Elite Chinese Politics and Political Economy

The Chinese government's trilemma. The article below highlights the trilemma facing banking regulators and central bankers today. First, the government wants to retain low interest rates because liberalized interest rates would increase the cost of bond issuance and the financing of various policy loans. However, if it keeps deposit interest rates low, depositors will withdraw money and speculate it in the informal capital market (see below). The government can try to increase deposit rates without raising lending rates, but that would squeeze banks' profit margin, which would be difficult since they are trying to list two major banks. So, of low bond financing costs, no informal capital market, and high bank profitability, the government can only get two without substantial transaction costs.

For example, you can keep bond financing costs low and no informal capital market by squeezing the banks with high deposit rates and low lending rates, but bank profitability would suffer as they are forced to either lend at low profit or buy low yield bond. If you want low bond costs and high bank profitability, meaning that you repress real deposit rate to negative or nearly zero, then you will have a thriving informal banking sector, as is the case now. So, what does the Chinese government do? It chooses a high transaction cost approach: shut down the informal banking sector. This is very inefficient and is extremely difficult to monitor due to an array of local economic interests against it. Well, until entrepreneurs in Wenzhou sit in the Central Committee, the party will continue to have its own way.




Informal Lenders in China Pose Risks to Banking SystemBy KEITH BRADSHERNew York TimesNovember 9, 2004http://www.nytimes.com/2004/11/09/business/worldbusiness/09yuan.htmlWENZHOU, China, Nov. 3 - The Wenzhou "stir-fry" is not a dish you eat. Butit is giving indigestion to Chinese regulators and could prove troublesometo many investors worldwide - from New York money managers, Pennsylvaniasteel workers and Midwestern farmers to miners in Australia.Here in this freewheeling city at the forefront of capitalism in China, thedish is prepared when a group of wealthy friends pool millions of dollarsworth of Chinese yuan and put it into a hot investment like Shanghai realestate, where it is stirred and flipped for a hefty profit.The friends often lend each other large amounts on the strength of ahandshake and a handwritten i.o.u. Both sides then go to an automatedteller machine or bank branch to transfer the money, which is thenwithdrawn from the bank. Or sometimes they do it the old-fashioned way:exchanging burlap sacks stuffed with cash.The worry for Chinese regulators is that everyone in China will startcooking the Wenzhou stir-fry and do it outside the banking system. In thelast few months, borrowing and lending across the rest of China is lookingmore and more like Wenzhou's. The growth of this shadow banking systemposes a stiff challenge to China's state-owned banks, already burdened withbad debt, and makes it harder for the nation's leaders to steer afast-growing economy.The problem starts with China's low interest rates. More and more familieswith savings have been snubbing 2 percent interest on bank deposits for thedouble-digit returns from lending large amounts on their own. They lend toreal estate speculators or to small businesses without the politicalconnections to obtain loans from the banks. Not only is the informallending rate higher, but the income from that lending, because it issemilegal at best, is not taxed. For fear of shame, ostracism and theoccasional threat from thugs, borrowers are more likely to pay back theseloans than those from the big banks.Tao Dong, chief China economist at Credit Suisse First Boston, calculatesthat Chinese citizens withdrew $12 billion to $17 billion from their bankdeposits in August and September. The outflow turned into a flood lastmonth, reaching an estimated $120 billion, or more than 3 percent of alldeposits at the country's financial institutions.If the bank withdrawals are not stemmed in the months ahead, Mr. Taowarned, "this potentially could be a huge risk for financial stability andeven social stability."With China now accounting for more than a quarter of the world's steelproduction and nearly a fifth of soybean production, as well as some of thelargest initial public offerings of stock, any shaking of financialconfidence here could ripple quickly through markets in the United Statesand elsewhere. For instance, if the steel girders now being lifted intoplace by hundreds of tall cranes in big cities across China are no longerneeded, that would produce a worldwide glut of steel and push down prices.On Oct. 28, when China's central bank raised interest rates for one-yearloans and deposits by a little more than a quarter of a percentage point,it cited a need to keep money in the banking system. Higher official ratesshould "reduce external cycling of credit funds," the bank said in astatement.The main Chinese banks have fairly substantial reserves, but they needthose reserves to cover huge write-offs of bad debts someday. TheInternational Monetary Fund's China division chief, Eswar Prasad, expressedconcern about bank withdrawals in a speech in Hong Kong three days beforethe central bank acted.The hub of informal lending in China is here in Wenzhou, 230 miles south ofShanghai. Some of China's first experiments with the free market began herein the late 1970's, and a result has been a flourishing economy togetherwith sometimes questionable business dealings.Depending on how raw they like their capitalism, people elsewhere in Chinadescribe Wenzhou as either a center of financial innovation or a den ofloan sharks. But increasingly, Wenzhou is also a microcosm of the kind oflarge-scale yet informal financial dealings now going on across the country.The withdrawals by depositors and the informal money lending have spread soswiftly here that it is only in Wenzhou that the Chinese central bankreleases monthly statistics on average rates for direct loans betweenindividuals or