Earlier this month, people started to gather outside the People’s Bank of China branch in Beihai, a coastal city in Guangxi province. They had heard that the central bank would soon be offering interes-free loans of up to Rmb500,000 ($81,478), reports HK Daily News. What started out as a small crowd grew to more than a thousand people looking for cheap credit.
The branch soon had to be protected by local paramilitaries and a barricade was set up, which the applicants tried to break through.
Shocked by the scene, the central bank felt the need to clarify that its role as lender of last resort only extends to financial institutions, not retail customers.
To make the point in plainer terms, it sent out a SMS message locally saying that it wasn’t in the loan business. “Interest-free loans are purely rumour, beware of being fooled,” it advised, according to reports from China News Service.
The incident is another reminder of the edgy mood in China’s banking system, as well as some rather exaggerated expectations of the central bank’s role in addressing financial challenges. So perhaps it should be less of a surprise that the PBoC’s recent move to get rid of the lending floor in bank interest rates is getting so much attention.
This latest move to liberalise interest rates means that there is no limit to the discount that banks can offer on the benchmark rate for commercial loans, a move that the Financial Times describes as the “biggest change to the country’s interest rate regime since caps on lending rates were removed in 2004”.
Without a doubt, it is a significant step in Beijing’s effort to get credit allocated more efficiently across the real economy.
At the same time, analysts acknowledge the process still has some way to go: “It signifies that the easiest part of market-oriented interest rate reforms has been completed, and that reform officially now enters the deep end,” Gao Shanwen, chief economist of Essence Securities told Economic Information Daily.
The greater challenge lies in allowing market forces to dictate the rates paid on deposits. As the FT points out, the nation’s banks are against such a move because their profits are dependent on the difference between the deposit rate (that is kept low) and the lending rate on offer.
As things stand now, it is not clear how much impact the more flexible lending rate will have as 89% of actual lending rates are still at or above the benchmark, according to HSBC research. The cost of borrowing could also be on an upward trend, as liquidity is expected to be tight in the second half of the year.
Others believe that this latest interest rate reform could require banks to seek fresh capital in order to maintain their capital adequacy ratios, according to ChinaScope Financial research cited by Fx678.com.
The Shanghai research firm said that the banks will have to ask investors for as much as $100 billion as net interest margins shrink, while assets increase. Smaller municipal banks will need more capital than their larger peers, the report said.
Further fundraising could also be a painful procedure, if the banks have to tap the market at a time when investors are worried about the robustness of the financial system in general.
The government will prefer to look at interest rate reform more positively, arguing that it will dampen the growth of the shadow banking industry, which has exploded in size since the financial crisis. Making the official banking system more competitive could be an important part of achieving that.
There are fresh signs of PBoC anxiety about underground lending too. That’s after the central bank recently released a report on peer-to-peer (P2P) lending – an industry that has grown to be worth Rmb60 billion in a very short period.
The idea behind these P2P websites is that they provide a venue for small lenders to lend directly to potential borrowers. The loan rates are high, between 10% and 20%, but borrowings are supposed to be small amounts. But the PBoC report points out that it is common for some of these websites to branch out into riskier areas of finance, including taking deposits, offering loan guarantees and bundling funds together into wealth management products, reports Century Weekly.
The central bank highlights two websites in Chongqing that aggregate money from a number of smaller lenders to make larger loans with higher returns. Customers are told to send money to the website’s account but are given little information about where the capital ends up.
These kinds of activities come with a wide range of risks. As with many wealth management products there is the problem of short-term funding being used to back projects that will take several years to start generating a return. There is also the leverage risk: many of these companies then borrow themselves and are lending out more than 10 times their investor capital.
Investors have already lost money on P2P websites. In 2011, a site called Angel Plan shut down and its founder disappeared with Rmb6 million of unpaid debt, reports Century Weekly. No money was ever returned.
According to 21CN Business Herald, the central bank is stepping up its efforts to establish greater oversight, after calling a meeting in May to work out further regulatory measures to cover P2P loans. Some of those present thought it was too early to impose regulations on the industry, the newspaper suggests, especially when there are more pressing problems, such as how to handle trust company lending (see WiC177).
This shows that the PBoC has plenty on its plate when it comes to regulating the amorphous world of shadow banking.
Interest rate reforms could turn out to be a key tactic: transforming the banking system into a more effective competitor to its unofficial cousins, before one of the many risks in the shadow banking sector are realised.
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