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Injecting a Little Risk into the Chinese Financial System

by | March 11th, 2014 | 04:54 pm

Moral hazard is a large and ongoing problem in the Chinese financial system. The past few years are full of examples of investors seeking government intervention on their behalf when a financial product goes bad. We have seen this type of behavior for bonds, trust products, wealth management products, real estate investments, and even individual stocks. The moral hazard problem isn’t limited to investors; financial institutions themselves have been the recipients of frequent government bailouts and ongoing support in the form of an implicit government guarantee. It was heartening, therefore, to see regulators take two small steps towards addressing these problems over the past week.

First, on the issue of investor moral hazard, the government finally decided to allow a domestic corporate bond to default. There have been corporate bond defaults in the past, but the bonds were off-shore issuances and losses were imposed upon foreign investors. The current default is that of Shanghai Chaori Solar Energy Science & Technology Co (Chaori) on a 5 year bond. That a solar energy company should face financial difficulties should come as no surprise given the sectors huge over-capacity problem. Indeed, the collapse of Suntech, another solar firm, was much covered in detail by the media. Suntech defaulted on an international bond last year and is undergoing bankruptcy restructuring.

Chaori’s default is a small but positive step. The company doesn’t appear to be insolvent, just illiquid. It is currently selling overseas assets in order to pay off bondholders. Nevertheless, it’s an important precedent for the bond market. The refusal of regulators to intervene to prevent a default did not lead to financial contagion. Instead, it has initiated the process of changing the implicit rules governing the bond market. If regulators stay the course, investors will slowly but surely adjust their perceptions of the riskiness of corporate bonds. This will lead to more careful purchases, slowing the rate of new bond issuances and leading to greater differentiation of the yield curve.

Financial authorities also took a step in the right direction this week towards addressing institutional moral hazard. 5 private banks were approved for operation Tianjin, Shanghai, Zhejiang, and Guangdong.  This is not the first introduction of private capital into the banking system (technically the term is 民间资本, non-state domestic capital which is mostly private but can include funds from collectives). The large state-owned commercial banks received private capital injections during their IPOs.  For joint-stock banks and urban commercial banks the share of private capital is already quite high, 45 percent and 56 percent respectively.  However, despite having a significant amount of private capital, these financial institutions still operate under the same market-distorting implicit government guarantee as state financial institutions.

The breakthrough involved with this new experiment is the creation of fully private banks that will operate without government backstops. The language of “market-oriented exit” for financial institutions first emerged in last fall’s Third Plenum decisions document. Regulators, however, are clearly reluctant to apply this reform to the whole financial sector. Instead, these newly-created private banks will be the test case. At this early stage, they are small enough that bankruptcy is unlikely to imperil the entire financial system.  Regulators thus have room to experiment with resolution mechanisms for financial instructions on a small scale.

Going forward, the approval of additional private banks has significant implications for the financial system. In contrast to other areas of the economy, most notably the manufacturing sector where the state share of equity has fallen to 25 percent, the financial sector remains overwhelmingly dominated by state-owned enterprises.

Given a fair shake, private banks have the potential to make large inroads into China’s banking system. As a first step, regulators should quickly remove the current geographical restrictions imposed on private banks. The large state-owned banks currently offer extensive nationwide branch networks and increasingly comprehensive international services. These services will be hard for any private bank to match given the current regulatory framework.

Where private banks can out-compete their state-owned rivals is on efficiency and offering financial services to underserved customers. In order to attract deposits and grow, these banks must be allowed to pass along their cost savings in the form of higher deposit rates. However, until the deposit insurance system is in place, regulators worry that deposit rate competition amongst banks will lead to bank failures and depositor financial losses. All the more reason for China to hurry up and join the 113 other countries around the world that already have deposit insurance.