China did stimulus the wrong way


When the Great Recession hit, China didn’t hesitate to open up the fiscal taps. But the fast-developing country also embraced another form of stimulus that was a bit different from what John Maynard Keynes had recommended — it encouraged its banks to start lending a lot more.

They lent money to corporations, local governments and a variety of private actors. Much of this lending was financed by the issuance of so-called wealth management products (WMPs) — basically, high-interest loans made by Chinese households to a variety of bank-affiliated lenders.

A new paper by economists Viral Acharya, Jun Qian, and Zhishu Yang provides a lot of detail about what happened. In China, there are four really big banks owned by the central government — Agricultural Bank of China Ltd, Bank of China (Hong Kong) Ltd, China Construction Bank Corp and Industrial and Commercial Bank of China Ltd. When the aftershocks of the Great Recession threatened the economy in 2009-10, the Chinese government told its banks to lend more money, and they did so — the increase in lending from the Big Four banks during those two years totalled about seven trillion yuan (RM4.44 trillion), or US$1 trillion.

But that put China’s smaller banks in a bind. In order to maintain regulatory loan-to-deposit ratios, the big banks had to take more deposits from Chinese households, and they did this by offering better deposit rates and various other incentives. This created stiffer competition for smaller banks, forcing them to find some other source of financing. They couldn’t just offer higher deposit rates, since deposit rates are capped by the government. Their answer was WMPs, which they issued indirectly by creating a large system of so-called shadow banks, or lenders that operate outside of the regulated financial regime. As Acharya et al document, the more local competition there was from the Big Four banks, the more WMPs the smaller banks issued.

China watchers, including my Bloomberg View colleague Chris Balding, have long been worried about the risks posed by the WMPs and the shadow banking system that supports them. As the US experience in 2008 and many other episodes around the world have shown, large amounts of high-interest loans created by complex networks of shadowy, unregulated lenders can be the tinder that sparks a financial crisis.

Acharya et al give some new evidence to justify this worry. They show that when WMPs mature, interbank lending rates go up — a scary indicator for anyone who remembers the American interbank freeze-up in 2008. Higher interbank lending rates in turn cause Chinese bank stocks to fall, with banks that issued more WMPs falling by more. WMPs are thus creating risks for the entire Chinese financial system.

But that’s not the only way China’s odd, unique form of stimulus created new risks. There’s also the issue of who received those loans. Another new paper, by economists Lin Cong and Jacopo Ponticelli, shows that the stimulus funnelled money to lowproductivity state-owned companies.

From 2000 to 2008, everything seemed to be going right in Chinese industry. Lending kept shifting from less productive companies to more productive ones, and from stateowned enterprises to the private sector. That’s a sign of a healthy economy.

After 2008, though, that positive trend went into reverse. Cong and Ponticelli document how state-owned companies started taking a larger share of lending, and that businesses with lower rates of return on capital before 2008 borrowed more.

Money flowing to less productive companies is always bad news. But when combined with the increase in high-interest loans and interbank lending risk documented by Acharya et al, it’s a recipe for a financial crisis. Low-productivity borrowers are less likely to repay their loans. So, the quality of loans has gone down at precisely the same moment that systemic risk has risen.

Even more worrying, the lending binge didn’t stop after the Great Recession ended. A figure from Lin and Ponticelli’s paper shows how the money has continued to flow, supported by more shadow banking and corporate bond issuance.

What Price Growth?

More borrowing, lower-productivity borrowers, slowing growth, and greater systemic risk are all consistent with the story that China’s economy has become too dependent on cheap, plentiful often wasteful financing. Naturally, the Chinese government is aware of the risks, and is taking some steps to reduce them. For example, the authorities are pushing lenders to lower the rates of return they offer on WMPs, which promises to reduce risky lending. But these measures may be too little, too late. A huge stock of high-interest debt has been accumulated by low-productivity borrowers. It will take years to unwind. Those years will probably bring slower growth for China, even as the risk of a general Chinese financial crisis continues to be elevated.

There’s a lesson here for future policymakers. When recession threatens, forcing banks to lend money cheaply is a very dangerous form of fiscal stimulus. Countries would be welladvised to stick with Keynes’ original idea, and simply have the government spend a bunch of money on infrastructure when the economy falters.


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