Chinese Financial Scandals

Mike Smitka, Economics, Washington and Lee University

We'll continue to see media coverage of financial scandals in China. For example, the FT Alphaville blog has a "Bezzle Watch" on financial institutions there. This should not surprise us on three levels.

First, under the Stalinist planning system that dominated the urban sector in China there were no banks as we understand the concept. Zero. Similarly in the rural sector communes were expected to fend for themselves – even when that meant privation – so again there was no role for finance, though there were institutions that accepted small individual deposits. Reforms began in the early 1980s that opened up space for "modern" financial institutions to operate, though the legal and institutional foundations weren't put into place until 1994-95. That means that no bank has more than 20 years operating experience. Young institutions that have no experienced staff – and cannot hire from elsewhere because such individuals simply did not exist – have control and monitoring issues. It takes time to set up accounting systems, operating standards, and checks and balances against individual behavior. If global institutions have problems restraining rogue traders, then China's challenges are worse.

...with lower growth, many who operated in the shadows will find their operations cast into the light...

Second, as a young system, it is biased towards large borrowers. This is accentuated by the intermingling of politics and business, as bank executives are typically also party stalwarts, leading to conflicts of interest. But other countries – Japan going into its series of financial reforms in the 1980s – also saw this. For one thing, lending to large borrowers is easier: one small group in a bank can lend to firms tied to electrical manufacturers, Toshiba and Hitachi, another to steel firms, what was in the US context called "National Accounts" (which in 1980 meant Fortune 100 borrowers). The administrative cost of lending was thus very low relative to what would be the case in lending to small firms or consumers, where one banker could only lend a fraction of the amount. Which it was difficult to lend at more than the ceiling "suggested" by government guidance, a bank couldn't offset the higher costs of small business borrowing with higher interest rates. This sort of bias in who can borrow leads those who can tap this flow of funds to borrow a lot, and then use those funds in ways that may lie well outside their core businesses. It can also lead to non-bank players in financial markets, such as manufacturers financing inventory for their customers. That can work out fairly well, helping out for example small retailers while the manufacturer-cum-lender can monitor their sales and inventory levels so as to control credit risk better than banks. But it can easily shade into direct and indirect lending for real estate and playing the stock market.

Third, the Chinese financial system suffers from financial repression. That is typical of developing countries, in which interest rates on deposits are held to low levels, which allows loans to be made at low rates. Even the US, we saw that in the 1970s, when Regulation Q kept banks from matching the rates that were available in money market mutual funds. Other options were available. When I got married, my wife and I pooled our savings – paying a penalty to liquidate time deposits early – and bought a Treasury bond. I carried more cash than I'd ever held before to the offices of the New York Fed to do that. But we also bought an MMMF. We weren't alone, and eventually the outflow of funds from banks (particularly savings banks) force the abolition of Reg Q. Anyway, financial repression creates room for sharp operators. At the same time it provides an incentive for non-bank players to get involved in finance, as per the examples of the previous paragraph.

In a "young" financial system, however, the sorts of players found in the US – my wife and I were early customers of Vanguard – are likely small and poorly known, and have management constraints that prevent them from expanding rapidly so as to service large numbers of customers. That challenge is accentuated by the low level of experience that China's new middle class (and nouveau riche) who need to be educated on what is sound and what is not. Furthermore, financial regulation is similarly "young" with a small and inexperienced staff whom the government, with its wont to pay at levels that lag the private sector, may have a hard time retaining. There's thus lots of space for shadow banking, investment trusts that take in money and use it for ... well, transparency is not the norm. Even when those running such operations intend to be honest, they are inexperienced. Lending to local developers and small businesses is easy, getting money back is harder.

Having worked on Japanese issues for many years, we're sure to be treated to many culturalist explanations, Chinese are intrinsically dishonest and so on. But with the amount of money in the economy, and the immaturity of all those involved – depositors-investors, intermediaries, borrowers – we'll see problems galore. The slowdown of the economy will bring them to the fore, as 10% growth allows all sorts of firms to do well enough, even with large structural shifts that render yesterday's businesses trying to provide goods and services unneeded today. At 6% growth, the unlucky and the incompetent will multiply. And those who were bending the rules and operating in the shadows will find their operations in trouble and in the light. We shouldn't be surprised at what we'll now be able to see.

Hence what we see is a normal transition, not peculiar to China, and not a prelude to collapse.