China: banks look increasingly unstable

China’s banks benefit from regulated spreads – the banks can only lose money via bad loans. But they do not book the majority of their bad loans, so reported profits are a fiction. The regulated spreads implement the Beijing policy of financial repression – transfers from savers (who earning next to nothing) to borrowers (who pay below market rates).

Beijing has driven Chinese growth by credit-driven spending, much of that wasted. This spending is driving up price levels but has not generated productivity gains. Result is 4.5% inflation, massive unrecognized bad loans, while businesses can’t get needed credit. Now what?

This WSJ editorial has it about right:

The optimistic spin on Beijing’s latest monetary easing is that policy makers are choosing to focus on growth instead of worrying about inflation, and maybe that’s true. But it pays to consider a less rosy alternative explanation: Beijing might not be “balancing” growth versus inflation—and it might not have much of a choice.

At first blush the move announced Saturday—a cut in the required reserve ratio governing what percentage of deposits banks much store with the central bank—seems like more of China’s monetary same. The measure releases roughly 400 billion yuan ($63.5 billion) into the banking system. The conventional explanation is that Beijing is worried about access to credit becoming too tight for businesses and, since everyone claims inflation will dissipate later this year, is engaging in some prudent pump-priming. Tinkering with reserve ratios is one of Beijing’s favorite policy tools.

But something has changed this time around: capital outflows. That fine-tuning approach presupposes a system in which capital controls keep money more or less locked inside the system. Before now, money not deposited with the central bank could be used only for credit creation.

Increasingly, another option is opening up—sending or keeping money abroad. Some $34 billion might have left China in the last three months of 2011. There are also signs that some exporters are keeping their earnings in dollars offshore rather than converting to yuan and putting that money into the banking system.

January saw a return to net inflows, but then banks face another drain on liquidity, increasing competition for depositors. Banks are creating a range of “wealth-management products,” which are often risky credit-related products that create substantial off-balance-sheet liabilities, in an effort to woo depositors. There’s frequently a big mismatch not only between the high interest rates offered on these products and the regulated low rates banks can charge on loans, but also between the short maturities of deposit products and the longer terms of loans.

All of this together seems to be putting a liquidity squeeze on the banks. (…)

(…) It might seem odd to worry about inflation, capital outflows and tight liquidity at the same time, but that’s a consequence of China’s distorted financial system. Because allocation of capital remains politicized, a significant portion of the credit stimulus has gone into wasteful projects; since that money is not creating real growth or productivity gains, it chases too few goods at higher prices.

Meanwhile, those who need cash—including bankers and small and medium-sized businesses—can’t get it. Liquidity injections might help bankers with short-term funding. But absent broader reform, that cash will only follow earlier credit down the inflationary rabbit hole.

(…)

This highlights what is set to become China’s most serious policy dilemma of 2012: how to balance the risk of inflation against the risk of financial instability. This is a far more perilous tightrope than the old growth-vs.-inflation acrobatics.

Read the whole thing »

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