Credit in China is growing at a breakneck pace, having increased from 125 percent of GDP in 2008 to 215 percent in 2012. Local-government debt has soared by 70 percent since 2009, reaching almost $3 trillion last June. This is raising serious concerns about the level of risk in China’s financial system.

China’s rapid credit growth reflects the government’s move to loosen restrictions on investment, as well as very low interest rates in the formal banking sector.

Since 2000, the one-year fixed-term deposit rate in China has remained in the 2 to 4 percent range, roughly equal to the consumer inflation rate. The lending rate in the formal banking system — which provides credit to state-owned enterprises (SOEs), urban mortgage borrowers and government projects — also has been relatively stable — 5.5 to 7 percent.

Unsurprisingly the combination of easy credit, low official rates and high demand caused property prices to surge by 300 to 500 percent in some Chinese cities over the last decade. This has led to broad-based wealth distribution, with 80 percent of urban households owning their homes.

Access to cheap credit remains a privilege reserved for a select group, which has amassed property and real estate. New entrants to the labor market and small and medium-size enterprises have struggled to acquire credit at reasonable rates.

Chinese authorities, recognizing that excessive credit was creating domestic economic imbalances, have been engaged in monetary tightening since 2010, slowing the pace of money-supply growth from more than 25 percent in 2009 to less than 14 percent last year. As new credit increased by only 9.7 percent in 2013, tight interbank liquidity conditions arose in June and December, with average interbank rates spiking to around 12 percent and 9 percent, respectively.

Since the beginning of this year, regulators have also begun to rein in shadow banking, which gained ground in the wake of the global economic crisis. With China’s export sector facing labor-cost increases and the renminbi appreciating against the dollar by 3 percent annually since 2005, conditions deteriorated sharply when crisis struck the advanced economies. After 2008, demand for Chinese exports fell, and buyers began to demand seller financing, cutting Chinese firms’ profit margins, cash flow and liquidity.

The shadow-banking system emerged to meet the demand from private firms and SOEs for extra liquidity to help them cope with the slowing economy and fulfill their investment commitments. Private-sector entrepreneurs in cities like Wenzhou were willing to pay annual interest rates as high as 15 to 20 percent.

On the supply side, savers — including wealthy households and corporations with surplus cash — wanted positive real interest rates on their deposits. Loan-guarantee institutions, trust companies and others sought to benefit from the gap between the 3.5 percent return on one-year fixed deposits in the official banking system and rates of up to 20 percent in the shadow-banking sector.

The result was a 43 percent increase in shadow-banking credit last year, accounting for 29 percent of China’s total credit.

Chinese policymakers now must determine how to unify the official and shadow rates without excessively disrupting the system — an objective that is made all the more challenging by the government’s recent decision to give market forces a greater role in resource allocation. If the unified rates are too high, the economy could come to a halt; capital inflows could negate the policy’s impact; or the asset bubble could pop, putting serious pressure on banks’ balance sheets.

What the debate really comes down to is liquidity versus solvency. Excessively loose liquidity and negative real interest rates obscure the credit risks in the system, while excessively high real rates could transform illiquidity into insolvency.

The question is whether borrowers can sustain much higher interest rates and still service their debts.

Proper credit discipline would ensure that private firms paying excessively high interest rates ultimately exit the game. While local-government financing platforms nominally carry state-credit status, some might not have the cash flow to make their payments, either.

Should they have to pay unsustainably high interest rates?

In other words, the problem stems from the quality of assets (or investments) that underlie China’s credit growth. A study of better-performing cities like Foshan suggests that some municipal-level enterprises will survive, owing to high productivity and sound fiscal management.

Even at a 7 percent interest rate, some towns will not be able to repay their debts — a situation that will demand either that platform companies declare bankruptcy or that municipal debt is restructured.

The current divergence between official and shadow lending rates parallels the gap between the renminbi’s official and swap market (unofficial) exchange rates in the 1980’s. The unification of the exchange rates in 1994 improved the market mechanism substantially, thereby enabling China’s foreign trade to grow exponentially.

At the domestic level, the current policy dilemma is how to reconcile the economy’s liquidity needs with the solvency of the system as a whole (rather than that of individual borrowers).

If interest rates remain too low, the shadow-banking system will squeeze out the formal sector. If money supply is too tight, the real economy will suffer, in turn damaging the financial sector.

The good news is that higher interest rates in advanced economies create more policy space for China to adjust domestic rates. A combination of price and quantitative adjustments would buy time for the real sector to improve productivity and for policymakers to reduce SOEs’ excess capacity.

In short, given China’s large state-owned sector, the transition to market-based interest rates will require strong government action to control public debt (especially local-government debt), while ensuring that there is enough credit to accommodate the growth in the volume of transactions and the increase in asset prices.

These complex reforms — which require that both formal and shadow-banking institutions adjust to a new, risk-based environment — certainly will entail some pain; but they are critical to putting China on a stable and sustainable growth path.

Andrew Sheng, president of the Fung Global Institute, is former chairman of the Hong Kong Securities and Futures Commission. He is currently adjunct professor at Tsinghua University in Beijing. Xiao Geng is director of research at Fung Global Institute. © 2014 Project Syndicate (www.project-syndicate.org)

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