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The root of China’s financial distortions

China’s financial distortions are rooted in deposit rate controls and implicit loan guarantees. Low remuneration on bank deposits in conjunction with capital controls have long subsidized banks and borrowers. Loan guarantees have spurred excessive lending and neglect of profitability. Reform is perilous as slowing credit would itself undermine credit quality. An IMF model analysis suggests that a removal of loan guarantees would reduce the capital intensity of the economy.

Anzoategui, Diego, Mali Chivakul, and Wojciech Maliszewski (2015), “Financial Distortions in China: A General Equilibrium Approach”, IMF Working Paper, 15/274.

The below are excerpts from the paper. Headings, links and cursive text have been added.

The two great distortions

Deposit rate controls

“Interest rates used to be heavily controlled and had been liberalized only gradually…While China has fully liberalized its bank lending rates since end-2013, deposit rates have been freed only since October 2015. All deposits used to be subject to the rate ceiling before…The ceilings used to range from 0.35 % for demand deposits to 3.3 % for 1-year time deposits….Average effective deposit rate has been between 1-2 % and have remained within this range even after the full liberalization in October 2015, likely reflecting the People’s Bank of China `window guidance’….The closest substitute to deposits… negotiated deposits and structured deposits…offered rates in the range of 4 to 6 %.”

“Low, administratively-controlled interest rates have worked in tandem with distortions artificially boosting saving rates. Both reduced the cost of capital to support what has long been the highest investment rate in the world.”

Implicit loan guarantees

“Even more entrenched is the system of implicit state guarantees covering financial institutions and corporates (particularly state-owned), giving an easier access to credit to entities perceived to be backed by the government…Implicit guarantees are widespread in China. A number of firms enjoy privileged access to credit as creditors presume that they are implicitly supported by the government. State-owned enterprises (SOEs) are the main, but not the only, beneficiaries of these guarantees. With the overarching goal of maintaining social stability, all enterprises sufficiently important for the local economy…are expected to benefit from such implicit support.”

“There is clear evidence that creditors have been bailed out in the event that their lending to these implicitly guaranteed enterprises went sour. One important example is from bank bail-out in early 2000s. As nonperforming loans (NPLs) from directed lending to SOEs mounted by late 1990s, the Chinese government had to restructure the banks. Ma (2006) estimated that the cost of cleaning up the banks was more than 20 % of GDP by mid 2000s. Another example is the fact that bond default in China is a rare event. Debtors usually receive support from their local government and bond underwriter to patch together payment to avoid default.”

The link between deposit rates and guarantees

“The bank bailout [of the] early 2000s…connects implicit guarantees with deposit rate ceilings. Financial losses from the guarantee being called were ultimately born by the government, taxpayers as well as bank customers…By receiving below-market rates on their deposits, bank depositors contribute to bank operating profits that would over time help rebuild bank balance sheets. In other words, deposit rate ceilings act as a subsidy to banks to pay for the guarantees that have been called (or that could be called in the future).”

The consequences

“Widespread implicit guarantees and interest ceilings were major distortions in China’s financial system, contributing to a misallocation of resources.”

“Deposit interest ceilings are a form of financial repression, or a tax on household savings. This distortion is aggravated by the limited choice of alternative saving instruments: with the capital account remaining closed, households can put their savings in only a handful of assets, such as property, stock market, gold, and more recently “wealth management products”. These asset classes are not only inherently more risky, but their limited size creates a fertile ground for bubbles. For the lack of better alternatives, bank deposits have continued to increase with the rise in savings, despite negative or low real yields.”

“Moreover, the deposit interest rate ceilings provide little incentive for banks to become more efficient. Indeed, even after the liberalization of bank lending rates, there is no clear evidence that the banking system as a whole has become more competitive.”

“Implicit guarantees distort lending decision. With the guarantees, there is incentive for creditors to lend more (and more cheaply) to those perceived to be guaranteed, regardless of the viability or profitability of the project. Indeed, there is evidence that SOEs have enjoyed better access to finance than their private counterpart.”

“The distortions…have costs, which become heavier over time. Abundant and cheap credit has increasingly flown to finance low-return activities, with true risks mispriced given the strength of implicit guarantees. The economy has got locked in an equilibrium that is fundamentally unsustainable: slowing credit growth would sharply reduce activity and profits in several sectors of the economy, putting in question their debt-servicing capacity. A continued credit expansion prevents this from happening by supporting demand and covering losses. The adjustment can be delayed as long as losses can be covered by still high national savings, but ultimately this and other buffers will be exhausted as growth slows further due to an increasingly inefficient allocation of capital.”

The difficulties with reform

“This paper attempts to address [the reform problem]…by calibrating a standard heterogeneous agent model. The model is then used to simulate the effects of lifting the deposit rate ceilings and removing implicit guarantees.”

Removing the deposit interest rate ceilings alone would not result in a more efficient allocation of credit…The removal of the ceiling will trigger stronger competition across banks to get more deposits, lifting the deposit interest rate. Furthermore, this increase in the return on savings will increase the stock of deposits in the banking system…Banks will have to compete in order to attract more borrowers, thereby reducing the lending interest rate….It would…increase capital intensity in the economy, and therefore boost output. However, with implicit guarantees still in place, both less efficient state-owned enterprises and more efficient private enterprises would expand given the additional capital.”

“Without implicit guarantees, deposit rate is pushed downward and private enterprises experience a significant fall in their lending rate. With less capital available, capital intensity decreases. Gains from removing implicit guarantees are based on efficiency increase… It happens through the reduction of the role of less efficient state-owned enterprises in the economy.”


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