Today, millions of Americans will go to the polls to reaffirm their loyalty to Obama, or not. At the same time, the debt crisis continues to rage on in Europe. Away from the spectacle in the West, the East is going through its own transition. Slightly more low key, but equally important, is the once in a decade leadership change in China. Although little more than a rubber stamp, the 18th Communist Party Congress due to get under way on Thursday will officially name China’s next leaders.
And amid a troubling global economic backdrop, Beijing’s new leaders will have a lot on their plate.
No one is less enthused by the handover than Qu Hongbin, HSBC’s chief China economist. According to Qu, China is due a:
| ... swathe of co-ordinated reforms which we believe will revolutionalise [sic] the country’s financial system. In fact, there are clear signs that China’s new leaders, who will take power in early 2013, will make speeding up reform top of their policy agenda in the coming years. This chain reaction will change the trajectory of the institutions and policies that are all intertwined – banks, bonds, interest rates, the opening of the capital account and the convertibility of the RMB – triggering a wave of deregulation that could happen much faster than many people think. We think interest rates will be liberalised, the bond market will double in size and the RMB will become convertible within five years. These changes would not only make capital allocation more efficient, boosting the private sector, but also provide the middle class with greater choice about where to put their money so they can earn a higher return and therefore spend more. This should help rebalance growth from investment to consumption and lift the potential growth rate in the coming years. |
Not much pressure for China’s new leaders then.
As Qu illustrates, HSBC expects to see a lot of changes within the next five years in China. And already under way are changes in interest rates, due to be completely liberalized in a mere three years, according to Qu.
This is the central problem and needs to be addressed, says Qu:
| Interest rate liberalisation lies at the heart of China’s financial reforms and much needs changing. Under the current system the PBoC sets a ceiling for bank deposit rates and a floor for lending rates, creating a high spread that generates fat bank profits. It also means that the returns savers earn on their deposits are below the level of inflation, so they are effectively losing money. |
This has side effects:
| This, in turn, works against the government’s policy to make consumption a bigger driver of economic growth. Consumption in China was 51.6% of gross domestic product in 2011, compared with about 70% in the US. |
Chinese economic growth has come under pressure of late as its export-driven economy has been hit by slowing global consumption. In an effort to offset losses in exports, Beijing has often harked on about how domestic consumption will be a key driver for economic growth. But depressed interest rates in China effectively work against this, since it taxes savers and encourages investors.
Not only would liberalizing interest rates create a class of consumers in China, but it would also develop the bond market, make it easier to lift capital controls and internationalize the renminbi, says Qu. So far so good.
But there are huge hurdles. For instance, if China were to raise interest rates, there is the chance that this could cause a spike in corporate and public indebtedness, bringing social unrest in its wake. Well-known China bear Michael Pettis, for example, reckons the Chinese banking system is effectively insolvent - propped up by artifically low rates - and higher rates will trigger a swathe of bankruptcies.
Moreover, China’s commercial banks are objecting to reform. As Qu points out:
| Powerful vested interests have a lot to lose from change – especially the big banks. Experiences from many other countries show that the net interest margin (NIM) tends to narrow after lending and deposit interest rates are liberalised. This is because banks have to compete with each other – they attract deposits by raising deposit rates and cutting lending rates to win business from valued (normally big) clients. This squeezes interest rate income and that’s why China’s commercial banks are the main group objecting to reform. NIM income represents 70- 80% of the banking sector’s profits, so it is understandable that the banks will try to postpone reform for as long as possible. |
But inter-bank competition would also lead to innovation, says Qu:
| Market driven interest rates would force them to grow their businesses in other areas, particularly fee income. |
In the long term, then, Chinese banks do need to diversify away from interest-derived income and look to expanding fee-generating products in the form of wealth management products, perhaps. As a result, higher deposit and lending rates are necessary to rebalance China’s economy towards a domestic consumption model.
So this issue could be rectified in the long term, but more worrying, especially for the Communist party, would be the near-term potential loss of power:
| During the 2008-09 global financial crisis the state’s control of the banking sector helped China’s strong economic recovery. In 2009 the banks pumped RMB9.6 trillion of new loans into the economy as Europe and the US floundered. We believe it is this deep-seated fear of the diminution of power that is the biggest obstacle to be overcome. |
This will be a real concern for China’s new leadership wishing for a peaceful transition and tenure. As is the case with the internationalization of the renminbi, or even the gradual extension of special economic zones, China will work slowly on a case-by-case basis to ensure that interest rate liberalization goes smoothly. So perhaps, full interest rate liberalization within three years might be a bit too soon.