China: Rate Hikes Likely on Excessive Loan Growth
Andy Xie (Hong Kong)
Summary and conclusions
Loan growth in China remains excessive, due largely, I believe, to local governments racing to hoard credit in anticipation of further tightening. This may force the central government to take additional measures soon. I expect China to increase both deposit and lending rates by 27bp shortly and by another 27bp before the year-end.
Two years of administrative measures to tighten the economy have failed. The stated goals of administrative measures to contain excessive capacity and ‘white elephant’ projects have not been met. The main reason is that local governments drive investment and control local banks. Moreover, local governments have been successful in attracting foreign capital wherever local funding is insufficient.
I believe that China must address the excess liquidity situation to control the economy. If credit hoarding by local governments is allowed to continue, the economy could run out of control for a long time. I expect the central bank to continue to drain liquidity out of the banking system and allow interbank interest rates to rise.
Administrative measures have failed
Despite repeated efforts by some central authorities, administrative measures have failed to regulate China’s economy properly. In 2004, when the overheating began, administrative measures were preferred to a monetary policy approach on the grounds that overheating was restricted to certain pockets, a monetary policy approach would damage the healthy parts of the economy, and administrative measures would be more efficient in targeting the overheated areas.
Two years later, these administrative measures have failed to achieve their stated goals. Excess capacity has become a bigger problem and more prevalent. The property market has turned into a nationwide bubble from being concentrated in a few coastal cities. Wasteful investments have multiplied.
The failure of the administrative approach is due to two factors, in my view. First, the central government has not been sufficiently determined. The administrative approach works effectively when it is accompanied by a rigorous anti-corruption campaign. The anti-corruption campaign has been tepid, however. Moreover, the potential financial implications for vested interests are much greater in this cycle due to the size of the property market.
Second, as line ministries for industries are no longer effective while state ownership remains dominant in capital-intensive industries, local governments have assumed a dominant role in fixed investment. Even though local governments have lost some influence over state banks, they control local banks, which are rapidly expanding their market shares. The local banks have been borrowing funds from state banks in the interbank market to fund their expansion.
China’s political system and economic structure have changed sufficiently to make micro fine-tuning by the central government ineffective. Such failure of the administrative approach to macro management in this cycle suggests that China must shift towards the global standard approach to macro management via fiscal and monetary policies.
Credit surge poses risks to the financial system
China’s risk management system is still developing. Rapid credit growth raises the risk of deteriorating credit quality and the rise of non-performing loans. In particular, a substantial proportion of loans are secured with land and property. Land prices have skyrocketed in many cities, and hence the potential for a substantial correction appears high, threatening the collateral value of many loans.
When a banking system has immature risk management systems, quantity control over credit expansion is of paramount importance for credit quality. Historically, rapid credit expansion in immature banking systems has led to bad debt problems without exception. China’s NPLs peaked at 40% in the previous cycle. Adjusting for inflation, real credit growth has been faster in the current cycle than in the previous one. The property market is also much bigger relative to the economy. We see both facts as warning signs that credit quality could suffer severely when the cycle turns down.
We suspect that credit hoarding is a major force in the current wave of loan growth. Local governments may be using land to secure loans without immediate construction plans. This would explain the decoupling of electricity demand and loan growth. The expectation of further tightening measures provides a motive for credit hoarding, but such hoarding destabilizes macro controls and makes further tightening expectations self-fulfilling.
Excess liquidity is the root cause of macro imbalance
The root cause of China’s excessive credit expansion and the associated ills (e.g., property speculation, overcapacity, etc.) is excessive liquidity in the banking system. Despite rapid loan growth, the loan/deposit ratio in the financial system has declined to 67% now from 77% in 2002. Banking reform has made banks more profit-oriented and, hence, more willing to lend when they have funds.
There are many reasons for the excessive liquidity in the banking system. First, China’s export success is clearly a major factor. China’s exports have risen three times as fast as global trade since 2002, compared with twice as fast in the previous two decades. China joining the WTO led to massive relocation of manufacturing to China, and this has resulted in its extraordinary export performance.
Second, speculation over renminbi appreciation has meant that local companies and households are less willing to hold dollars. Foreign currency deposits in the financial system grew by 3.2% per annum between March 2003 and March 2006, versus 11.2% in the preceding three years. Further, an unspecified but large amount of capital has flowed into China for the purchase of local currency assets (e.g., property, equities, bonds and bank deposits).
Third, recent reforms have strengthened government and SoE finances, shifted financial burdens to the household sector and increased uncertainties in respect of household expenditure. Government revenue and SoE profit have been rising about twice as fast as household income. This has led to less demand for credit from such entities, which has contributed to the excess liquidity in the banking system.
The household sector has not increased credit demand sufficiently to offset the waning credit demand from the government and SoEs. This is due largely to a declining share of household income in GDP, rising uncertainties over future expenditures (e.g., education, healthcare) and the lack of a robust pension system.
The government is pursuing structural reforms to remedy the situation. Measures to increase export production costs, cut down healthcare and education costs, cap property prices and improve the pension system are already in the works. Over time, China should be able to shift towards a more consumption-oriented economy with balanced liquidity.
Dealing with excess liquidity now
While structural reforms should work over time, I believe that their effect will not be fast enough to deal with the current situation — excess liquidity fueling excess credit expansion that may lead to bad debts. The experience from the tightening of the past two years suggests that administrative measures do not work. As long as there is excess liquidity in the banking system, local governments will find ways to obtain money for their investment projects. Further, local governments have incentives to hoard credit in anticipation of further tightening. The only effective policy is to drain away excess liquidity in the banking system, in my view.
Recent indications suggest that the central government is prepared for such a policy shift. The central bank has expressed its intention to issue savings bonds to decrease deposit growth in the banking system. It is issuing bills to banks to soak up some excess liquidity. Interbank rates have been rising due to tightening liquidity.
The excessive loan growth in June indicates that the liquidity environment is still too loose. I believe that China must drain much more out of the banking system to normalize monetary conditions. While currency appreciation expectations threaten its effectiveness, the rapidly rising US interest rate has created room for China to raise interest rates. I believe that China could raise interest rates by one percentage point at the current level of renminbi appreciation expectation. If China introduced a little more currency flexibility, interest rates could rise by much more.
I expect China to raise its deposit and lending rates by 27bp shortly and by another 27bp before the year-end. In 2007, I think we could see a further 100-200bp of rate raises.
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