New tools for China´s central bankers – Sara Hsu

One of the reforms in China have changed the way it´s central bank is operating, writes financial analyst Sara Hsu in the Diplomat . A new set of tools allows the bankers to be more creative.

Sara Hsu:

China also has some new tools to add to the traditional monetary policy system. The People’s Bank of China introduced a standing lending facility in 2013, which provides funds to banks facing a liquidity squeeze. The standing lending facility was expanded in January of this year to lend to small and midsize banks in 10 provinces and cities. In addition, relending has been used historically and again today to provide incentives for banks to lower financing costs when lending to targeted sectors. Recently, the central bank has added a new tool, called pledged supplementary lending to help banks target borrowers with collateral. Pledged supplementary lending targets medium-term interest rates and, like relending, avoids the blanket changes to the monetary system that are associated with traditional tools.

Some analysts feel that the targeted tools go too far, into the realm of fiscal policy. In particular, the practice of relending and the new pledged supplementary lending tool give preference to specific sectors. However, these tools counteract a long-standing complaint that monetary policy is a blunt instrument. Targeting particular segments of the economy sharpens the policy. And why shouldn’t the central bank go further? After all, it is not independent of the government. Government bodies in China are expected to follow policy mandates, and the central bank is no exception.

Perhaps a more salient question is whether these creative monetary tools will allow market forces to emerge, or whether they will perpetuate a financial regime of policy-led lending. One major problem with China’s banks, recognized by analysts for decades now, is that financing is constrained since banks tend to lend to particular enterprises, mainly large and state-owned enterprises. With new, directed lending, market forces continue to be left out of the picture. Less efficient and less profitable enterprises may receive funding while more efficient and more profitable enterprises may be unable to secure a bank loan. In this case, the latter are forced to turn to the shadow banking system to obtain funding.

The shadow banking system is, well, shadowy – it may face challenges in controlling for risks, especially since shadow banking loans often come at higher interest rates. This gives rise to adverse selection, in which borrowers who are willing to pay higher interest rates are often riskier firms. An expanding shadow banking system (with the exception of informal finance, in which borrowers and lenders have preexisting relationships) may therefore pose economic risks that banks would be able to control.

Doubtless the People’s Bank of China has a difficult task, particularly in a less buoyant economy. The leadership wants to maintain a stable economic growth rate, and this poses a challenge since market forces would otherwise most likely act to pull economic growth down. The central bank is currently playing a major role in balancing the economy. Ironically, to meet long-term financial reform goals that entail opening up to market forces, the central bank must be less involved in targeting individual sectors. The impact of less directed lending will be more financial capital available to other enterprises, hopefully those that are efficient enough to remain strong during the next economic downturn.