Excitement is growing about possible shifts in China’s financial markets, following the release of a blueprint for capital account liberalisation by the central bank official last week. And for good reason: This development would profoundly re-shape financial markets and global savings trends.
At present, China’s economy is characterised by top-down monetary management, artificially low interest rates and a closed financial system. But last week, the head of the bank’s statistics department proposed liberalising stock and bond markets for foreign investors and taking active steps to globalising the renminbi. Debate about China’s capital account liberalisation plans has raged for years but this was seen as the one of the most detailed public proposal on loosening controls.
The proposal has been met with a healthy dose of scepticism internationally. Many commentators argue the eurozone crisis and the country’s upcoming political transition have underscored the attraction of the stability and financial protectionism conferred by China’s current monetary model. And market consensus remains that China will continue to move towards reforms in baby steps.
But recent measures by the PBoC highlight how high the stakes are. Pressures are growing for a more liberalised capital account within the financially repressed economy, while the government is in no rush to decontrol interest rates, a pre-requisite for monetary reform.
Hence the PBoC has had to take active steps towards curbing off-balance sheet transactions in order to retain its hawk-like grip on the financial system.
An excellent report from the Institute for International Finance (IIF) on Monday digs deeper. First, here is how off-balance sheet financial activity by banks has grown ever since China implemented monetary stimulus to shore up growth in the post-Lehman environment:
| This activity expanded rapidly with the explosion of liquidity, growing sophistication of the banks and the slow pace of financial sector reform. Off-balance sheet transactions provide an avenue for banks to increase business and profitability by circumventing credit quotas and the fixed interest rate regime. Official lending rates are subject to an administrative floor, while official deposit rates are subject to an administrative ceiling. The corporate sector and the growing ranks of wealthy individuals aided the expansion of off-balance sheet transactions by seeking higher returns and investment alternatives to bank deposits. As large banks favor doing business with the state enterprises, the rapidly growing private sector also sought alternative intermediaries or channels to meet their strong demand for funds. In addition to hampering the effectiveness of monetary policy, off-balance sheet transfers are viewed by the government as increasing market and credit risk, as well as creating the potential for destabilizing the banking system. |
And the regulatory backlash:
| A key measure taken by the PBOC was the directive issued at the end of the third quarter of 2011 instructing banks to include margin deposits as part of total deposits eligible for the reserve requirement. Margin deposits are placed in a bank by a client in return for a bank guarantee or Bankers’ Acceptance (BA), which is a short-term note issued by a company and guaranteed by a bank ). In addition to evading the reserve requirement, banks favored margin deposits because they counted as deposits in the loan-to-deposit ratio. BAs are excluded from the loan calculation of the loan-to-deposit ratio, which cannot exceed 75%. BAs are most widely used in international trade by the large state-owned enterprises, and had been one of the most prominent sources of the [financing] until the imposition of the reserve requirement. |
In other words, China tightened monetary policy by broadening the base used to calculate domestic banks’ required reserves, including previously-lucrative margin deposits, all in a bid to reduce off-balance sheet lending.
And recent figures highlighting aggregate financing flows in China show the policy has had some success. What’s more, the PBoC has in recent weeks warned banks that illegal off-balance sheet lending will be severely punished.
In sum, the PBoC shows little sign of accommodating financial innovation and adopting a liberal posture. In the IIF’s words:
| The official aversion to the expansion of off-balance sheet transactions is in keeping with frequently stated concerns that financial activities which take place outside of regulatory oversight have the potential to build systemic risks over time. The success of measures curbing the emergence of Trust Loans and BAs highlight the usefulness of TSF in alerting the authorities to new financing avenues. While these factors may help safeguard financial stability over the near term, they suggest that the government is in no rush to decontrol interest rates or abolish lending quotas, which have spurred financial innovation in these areas. |
The central bank is already grappling with the challenge of averting a crisis in the local government debt market. The last thing it needs is pesky financial innovators seeking to circumvent draconian internal controls. Although the PBoC might ultimately fail in curbing off-balance sheet activity given market pressures, it will do its darn best.
In other words, since banking sector reform is a pre-requisite for capital account liberalisation, there are few basic conditions in place on the mainland for China to liberalise its capital account.
Further reading:
Coverage of China - EM