Tag Archives: Reform

(Revised) A Critical Move in China’s Financial Reform

China, the global growth engine, is undergoing a significant transition as the new administration is committed to structural reform in its overall economy. Undoubtedly, financial innovation is on the to-do list, and top officials confirmed an initiative this week: liberalization of the deposit rate.

Specifically, the country’s top central banker reaffirmed their commitment to liberalizing interest rates on bank deposits within two years, an unprecedented move that would force the nation’s lenders to compete for customers by offering the best terms.

What does that mean? Let’s think about this from the standpoint of China’s state-owned banks.

On the borrowing side, they have been soaking up piles of money at a relatively low cost. The Chinese central bank maintains a cap on the rate banks can pay depositors, a system that has left Chinese households poorly compensated, because deposit rates often fall short of the rate of inflation. At present, inflation is running at about 2.5%, while a one-year deposit can pay no more than 3.3%—a level China’s big banks rarely reach. However, most Chinese people still overwhelmingly allocate their assets in savings due to limited investment channels available in the country. As a result, those state-owned banks have no incentive to compete for deposits and make huge profits through the cheap funding.

But with the reform of deposit rate liberalization, they have to improve operations and manage risks more prudently so as to offer the best possible rates in the deposit competition. Who is the winner? Savers! They are highly likely to obtain higher pay on their deposit under the fierce race.

On the lending side, China’s banking sector is well known for the so-called shadow banking system. State-owned banks mainly make loans to state-owned enterprises and many small and medium enterprises (SMEs) are struggling with financing. Furthermore, state-owned banks bypassed the savings restriction by offering wealth management products. The seemingly fancy name of “wealth management” is just another channel of financing. Basically, banks offer higher-than-deposit rates on financial products sold to the general public and then charge even higher rates on lending to government-led investment projects. In this scenario, banks and the government are both winners because they could easily pocket the difference between cost and return, but savers might be the loser since the mismatch of short-term maturity of products and long-term investment projects could trigger serious defaults.

However, I have got a concern here: there is a possibility that those state-owned banks might become even more reluctant to offer loans to SMEs under the pressure of higher borrowing cost. As lenders, what they really care about is borrowers’ credibility, which is usually measured by collateral size, company revenue, track record of investment projects. Consequently, those national lenders might still be skeptical about SMEs’ repayment ability and therefore fund state-owned enterprises, a continuation of what they have been doing for years.

Fortunately, the Chinese government shows its ambition for reform as Beijing advanced a pilot program of private banks at the same time, including two of the country’s Internet giants, Alibaba and Tencent.

For clarification, “Private Bank” here does not refer to the Swiss-style private banking division, which is focused on wealth management business for high-net-worth individuals and families. Instead, it is a new form of banking managed by the private sector, in contrast to those lumbering, state-owned banks.

From my perspective, this initiative would complement the deposit rate liberalization by breaking the state-dominated banking monopoly and addressing the financing problem of SMEs effectively. For instance, let’s think about Alibaba, a selected player in the private-bank trial. The company dominates China’s e-commerce market, which by one measure is now the biggest in the world. Its biggest website, Taobao, is mostly for small merchants and has developed into an online business powerhouse with about 760 million product listings from 7 million sellers. The bond between Alibaba and SMEs has been strengthened through the development of the company’s another affiliate of Small and Micro Lending Group, as well as the enhancement in the so-called Alipay, which is a electronic payment system that protects buyers if sellers don’t deliver. Therefore, the company’s well-developed understanding on SMEs and significant capital advantage tend to prompt financing for SMEs, an action partly motivated by another prospective boom of e-commerce as SMEs progress.

In conclusion, I think the liberalization of deposit rate, as well as the creation of private banks, both call for a stronger regulatory framework, as a significant portion of liquidity in those state banks and in money-market funds offered by Alibaba are flowed into unregulated and untested investments. Therefore, regulators have to develop advanced risk management and consolidation skills to integrate all players into a uniform system for sustainable growth in the financial markets.

The Inception of Private Banks in China’s Banking System

In my previous post, I focused my analysis on a critical move in China’s financial reform: liberalization of the deposit rate. The major goal of this free-up is to increase returns for Chinese savors and promote stronger risk management in state-owned banks, since they have to compete for customers by offering the best terms.

However, I have got a concern regarding this initiative: there is a possibility that those state-owned banks might become even more reluctant to offer loans to small and medium enterprises (SMEs) under the pressure of higher borrowing cost. As lenders, what they really care about is borrowers’ credibility, which is usually measured by collateral, company revenue, track record of investment projects. Consequently, those national lenders might still be skeptical about SMEs’ repayment ability and primarily fund state-owned enterprises, a continuation of what they have been doing for years.

Fortunately, the Chinese government shows its ambition for reform as Beijing advanced a pilot program of private banks, including two of the country’s Internet giants, Alibaba and Tencent.

For clarification, “Private Bank” here does not refer to the Swiss-style private banking division, which is focused on wealth management business for high-net-worth individuals and families. Instead, it is a new form of banking managed by the private sector, in contrast to those lumbering, state-owned banks.

So what motivated the authorities to launch the trial? From my perspective, it is due to two key reasons.

First, the incorporation of private capital could address the financing problem of SMEs by breaking the state-dominated banking monopoly. As mentioned above, many SMEs are struggling with funding because national lenders are more willing to offer loans to state borrowers. Comparatively, private banks run by the private sector are more capable of doing smaller-sized lending. For instance, let’s think about Alibaba, a selected player in the private-bank trial. The company dominates China’s e-commerce market, which by one measure is now the biggest in the world. Its biggest website, Taobao, is mostly for small merchants and has developed into an online business powerhouse with about 760 million product listings from 7 million sellers. The bond between Alibaba and SMEs has been intensified through the development of the company’s another affiliate of Small and Micro Lending Group, as well as the enhancement in the so-called Alipay, which is a payment system that protects buyers if sellers don’t deliver. Therefore, the company’s well-developed understanding on SMEs and significant capital advantage tend to allow it to finance SMEs, an action partly motivated by another prospective boom of e-commerce as SMEs progress.

