MANY commentators, including this newspaper, like to compare China’s economy with America’s, the world’s biggest, which it is on course to rival in size if not in sophistication. Recently, however, parallels between the two economies have started to look more ominous. China suddenly seems to be exactly five years behind America. After several years of excessive credit, much of it in the shadows of the banking system, China’s financial institutions stopped lending to each other this month; on June 20th interbank interest rates briefly soared to 25%. The crunch seemed horribly reminiscent of America’s financial crisis in 2008, from which it has yet to recover in full.
Two questions emerge from this. Is China’s economy in as much trouble as America’s was in 2008? And have the authorities done the right thing? The answer to both is: not really. A lot depends on China now pushing through reforms.
The pros and cons of already owning your bad banks
China’s economy certainly has some worrying excesses. Credit has been rising much faster than GDP, and property prices, especially in coastal cities, have been soaring. That is often a sign of trouble. Sharp rises in lending, accompanied by property booms, set the stage for America’s crisis in 2008 and many others like it. In those cases, when rash investments turned sour banks went bust, lending stalled and confidence evaporated. Governments had to step in, recapitalising some banks and urging others to resume lending.
Yet China’s situation is different in important ways. It has an extraordinarily high savings rate. Unlike America in 2008, the country as a whole is living well within its means. Its banks are subject to pretty stringent rules: their loans cannot exceed 75% of their deposits, and, unlike many countries, China is already implementing the global prescriptions on bank capital known as Basel 3. And the state already owns the biggest banks. That has its drawbacks (too many loans have gone to state-favoured firms), but a bonus is that, when those loans turn bad, the state does not need to nationalise anything: it can tell the banks to keep lending while it decides how to allocate the losses and when. In effect, China’s state can serve as a bankruptcy judge for the economy, keeping creditors in check, spreading the pain in an orderly fashion and, above all, preserving the value of the economy as a going concern.
China’s cash crunch also came about for a different reason. In 2008 America’s interbank market froze because banks refused to lend to each other. China’s froze last week because the central bank itself refused to lend. Despite the need of some banks for cash as the end of the quarter approached, the central bank sat on its hands, allowing rates to spike and signalling its determination to restrain the reckless growth of credit.
Letting interbank rates spike is a brutally effective, if crude, way to punish overstretched lenders; it may also have sent a useful message to profligate local governments. But it risks punishing everyone else, too (see article). As a result of the central bank’s abstention, rumours swirled about bank defaults and ATMs running out of cash. On June 24th China’s stockmarkets suffered their worst day in years; the Shanghai composite index fell by 5.3%. The central bank’s inaction threatened to endanger the confidence that makes banking possible. Fortunately, the authorities eventually woke up to the danger, moving to calm the markets on June 25th.
The priorities now should be to start cleaning up the financial system and rebalancing the economy. Letting banks raise interest rates on deposits would help them attract funds that are now disappearing into the shadow banking system. Introducing deposit insurance would also help distinguish protected deposits from unprotected, shadowy alternatives.
The government also needs to cool some overheated industries and liberate others. It should suppress speculative demand for housing by imposing an annual property tax on the market value of homes, broadening a pilot tax in Chongqing and Shanghai. And it should do more to encourage private investment in industries, from railways to telecoms, that are now dominated by state-owned enterprises. That would free China’s banks to lend to other sources.
Such reforms will take time to work and will slow the economy in the short term. Growth may run at only 6% next year, according to Dragonomics, a research firm—a sharp reduction from the double-digit rate that China has become accustomed to, and significantly below the government’s target for this year of 7.5%. That may cause a flurry of anxiety in Beijing. Yet the alternative is more wasteful lending and unproductive spending. China is a resilient economy that has grown its way out of problems in the past. But if it lets bubbles expand, then comparisons with America may become more apposite.
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