While financial reforms will lead to better resource allocation over time, there could be complications during the process. International experience generally points to an increase of volatility in interest rates, associated with an increase of financial fragility and loss of output. Credit and liquidity risks are two prominent areas of vulnerability associated with interest rate reforms, deleveraging and a slowing economy, as is the case with China.
Coping with credit risks
The large economic stimulus in response to the global financial crisis was associated with a significant rise of leverage. Between 2008 and 2014, total social financing - a measure of the non-government debt by the non-financial sector - increased from 130% of GDP in 2008 to 200% of GDP in 2014, although the pace of increase has moderated in the past two years, according to International Monetary Fund data. The deleveraging process in the manufacturing sector will likely be accompanied by a cyclical rise of defaults, which will need to be managed carefully during the economic transition.
Many observers believe it should be possible to manage the debt defaults. The credit risks associated with leverage are mitigated as the balance sheet risks are concentrated in a few state-related sectors, while systemic risks are limited. Chinese households enjoy a healthy balance sheet, with remarkably low debt (20% of GDP) and high savings (30% of GDP). Chinese government direct debt is also low, accounting for less than 30% of GDP. Corporate debt, on the other hand, is relatively high, at 220% of GDP.
Debt burdens are particularly high in two areas: local government and construction-related cyclical sectors. Local government financing vehicles are the main borrowing channel used by subnational governments to supplement their off-budget spending and local construction projects (direct municipal borrowing has been prohibited until now). As a property downturn sets in, local government finds that land sales - the key source of funding for local finances and repaying debt - are dwindling significantly. The financing gap is likely to be greater in lower-tier cities where the housing slump is particularly steep. In response, fiscal remedies, such as more direct central government transfers combined with an improved local debt system, have been proposed to backstop the financing slippage of local governments. Institutionally, the fiscal system of local government and central government, though independent on the surface, is integrated. Central government relies on local government for tax collection and shares local income (70% of tax revenue has been attributed to the central government since 1994), and is also in charge of providing direct transfers.
Cyclical sectors that have high leverage include the overcapacity sectors such as steel, cement and some property developers. Much of this debt will have been restructured, and industrial consolidation/bankruptcy will likely be an inevitable and constructive process to reduce excess.
Financial deepening and reform imply a potential tightening of financial conditions for low-quality borrowers. Indeed, borrowing costs for these companies have increased since last year, as banks have become more sensitive to default risks. So far, the government has chosen a deliberate approach to allow selective default in an effort to curb the rise of moral hazard (whereby parties take on more risk in the knowledge they will be bailed out should a problem arise), while containing the spread of financial panic. The process has been a lot more measured and slow than the corporate restructuring in the late 1990s, possibly out of concerns for employment.
Liquidity risk concerns
Liquidity risks could also arise during interest rate liberalisation. First, for the system as a whole, there could be the risk of a disintermediation of deposits, given the widening gap between controlled and market rates. In addition, the rapid expansion of wealth management products and money market funds lately has broadened the channels of deposit outflows.
At present, overall liquidity is still ample. Indeed, excess reserves as a share of deposits have risen in the last few years (as other regulatory requirements such as the loan/deposit ratio constrains the ability of banks to lend), pointing to an abundance of liquidity. Banks are largely domestically funded, and mostly by deposits. This contrasts with international examples, such as in the Nordic countries and South Korea, where the reliance on external wholesale borrowing was the cause of a significant liquidity crunch. Chinese banks maintain nearly 20% of deposits with the central bank, even after the recent cuts, and these can be used as a liquidity buffer.
The second reason for liquidity risks can arise from friction in the interbank market. Despite the system-wide abundance of liquidity, distribution is very uneven. Large commercial banks account for about two-thirds of overall deposits. Regulatory requirements, and in particular the loan/deposit ratio and loan quotas, mean that the large banks have surplus funding to be placed in the interbank market. In contrast, smaller banks, non-banking institutions and foreign banks are structurally short of liquidity as they lack a deposit base and need to access funding from the interbank market. These institutions bear the largest part of the cost of the more expensive interbank funding.
Liquidity pressure was prominent in the second half of 2013, as seen from the spikes of interbank rates. To reduce the liquidity risks, the People's Bank of China (PBOC) added new instruments to its policy toolkit to lend to banks in time of stress. The shortterm liquidity facility and short-term liquidity operations were announced by the PBOC in 2013, and the scope of bank eligibility has been expanded in the ensuring months. Central bank funding is now directly available to a broad range of banks when they face liquidity shortages, which should prevent potential systematic contagion. In 2014, the PBOC also introduced pledged supplementary lending, which may be initiated by the PBOC, to offer funds over a three-month to five-year horizon. The introduction of these facilities, along with policy easing, resulted in the volatility