Michael Pettis has a blunt way of describing the China predicament, after Friday saw the People’s Bank raise required reserve ratios for the seventh time over the past year, in an effort to rein in inflation and curb lending by the country’s banks.
In a sentence, it’s “damned if you do and damned if you don’t.” The issue, says the Shenyin Wanguo Securities analyst and all ’round China expert, is that high or just persistent inflation creates “an almost unsolvable problem for the PBoC.
On the one hand the PBoC can raise nominal interest rates in tandem with inflation (which they have certainly not done so far) so as to keep real rates unchanged. The problem of course is that raising nominal interest rates – even if real rates are unchanged – is effectively the same as accelerating principal payments, and with many borrowers struggling to generate the cash flows needed to meet interest payments, a significant rise in nominal interest rates could cause a sharp rise in financial distress.
On the other hand the PBoC can repress interest rates further, allowing them to rise much more slowly than inflation, but this would make deposit rates even more negative in real terms than they already, putting more downward pressure on household income as a share of GDP, and with it household consumption. (Given the high level of household savings relative to household income, income on those savings should be a significant part of overall household income). Lower, or negative, real lending rates would also make it even more rational to borrow money and spend it foolishly on increasing capacity, fueling bubbles, or building even more non-economic real estate and infrastructure projects. In that case lower real interest rates means worsening the imbalances in the economy.
So with rising inflation, it is dammed if you do and damned if you don’t, and the fervent discussion within policymaking and analyst circles has not arrived at any resolution. This discussion has, however, generated two claims, one of which is debatable and the other is just plain foolish. The debatable claim is that raising interest rates and reducing lending is one of the ways the PBoC can combat inflation.
We’re going to focus on the ‘foolish claim.’
That’s the notion, Pettis says, that China was able to ‘grow out of’ its last banking crisis (which happened a decade ago) and can therefore do so again.
This is just WRONG! says Pettis, but with less caps and exclamatory marks.
Some 10 years ago, China did suffer a banking crisis, but it did not escape from it unscathed. In fact, China’s crisis was resolved just like all banking crises tend to be resolved — by transferring wealth from households/taxpayers to the banks. For instance, by lowering lending rates to spur investment and help out borrowers.
The problem, though, is that this subtle debt-forgiveness doesn’t come free:
The combination of implicit debt forgiveness and the wide spread between the lending and deposit rate (which adds at least another 100 basis points annual loss to household depositors, and probably more) has been a very large transfer of wealth from household depositors to banks and borrowers. This transfer is, effectively, a hidden tax on household income.
It is not at all surprising, then, that growth in China’s gross domestic product, powered by very cheap lending rates, has substantially exceeded the growth in household income, which was held back by this large hidden tax – and my back-of-the-envelope calculation suggests that the tax has amounted to at least 5-7% of GDP annually (all the more painful when you consider that in China, household income is only around 50% of GDP). It is also not at all surprising that household consumption has declined over the decade as a share of gross national product from a very low 45% at the beginning of the decade to an astonishingly low 36% last year.
So in the end this is really how China’s banking crisis was resolved. It was not that China managed to grow rapidly and resolve the NPL problem with growth. It is that both China’s rapid growth and its rapidly developing imbalances were at least in part the consequence of polices aimed at resolving the NPLs. The banking crisis did not result in a collapse in the banking system, but it nonetheless came with a heavy cost. The banking crisis in China resulted in a collapse (and there is no other word for it) in household consumption as a share of the economy.
You can see where this is going, then. The worry is that a surge in non-performing loans amongst China’s banks won’t be so easily resolved this time around. Households would have to pick up the tab (once again) leading to even more imbalances.
PBoC rock — meet hard place.
China-Japan analogy du jour – FT Alphaville
China’s crouching commercial paper, hidden loan targets – FT Alphaville
Here comes the quantitative tightening… – FT Alphaville