Second, the private-bank trial could lead to an integrated framework for regulation. China’s banking sector has been in chaos in some sense, as state-owned banks are offering various wealth management products and privately owned companies are catching up by offering money-market funds, many of which are flowed into unregulated and untested investments. The creation of private banks, along with tightening control on the wealth management products offered by traditional banks, tends to integrate all players into a uniform system for regulation. Meanwhile, it also calls for stronger risk management and consolidation skills from regulators.

A Critical Move in China’s Financial Reform

China, the global growth engine, is undergoing a significant transition as the new administration is committed to structural reform in its overall economy. Undoubtedly, financial innovation is on the to-do list, and top officials confirmed an initiative this week: liberalization of the deposit rate.

Specifically, the country’s top central banker reaffirmed the commitment to liberalizing interest rates on bank deposits within two years, an unprecedented move that would force the nation’s lenders to compete for customers by offering the best terms.

What does that mean? Let’s think about this from the standpoint of China’s state-owned banks.

On the borrowing side, they have been soaking up piles of funds at a low cost. The Chinese central bank maintains a cap on the rate banks can pay depositors, a system that has left Chinese households poorly compensated, because deposit rates often fall short of the rate of inflation. At present, inflation is running at about 2.5%, while a one-year deposit can pay no more than 3.3%—a level China’s big banks rarely reach. However, most Chinese people still overwhelmingly allocate their funds in savings due to limited investment channels available in the country. As a result, those state-owned banks have no incentive to compete for deposits and make huge profits through the cheap funding.

But with the reform of deposit rate liberalization, they have to improve operations and manage risks more carefully so as to offer the best possible rates in the deposit competition. Who is the winner? Savers! They are highly likely to obtain higher pay on their deposit under the fierce race.

On the lending side, China’s banking sector is well known for the so-called shadow banking system. State-owned banks mainly make loans to state-owned enterprises and many small and medium enterprises are struggling with financing. Furthermore, state-owned banks bypassed the savings restriction by offering wealth management products. The seemingly fancy name of “wealth management” is just another channel of financing. Basically, banks offer higher-than-deposit rates on financial products sold to the general public and then charge even higher rates on government-led investment projects. In this scenario, banks and the government are both winners because they could easily pocket the difference between cost and return, but savers might be the loser since the mismatch of short-term maturity of products and long-term investment projects could trigger serious defaults.

So the impact of the reform initiative is yet to know because state-owned banks might be more reluctant to lend to privately owned firms under the pressure of higher borrowing cost. Also, this calls for strong regulatory framework to coordinate the relations between banks, firms, and savers.

What Caused the Fluctuations in Commodity Prices?

Our discussion over commodity prices in today’s class really triggered my interest. As Professor Kimball said, the price of copper at time t is equal to the sum of extraction cost and its value at time t, while the present value is the real value at time t+1 discounted by the real interest rate at time t.

Relatively, John Taylor argued that:

There is yet another downside. Foreign central banks—whether they like it or not—tend to follow other central banks’ easy-money policies to prevent their currency from appreciating sharply, which would put their exporters at a disadvantage. The recent effort of the new Japanese government to force quantitative easing on the Bank of Japan and thus resist dollar depreciation against the yen vividly makes this point. This global increase in money risks commodity booms and busts as we saw in 2011 and 2012.

His argument certainly is unconvincing based on the calculation above, and I also disagree with him on the worldwide impact of the US quantitative easing. After the burst of the 2008 global financial crisis, major economies went into recession and therefore, it is absolutely reasonable for central banks around the global to conduct expansionary monetary policy to stimulate economic growth. So the increasing liquidity itself, as a growth momentum, is not a bad thing.

In particular, I think commodity prices have a lot more to do with global demand and economic growth in some particular countries instead of the monetary policy of central banks.

Copper prices fell to a seven-month low today on concerns about an economic slowdown and the health of financial system in China.

Last weekend, China reported that its exports fell 18% in February from a year earlier, which caused the decline in copper prices because the country is the top consumer of the medal and weakening exports might be a signal of slowing growth and modest consumption.

Furthermore, the so-called “Copper Financing” in the country has significantly affected the medal’s prices. Many investors claimed that the copper market’s problems go beyond the factory floor. The cracks appearing in China’s financial system likely are playing a bigger role. Much of the copper stored in China, the world’s biggest consumer of the metal, is used by companies and investors as collateral for loans from banks and other lenders. They then invest the money in higher-yielding assets. So the emerging concern is that the recent drop in copper prices might lead to a vicious circle in China’s copper demand as banks are becoming reluctant to accept copper as collateral.

So why can “Copper Financing” be a thing in China? It has to do with the shadow banking system in the country. As Professor Kimball said in today’s class, state-owned banks mainly make loans to state-owned enterprises in China, and therefore, many small and medium enterprises have confronted the financing problem. Consequently, they have to turn to some other channels for financing.

Nevertheless, I am still optimistic about the future demand of copper in China as the newly-established administration is determined to roll out structural reform initiatives and allows the market force to play a bigger role in the overall economy. In the financial sector, the Chinese central bank is trying to increase the flexibility of the yuan as it weakened the daily reference rate for its currency by the largest percentage in more than a year and a half on this Monday, which could stimulate the country’s exports and ensure financial stability in the long run. In addition, the government is expected to curb speculation and enhance credit quality by imposing stricter restriction on the shadow banking system.