The mainland equities market is stricken with problems such as insider trading and false reporting on earnings. China’s major stock indices have been among the worst performing in the world for several years and the losers have generally been retail investors. Trust in the market has been all
but depleted.
At the same time, the CSRC maintains an overbearing role in the approval process for companies coming to market. The regulator closed the IPO pipeline between November 2012 and January 2014. Nearly 1,000 firms queued for approval; some reportedly went bust in the desperate search for capital. The CSRC has promised to move away from its rigorous approval process for new listing by enacting an IPO registry, where all companies that meet a set list of regulations can sell shares on the market. However, it’s stumbling in that effort. In 2014, the regulator has signaled that it will continue to tightly control the number of IPOs, allowing just 100 firms to list in the second half of the year.
The laggard pace of capital markets reform at home will stall any major openings in China’s capital account. Chinese investors tired of losing money on domestic bourses will jump at the first opportunity to put their money into better-performing capital markets overseas; meanwhile international investors aren’t exactly eager to access China’s exchanges. The QFII quota proves this point: Of the US$150 billion available to international investors, nearly US$100 billion hasn’t been used.
“If the capital account is fully open there would be huge outflow,” says Dariusz Kowalczyk, senior analyst at investment bank Credit Agricole in Hong Kong. “It would reduce banks’ deposit bases and the ability to fund growth in China and lead to a collapse of the exchange rate.”
International foreign investors already have diversified stock portfolios whereas Chinese do not,Kowalczyk pointed out, another reason why more capital would pour out than in.
When reform is not enough
For the People’s Bank, perhaps the most difficult aspect of coordinating financial reform will be trying to get state-owned companies and local governments to follow their lead.
China isn’t just waist deep in reworking its financial system. The country is also carrying out much-needed overhauls in nearly every corner of the economy. That includes shaking up the way in which local governments fund their public works, how rural migrants move to cities and how state-owned enterprises operate. All of these overlap with financial reform, especially with the liberalization of interest rates.
China’s budget law prevents local governments from taking on debt. To circumvent this rule, towns, cities and provinces have set up companies, called local government financing vehicles, to borrow in their place. These companies go on to hire other firms, often state-owned, to build roads or erect apartment buildings and the funds stay off the government balance sheets. A national audit publicized on the last day of 2013 showed that local governments had racked up nearly US$3 trillion in debt; some county-level authorities had debt-to-GDP ratios of more than 70%.
This model of growth at the local level is inherently flawed. Local governments base their public works on centrally set economic development targets. Officials, who are flown in for temporary leadership posts, must hit the targets to be promoted to another position somewhere else, leaving a pile of debt behind. Generating growth has relied on the rapid building of infrastructure often without consideration for demand or how projects will produce a profit capable of paying off the loans used to fund them.
The cheap cost of borrowing has played a major role in this process. For decades, banks have channeled depositors’ money to local governments and state firms at a very low price. The recipients have few budget constraints because governments aren’t sensitive to changes in interest rates as long as the money keeps coming. After all, officials in Beijing have mandated local officials to grow this way.
Interest rate liberalization is set to give the model a painful death. Once the cap on deposits is scrapped and interest rates rise, banks will no longer be able to funnel cheap money to local governments. The question is: Can local governments stomach this kind of financial reform?
“I recently realized that financial liberalization is not enough,” say Shen Jianguang, chief China economist at Japanese investment bank Mizuho in Hong Kong. “Actually, what I think is wrong now is that financial liberalization has progressed very fast but fiscal reform as well as SOE reform are lagging behind.”
Progress is being made on the local level – albeit slowly. Since 2011, China has experimented with municipal bond markets in which cities will eventually be able to issue their own debt.
In order to value the bonds, these governments must first straighten up their balance sheets, a long, tedious process. As regional governments build infrastructure, the value of those projects are usually assessed upon completion. But appreciation or deterioration of these assets has not been recorded in most places. Experts who spoke with China Economic Review said that this process is still far from complete and local bond issuance will not happen anytime soon. That means a change to interest rates could limit local government access to capital long before they have found an alternate means of funding. Local officials may soon find their economies running on an empty tank.
The 2016 timeline announced by PBOC governor Zhou in March was likely meant to grab the attention of these governments and other parties set to be shaken by reform.
“I would think that announcing in advance a liberalization of deposit rates is designed to give banks, governments and SOEs time to adjust their policies, capital structures and approach to a more market-based financial system,” said Michael Spence, a professor at New York University and winner of the Noble Prize in economics.
Black swan
The entire economy will need to prepare.
China’s growth is slowing yet the cost of borrowing is rising, putting mounting pressure on the property sector, one of China’s most important sectors for growth and employment. Residential real estate prices are slowing while developers are left with great amounts of housing supply on hand. Most of these businesses are highly leveraged and rely on advanced sales of new homes to pay off debts.
Financial reform is not helping developers. If property sales continue to fall, developers will be increasingly reliant on a steady channel of credit to roll over loans and avoid default. Interest rate liberalization will drive up the cost of this borrowing and reduce the banks’ abilities to funnel cash to distressed companies.
A black swan event could be hidden somewhere in this confluence where economic slowdown meets financial reform.
Real estate loans account for 20% of total outstanding loans at China’s commercial banks, according to the Peterson Institute for International Economics. At the same time, up to a third of the country’s GDP is directly connected to property development with the residential sector accounting for about 70% of that growth.
“If [real estate] suffers a slowdown then the whole growth of the economy is under pressure,” says Kowalczyk. “One of the reasons we have delays in interest rate liberalization is precisely because of economic weakness, in particular in the real estate market.”
As PBOC continues to check items off of its to-do list and push harder for advances in financial reform, it will need to make sure that it doesn’t nudge the property sector off a cliff.