Can China's New Central Banker Restart Reforms?


China has a new central banker:

Yi Gang,

outgoing Governor

Zhou Xiaochuan’s

longtime deputy. Investors should be cheered that a U.S.-trained economist—known, like his boss, as an advocate of market-based reforms—nabbed the role.

They should also recognize his limitations. Fixing China’s financial system—and making further substantial moves toward a free-floating yuan—requires real state-enterprise reform, a dim prospect under

Xi Jinping,

China’s powerful statist president. China’s central bank has plenty of talent within its ranks. What it doesn’t have is the political clout to force real change when it comes to China’s persistent moral hazard problem.

Sure, the Xi administration’s top-down, post-hoc approach to China’s debt problem, including forced factory closures and banning various risky lending schemes, has had some success so far. The central bank, although not fully independent like its western counterparts, played a key role by nudging interbank rates higher last year, deflating a dangerous bond bubble.

The incentives that led to the bad debt buildup and the financial system’s increasing complexity still persist, however. The next time the economy turns down, there is a significant risk of another ramp up in questionable lending.

Even though Chinese deposit and lending rates are, in theory, now fully liberalized, the state’s influence continues to distort banking in subtle and powerful ways. Depositors still feel safest leaving their money with the biggest state institutions, which still feel safest lending to politically favored state enterprises. Small and medium-size banks, meanwhile, have trouble attracting deposits although they do much of the actual lending, particularly to the private sector. The result: they have to continually borrow money from the bigger banks, and sell bonds, certificates of deposit, and a constantly mutating array of high-interest investment products to raise funds.

Beijing’s campaign against so-called wealth-management products hasn’t halted this trend. Traditional deposits as a percentage of small and medium-size banks’ total funding has continued to creep lower, and now make up just over half such banks’ liabilities, against nearly 70% for the largest institutions.

On the asset side, China’s cyclical uptick has obscured the fact that state-owned firms continue to absorb bank funds—and create questionable assets—at an alarming pace. The Xi administration’s preference for the state sector has only deepened the problem. Investment by state-controlled companies hit a six-year high at 37% of China’s total in 2017. Yet state-owned industrial firms’ return on assets remains dismal—at 3.5% by mid-2017, below both benchmark loan rates and private firms’ 10% rate.

Fragile funding for small banks and a lot of low-performing state assets—which require a deep pool of cheap deposits at home—makes the prospect of a truly open capital account and a free-floating yuan rather problematic. China’s financial system, as currently constructed, cannot withstand heavy money outflows.

Chinese reformers’ rhetoric may cheer the spirit. Real change to the country’s capital-account regime still requires fixing deep-seated problems at home.

Write to Nathaniel Taplin at nathaniel.taplin@wsj.com



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