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China Punts on Financial Reform?

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Pacific Money

China Punts on Financial Reform?

A number of developments suggest Chinese leaders are souring on implementing financial reforms.

Although details are vague, a number of signs suggest that China is backing away from the financial reforms necessary to rebalance the economy.

China’s current economic model thrives on state-driven investment made possible by fiscal and monetary policies that provide cheap and plentiful capital to local governments and state owned enterprises (SOEs). This cheap capital comes at the expense of Chinese households, who have seen their consumption as a percentage of GDP decline precipitously over the last couple of decades. This economic model has become increasingly unproductive and unsustainable, prompting Chinese leaders to pledge to implement an economic rebalance.

Many analysts expected Chinese leaders to move first on the financial aspects of this economic rebalance. Indeed, Chinese leaders have been shown greater concern in recent months over the amount of local government debt and the shadow banking industry. In addition, last year China announced it was eliminating the floor on its lending rate.

However, the last week has brought new signs that China may be backing away from moving with a sense of urgency on financial reforms. Over the weekend Chinese state media announced the 2014 priorities of China four main financial authorities. They presented a mixed picture in terms of reform. For example, the Global Times reported that the People’s Bank of China — the country’s central bank — will continue trying to internationalize the Chinese currency, the renminbi, which could mean that it will increasingly let it float more.

At the same time, the same report said that the PBoC “will stick to prudent monetary policy and maintain steady credit growth” in 2013. This suggests that Beijing is not serious about reining in the credit that underwrites its investment-driven economic model. However, other reports in Chinese state media said that Chinese local governments were seeking to reduce their fixed-asset investment targets in 2014.

Additionally, last week numerous reports emerged that China’s top banks had raised deposit interest rates, a crucial reform necessary to shift more resources to Chinese households. However, according to Xinhua, on Friday China’s five major state-owned banks denied the reports and claimed that they were maintaining the deposit interest rates. The reports did not indicate whether the banks said they intended to raise deposit interest rates in the foreseeable future. However, it did mention that the Bank of China claimed that lending institutions hadn’t hit the ceiling rates currently in place.

Finally, last week it was reported that a trust product pushed by the Industrial and Commercial Bank of China to 700 investors was in risk of defaulting on debt owed by the end of this month. Allowing the trust to default would have significant implications in terms of reining in China’s shadow banking industry, by demonstrating that the government and state-owned banks do not guarantee risky investments. Chinese leaders have signaled in recent months that they wish to crack down on the shadow banking industry.

At the same time, allowing the trust to default could have sparked a confidence crisis in China’s financial markets, and possibly caused a shortage in credit. This in turn could significantly constrain economic growth. Likely fearing these consequences, ICBC announced on Monday that it had reached a deal that will allow the investors to receive their principals.

Thus, it appears that Chinese leaders are backing away from much needed financial reforms. However, it’s worth noting that this may be a tactical retreat, as this week it was also reported that the new national security commission that President Xi Jinping will head will have a division dedicated to financial security.