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China’s Nips and Tucks Won’t Stop Leverage Buildup

Anjani Trivedi

(Bloomberg Opinion) -- China’s central bank is nipping and tucking across the financial system. It still looks ugly – and will only get worse.

As Covid-19 and its aftershocks have rippled through the economy, the People’s Bank of China has tried to boost lending by easing various rates. On Monday, the bank cut the recently introduced de facto benchmark funding cost by 20 basis points, after lowering it earlier this year. It has also slashed the interest charged on excess reserves for the first time since 2008. While liquidity remains sufficient, all the trimming hasn’t substantially moved the needle given the severe hit from the pandemic.

What the cuts are doing, however, is creating a differential between the near-term and long-term cost of money. That incentivizes behavior that clogged up China’s financial plumbing in the first place. Think of the peak of the shadow banking boom in 2016, when lesser rates in the overnight and short-term markets prompted institutions and companies to borrow and then invest the proceeds in corporate bonds and other assets over a longer period for leveraged returns.

That’s started happening. In the last two months, one such investment — structured deposits — has shot up. Companies are borrowing in the short-term markets and redepositing the money in banks. About a fifth of corporate lending, around 1 trillion yuan to 1.5 trillion yuan ($141 billion to $212 billion), is in such financial arbitrage investments, according to the Rhodium Group. These products, typically priced as a spread over the underlying deposit rate, increased by 851 billion yuan last month, indicating a rise in speculation. 

Let’s turn to the institutions. Banks facilitate this activity to offer higher yields and to compete for customer deposits. They’re the main beneficiaries of the looser monetary policy: Short-term rates, in theory, allow banks that fund most of China’s financial system to reduce costs. But some are more dependent than others on these rate cuts. Big lenders are typically flush with liquidity from deposits. Their smaller and more regional counterparts are not. They rely on larger institutions to lend to them in the interbank market, or wholesale funding.

With all the jitters over the past year around regional lenders that were seized by regulators, China’s Big Four(1) aren’t willing to lend to their lesser peers for long periods. The surge in trading volumes in the overnight interbank market suggests that short-term borrowing to fund leveraged asset growth is gathering pace. In the first quarter, small banks were the biggest issuers of structured deposits, and most of them were held by companies. 

So what now? For one, bad behavior typically ends up more widespread and twisted in China’s financial system than it starts. As money market rates fall and the economics on these trades work less well, banks will have to depend on third parties to help leverage returns. That means non-bank financial institutions get involved, creating another layer of complexity. Banks’ claims on such institutions have started rising. In the past, they acted as warehouses of bad risk and assets. All too familiar: This is precisely how China’s shadow banking adventure became a labyrinthine mess.  

Small banks face a deluge of bad loans as the Covid-19 impact shows up on balance sheets. They’re now going to end up with more expensive and flighty funding. Lending out more will be hard. Meanwhile, the picture for real credit demand is muddied. Companies may be borrowing short-term, but the cash isn’t all going to restart businesses. Some of it is sitting in banks. Credit isn’t ending up where it’s needed to revive China Inc., and every yuan pumped in by the central bank becomes less effective.

One way out of the arbitrage hole is to cut the deposit rate, a long-discussed reform. But doing that in the current environment would surely lead to instability, because no one wants to lose out on returns.

Don’t be surprised if China’s financial underbelly suddenly appears larger, despite all the surgery.

(1) By assets; Bank of China Ltd., Industrial & Commercial Bank of China Ltd., China Construction Bank Corp. and Agricultural Bank of China Ltd.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Anjani Trivedi is a Bloomberg Opinion columnist covering industrial companies in Asia. She previously worked for the Wall Street Journal.

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