likely to occur within the broader shadow banking sector, particularly in relation to trust loans to industries with poor profitability, such as the coal sector, the NAB economists say, citing estimates by Bank of America Merrill Lynch that the coal industry accounts for around 14 per cent of the top 200 trust products maturing this year and next year.

Should we care? Might China's shadow banking system form the epicentre of Global Financial Crisis II, the sequel?

The NAB analysis suggests not.

"Concerns of financial contagion in response to such a default are not baseless. However with careful management they can be significantly reduced. The vast majority of shadow banking involves domestic counterparties, so the likelihood of a Chinese default spreading to global financial markets is minimal."

China's banks have considerable capital reserves to meet obligations that may result from the collapse of a wealth management product or trust which they back, they say.

"In addition, Chinese authorities have considerable scope to inject liquidity into financial markets. That said, should a default trigger a wave of risk aversion among Chinese investors, attempts to liquidate comparatively risky shadow banking assets could have a significant negative impact on the real economy."

This may be too sanguine a view.

The problem is that this is unfamiliar territory for many Chinese savers.

If a couple of NZ superannuitants lose their life savings in the collapse of a finance company, our sympathy is moderated by thoughts of eggs and baskets, the assumption that they probably own their own home and that in any case their NZ Super will continue.

In the absence of comparable social safety nets it could be a much scarier prospect for their Chinese counterparts.

So the risk of a panic and a credit crunch may be small but it is not zero.

Conscious of that, and of the nexus between financial stability and social and even political stability, the Chinese authorities can be expected to err on the side of caution and proceed gingerly with their liberalisation.

New Zealand's experience of the bull-at-a-gate approach suggests that is wise.

- NZ Herald

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Former Economics Editor of the NZ Herald

Brian Fallow is a former economics editor for the New Zealand Herald. A Southlander happily transplanted to Wellington, he has been a journalist since 1984 and has covered the economy and related areas of public policy for the Herald since 1995. Why the economy? Because it is where we all live and because the forces at work in it can really mess up people's lives if we are not careful.

Read more by Brian Fallow

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