companies. The rate hovered at 1 percent a month for yearsuntil April, when the authorities began limiting the volume of bank loans.Borrowers default on nearly half the loans issued by the state-owned banks,but seldom do so here on money that is usually borrowed from relatives,neighbors or people in the same industry. Residents insist that the risk ofostracism for failing to repay a loan is penalty enough to ensure repaymentof most loans.Although judges have ruled that handwritten i.o.u.'s are legally binding,creditors seldom go to court to collect. "If it is a really good friend, Iwould lose face if I sued them in court," said Tu Shangyun, the owner of alocal copper smelter and part-time "silver bearer" - a broker who putslenders and borrowers in touch with each other, "and if it weren't a goodfriend, I wouldn't lend the money in the first place."Violence is extremely rare, but the threat of it does exist as the ultimateguarantor that people make every effort to repay debts. "Someone can hire akiller who will chase you down, beat you up and maybe even kill you," saidMa Jinlong, who oversaw market-driven financial changes in the 1990's inWenzhou as director of the municipal economic reform committee and is nowan economics professor at Wenzhou University.An austerity policy was invoked, its goal to slow rapid economic growth inthe hope of stopping an upward spiral in the inflation rate. With consumerprices rising at 5.2 percent a year despite price controls on many goodsand services, and with less-regulated prices for goods traded betweencompanies climbing nearly twice as fast, people lose buying power whiletheir money is on deposit at a bank.The interest rate for informal loans jumped last spring to 1.2 percent amonth, or 15.4 percent compounded over a year, and has stayed there since.According to the nation's central bank, total bank deposits in Wenzhou havebeen dropping by $250 million a month since April as companies andindividuals withdraw money either because they can no longer obtain bankloans for their investments or because they want to lend the money athigher rates to each other.For lenders, these interest rates are much more attractive than earning ameager 2.25 percent a year, even after the recent rate increase, on adeposit at a government-owned bank. And while Beijing assesses a 20 percenttax on all interest from bank deposits, nobody pays tax on the income theyreceive from lending money on their own, Mr. Ma said.Most informal loans have traditionally gone to relatives or neighbors tofinance the starting of small local businesses. Wenzhou is now one of theworld's largest producers of nonbrand sunglasses; Dong Ganming, the ownerof a 350-employee sunglass factory here, said that his plant was just oneof almost 1,000 here involved in making glasses.Fierce competition has prompted local residents to borrow money to exploitevery possible niche in the industry, with some factories making nothingbut bridges for sunglasses so that they will not slide down customers'noses, other factories making only the lenses and so forth. Any governmentcrackdown on informal loans would carry the risk of stifling highlyefficient small and medium-size businesses that have little hope ofobtaining loans from the state-owned banks, which still allocate creditbased partly on political connections.Mr. Dong said that loans from friends and family allowed him to start hissunglass company with 10 employees a decade ago; he quickly paid off theloans and has been reinvesting most of the profit ever since, putting verylittle into bank deposits. "The interest in the bank is very low," he said."If you invest the money, you can get much more money."But more recently, local residents say, a lot of money has been flowinginto real estate here and in other big cities, especially Shanghai, helpingto fuel double-digit increases in interest rates. Deals increasinglyinvolve people who have no family or neighborhood connection, raising therisk of disputes.Kellee Tsai, a specialist in Chinese informal banking at Johns HopkinsUniversity, said that many overseas emigrants from Wenzhou had also beensending their savings back to be lent at much higher rates here than areavailable in the countries they have moved to.Some local investors have been able to pay for their investments withprofits from businesses here, like Chen Shen, the owner of four shops thatsell shoe-manufacturing equipment to the hundreds of shoe factories thathave popped up in this area. She said she paid cash for an apartment nearShanghai's Bund, its riverfront district, that had appreciated as much as60 percent in less than two years.Still, Chinese regulators do not like the practice, and officials have beentrying to stamp out such operations with limited success. They haveoutlawed the practice of pooling savings into various kinds of informalbanks that make loans for real estate and other investments: organizers aresubject to the death penalty but are rarely caught unless the informalbanks collapse.Oriental Outlook, a Chinese current affairs magazine, reported late lastmonth on the trial of a man accused of operating an illegal bank northeastof here that collapsed a year ago, leading to the filing of more than 200civil suits. Another man who lost money in the scheme, and went bankrupt asa result, assaulted the defendant outside the courtroom, the magazine said.The extent of such pooling is unclear. But it poses the greatest risks ofdamage to financial confidence if bank runs occur at these informalinstitutions, economists agree. Bank runs, with depositors lined upclamoring for their money back, have been an occasional problem aroundChina for years, but always quickly contained as the authorities rushed todistribute as much cash as necessary."The policy with bank runs, even with illegal banks in some cases, has beento flood the bank with liquidity and pay everyone off," said MichaelPettis, a finance professor at Beijing University, who criticized as illadvised the Chinese policy of bailing out even illegal banks. "One of themost salutary ways to let people know not to put money in these is to lettwo or three go bankrupt."