Something that dawned on me as I analyzed the current liquidity crisis engulfing the Chinese banking industry was to reflect on the way in which China’s top policy making body, the State Council, delays or sidesteps its most important decisions. It should come across as surprising, given China’s meteoric rise, that I should be thinking that the State Council is anything but wise and decisive about policies. But given the complexity of the system, there are decisions that have been delayed for a very long time, or made but not followed through, and which may be consequential in the near future.
In the financial services industry, the liberalization of China’s stock market never happened, notwithstanding countless assurances to the contrary. 70% of the stocks in China are owned by the state, and of the remaining free float, only a small percentage are traded even by the Chinese public. Every time the market slides, the state only shores up it stake yet again to hold prices. More recently, the state has been surreptitiously increasing its stake in the big four banks which were painstakingly opened up to international investors in Hong Kong only a few years ago.
China is now entering a very dramatic shift in its economy. The roles of foreign trade and investments have now diminished as drivers of economic growth. The real reason for the recent liquidity crisis I believe is that the central bank is now left with fewer instruments to create liquidity in the marketplace. I believe that the excuse that the central bank was trying to dissuade the “shadow banking” industry was a red herring. Nothing done by the central bank subsequent to the liquidity crisis discouraged the shadow banking industry at all.
The central bank is now really dependent on policy directions from the State Council on a number of matters. The most pressing one is which of the policy tools will the State Council activate to make up for the fall in foreign reserves. Another round of quantitative easing, in the form of a deficit budget is not inconceivable, but it is not spelt out anywhere. As an interim answer to this question, the State Council recently decided to allow provinces and state-owned corporates to issue bonds. Naturally, when the time comes, the central bank will be the buyer of last resort for these bonds.
But this forestalls a more direct programme driven as a national budget, perhaps because of the criticism it will entail, especially after the simplistic way the previous quantitative easing was applied in 2009. Also, allowing the provinces and various ministries to issue their own debt in a complicated country like China will make it difficult even to calculate the total liabilities created in this way. This lack of transparency works in the favour of the central government being able to maneuver during turbulent times.
Sometimes we think that the policy statements are in place, but the most substantive ones are not. While there are many policy statements issued to encourage the liberalization and the real transformation of the banking system, hardly any of them have found the light of day, if only because the State Council issues many economic and social policy statements that contradict each other, resulting in essentially nothing happening.
Very simply, real reform to the banking industry will only begin when deposit insurance is set in place. The Chinese banking system is one of the most efficient in the world in transforming policy into practice. I have seen the banks consolidate thousands of data centers within a matter of months, while the same would take forever in much smaller countries. I know that introducing deposit insurance can be done within one year, but only as soon as the policy direction is triggered.
Since deposit insurance will set in place a whole series of profound competitive changes to the banking system, the lack of clarity is allowed to continue. It will set the stage to liberalize interest rates fully and finally allow for credit to flow to parts of the economy that needs it most. It will make small banks as competitive as big banks. It will allow bankruptcy as a tool for making shareholders wipe out the bad loans of badly run banks, instead of the state picking them up into asset management companies, as they do now. But the State Council is clearly not ready for an economy that is not driven by state-owned enterprises.
We see a similar anomaly in the energy sector. The one decision that could make a remarkable difference to the profound environmental pollution that China’s cities suffer would have been to use higher grade coal. Despite lengthy policy statements on clean breathing air, and even a recent commitment to spend $270 bil ($1.1 trillion renminbi) on projects, the decision that the State Council needs to make is to allow energy prices to go up. The sub-text on current policies is really that they are willing to try any alternative except to make that one decision to use more expensive energy.
The recent decision to liberalize the floor on bank interest rates was a curios move in the opposite direction. Instead of liberalizing the banking industry, the move reinforced the position of the Big Four banks and assured access to funding for state-owned enterprises. There is some thinking at the China Banking Regulatory Commission (CBRC) and the central bank that removing the ceiling would have been better for the long term. The sub-text here is that the policy makers are still in the mode of protecting the model they are familiar with, instead of inching towards something they potentially cannot control.
Finally, they will eventually need to answer for themselves their position on increasing wages as an economic tool. It may be that the country’s property prices may be inflated at the moment, but only in selected cities. The wealth created in the past thirty years through greater supply chain efficiencies, foreign trade and investments are not going to last very long.
Again, there is much already said in the State Council’s statements in recent years. They see it coming. But again the most fundamental of policies are not in place, let alone in action. Higher wages will enable the government to subsequently liberalise the social infrastructure as people’s expectations rise. Health care is currently artificial and subsidized. Energy is subsidized. Education is state-supplied. Public transport is highly subsidized. The guaranteed lifetime pension liability of the state for its employees is potentially unsustainable in the future – at about 90 percent of the last drawn salary. The thinking behind these infrastructure are perhaps the best reminder that this is still a communist state.
The reason members of the State Council traditionally avoid the hardest of decisions is understandable. Many of its members have spent a lifetime getting to their positions and to take a stand is to risk a lifetime’s worth of work. The debate on managing inflation have historically been the hardest inside the State Council, dividing opinion and camps passionately. There is also a benign paternalistic care that the Chinese government provides its people, that protects them from the harshest of an otherwise capitalistic economy.
Generally, the working policy model for a whole range of less consequential decisions functions very well. The State Council makes a vaguely worded policy and the ambitious young people at the provincial or ministerial levels chisel out the details. Mistakes are corrected and modified and the country looks picture perfect. But some events have a way of carrying the decisions with them, and I do believe that if the State Council keeps avoiding liberalizing the financial sector now, tomorrow may be a bit too late.