China Just Killed Its $491 Billion Private Lending Market

(Bloomberg Opinion) – Sometimes you have to wonder what Beijing’s priorities are: helping small businesses weather the Covid-19 storm or taking victory laps. The message to the world of private banking is unclear.

Beijing has pledged to reduce the cost of borrowing and its latest focus is private lending. China’s Supreme Court has ordered that interest rates on private loans, which include microcredit, pawnshops and online peer-to-peer lending, be lowered by up to 10 percentage points. Previously, when disputes arose, the Chinese legal system honored agreements with rates of up to 24%. From now on, the ceiling is 15.4%, i.e. four times the reference rate.

At first glance, China seems to be protecting the little guys. In reality, however, Beijing is shutting down an important funding channel for those who need it most. The Covid-19 outbreak has worsened small business credit profiles, and this new lending cap could completely shut down a corner of shadow banking. Moody’s Investors Service estimates the informal lending market stood at 3.4 trillion yuan ($491 billion) as of March 31.

The Wenzhou Private Finance Index gives us insight into the prevailing market rates for private loans. The composite rate, which includes services such as microfinance, was above 16% in the third week of August. Even direct loans – usually cheaper because they avoid bank charges – would require an interest rate of 13%. Anything below is unprofitable for lenders.

This is why this new decision of the Supreme Court is most likely the result of political considerations. After all, it coincided with the first anniversary of China’s new benchmark lending rate.

In August 2019, the People’s Bank of China changed its benchmark rate to the prime lending rate, or what banks charge their best customers. It was designed to connect the sleepy, opaque world of lending to more liquid money markets, which react to the policy tools of the PBOC. Over the past year, the benchmark has been lowered by 40 basis points to 3.85%.

In the murkier world of private lending, however, financiers simply ignored the new benchmark. Look no further than the Wenzhou indices for proof: the cost of borrowing hasn’t come down at all, which is likely why Beijing is locking in the new rate.

One cannot help but marvel at the Supreme Court’s market pricing mechanism. Why four times the prime loan rate, and not 3.5 or 4.5 times? For a sprawling bureaucracy that can calculate its bankers’ compensation with a complex formula involving inverse trigonometric functions, this one is too linear, rushed and simplistic.

And since we are one year away, it is reasonable to ask whether the new key rate has lowered the cost of borrowing. Let’s take a reality check.

A PBOC crackdown on interest rate arbitrage in the spring caused a bond rout this summer, raising costs for corporate borrowers. For the same reason, the cost of issuing negotiable certificates of deposit, an important source of funding for regional banks, has also increased. On average, banks issue 1-year AAA-rated MNTs at 2.9%, leaving little room for them to make a profit if they have to lend at 3.85%. In practice, this means that bankers prefer to sit back and not lend at all.

Ultimately, the problem comes down to how the reference is defined. These are the interest rates that banks are getting through PBOC open-market operations, as well as the macroeconomic risks that they perceive, which, in theory, should amplify in the event of a downturn. But this is China. No big boss of a public bank is willing to admit that credit spreads can widen – not even in the age of Covid-19. Accordingly, the new rate is a joke.

By setting artificially low lending rates, Beijing is virtually shutting down some markets. Even the Federal Reserve, which buys everything from corporate bonds to mortgage-backed securities, largely stays away from opaque private lending. China still has a lot to learn.

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. She previously wrote about markets for Barron’s, following a career as an investment banker, and is a CFA charterholder.

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Priscilla C. Carnegie