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Editorial: Policymakers Need to Tread Carefully When Tightening Policy to Avoid Liquidity Crunch

Money market rates in China have risen in recent months, fueling concerns that increasing borrowing costs may hurt the rebounding economy. Last week, the one-year Shanghai Interbank Offered Rate (Shibor), a key indicator of interbank borrowing costs, rose for days and exceeded the one-year prime loan rate, or the interest rate banks charge to their best clients. This sparked a debate on whether the government’s decision to quietly use interbank rates to discourage risky high-leverage loans, diffuse asset bubbles and tighten policy have had the side-effect of pushing up borrowing costs for businesses.

The Chinese central bank’s move was partly aimed at limiting any fallout from currency volatility in the wake of the U.S. Federal Reserve’s decision to raise U.S. interest rates in March.

But, it could derail China’s fragile economic recovery as many companies, especially small-and medium-sized enterprises, continue to see their profits weaken and struggle to raise funds. Although the People’s Bank of China (PBOC) has in its first quarter policy report stated that the rise of money market rates is not comparable to a domestic interest rate hike, it will affect the real economy by pushing up rates of bank bills and bonds. Private companies have relied heavily on bank bills and bonds to raise funds, and the rising costs will force them think twice before investing. This will dampen economic activity and hurt financial institutions. In April, the annual growth rate of private investment dropped to 5.3% from 8.6% the previous month, a development that should serve as a warning to policymakers.

Some analysts have compared the recent money market rates to levels that existed prior to the 2013 liquidity crunch when the interest rate for an overnight loan from one bank to another briefly hit 30% on June 20, 2013. Research by CEBM Group, a subsidiary of Caixin Insight Group, found that Chinese banks are now facing a greater debt burden than in 2013 and the rising money market rate is likely to have a quicker and stronger domino effect on the economy. But other analysts believe the impacts of the recent rise of the Shibor should not be over-estimated. Policymakers need to juggle the conflicting goals of curbing leverage, which includes clamping down on the nation’s shadow banking sector, and maintaining economic growth.

At a recent Politburo meeting, President Xi Jinping highlighted financial security as a strategic and fundamental issue affecting China’s social and economic growth, signaling that efforts to strengthen financial supervision will be pushed forward.

Policies to tighten financial market oversight are designed to help the real economy grow in a sustainable way. Those who are resisting stricter supervision say it could adversely affects the real economy, but these claims should be taken with a pinch of salt.

It is true that stricter regulatory policies may have a short-term negative impact on some industries and companies. Regulators mustn’t soft-pedal on long-term reform goals due to fears of inflicting short-term pain. They must enhance interdepartmental coordination to remove any policy conflicts, be transparent and release timely information to ensure market expectations remain stable.

As the government’s clampdown on financial leverage ripples through markets, billions of dollars in value have been wiped out from stocks and bonds and banking and insurance sectors. This is likely to cause a liquidity crunch. Policymakers should consider using monetary policy tools to cushion the impact from their efforts to cut financial leverage. The yuan’s exchange rate against the U.S. Dollar has remained stable after the Fed’s March rate hike and capital outflows have slowed in the short-run, creating greater room for domestic monetary policy maneuvering. However, many expect the U.S. Federal Reserves to raise interest rates again in June, which might prompt an exodus of capital from China and further drain domestic liquidity.

PBOC has urged commercial banks to lend more to smaller companies to help them tide over difficult times, but the effect of such policies are limited and it is hard to track how the funds are used. Many analysts expect the latest slew of tax cuts to help businesses, but the room for fiscal policy maneuvering is shrinking as government expenses go up and revenues growth slows. In the first quarter of 2017, total public expenditure exceeded government revenue by 15.5 trillion yuan, indicating a higher-than-expected budget deficit this year. 

But this should not hamper policymakers’ efforts to reduce the country’s reliance on low-end manufacturing and beef up high-tech production and the services sector. The urgent task at hand is to improve market access to allow more private players into lucrative areas that have been dominated by state-owned enterprises. For example, as the ongoing campaign to trim overcapacity pushes up prices of industrial materials such as steel and coal, state companies that largely control the upstream business have benefitted. But many private companies have complained that this was squeezing their margins. Meanwhile, poor performing state giants should be allowed to fold and their assets and resources channeled to more productive parts of the economy.

Although the goal of tighter supervision is to mitigate risks, this should not get in the way to implementing bold reforms. Policymakers should aim to keep long-term risks under control, while plugging black holes that drain money out of the real economy.

Hu Shuli is the Editor-in-Chief of Caixin Media.

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