China Tobin tax, shadow banking and moral hazard
James Saft: China’s regulators sending out confusing signals.
Sometimes it can be hard to understand just what exactly China’s regulators are trying to achieve.
Take, for example, two interesting but fundamentally conflicting stories in the past week: the bailout of a trust product and discussion of a Tobin tax on financial transactions.
The forces behind these two stories are pulling against one another, with the shadow banking bailout creating a moral hazard enticement for the capital flows the Tobin tax is intended to stem.
In a deal reportedly orchestrated by Chinese authorities, a US$495m wealth management product called Credit Equals Gold averted default this week, though investors will be singed by the loss of some promised interest payments. The deal, originally raised by China Credit Trust for an investment in a coal mining company and sold through the Industrial & Commercial Bank of China Ltd., is part of a burgeoning US$6trn shadow banking sector.
While allowing the high-yielding deal to default would have dealt a blow to the banking sector, it would also have sent the much-needed message that risk and reward in China are connected. But with investors taking the rewards and someone else bearing the risks, moral hazard is the obvious outcome.
“The concern is that a wealth management product credit event could trigger a broader loss of investor confidence akin to a deposit run,” ratings agency Fitch said in a commentary.
“However, by bailing out investors in this particular instance, the authorities are perpetuating moral hazard within the Chinese financial system and this risk may in fact have become a whole lot bigger.”
Investors in China have treated, and for good reason, wealth management and other shadow banking products as if they were somehow guaranteed, paying more attention to who is selling them and how much they yield than how secure is the investment the money is ultimately funding.
That lack of discrimination about capital allocation can be seen in the wilderness of unused or unoccupied real estate developments in China and in the very low aggregate returns on capital investment there. Send yet another message that investors will be bailed out even if, as in this case, the mine proves a bust, and you will get more un-needed holes dug in the ground.
That brings us to the idea of a Tobin tax – a small levy on individual currency transactions intended to stem speculative hot money flows into the yuan. Long debated for China, the idea was most recently elevated by Guan Tao, head of the department of international payments at the State Administration of Foreign Exchange (SAFE), who last Friday said it was under consideration.
“If the renminbi (yuan) continues to be stable or rise sightly while yuan interest rates are higher than those of major currencies, financial operations of many companies could lead to more money inflows,” Guan told a news conference.
True enough, but what is also true is that if you institutionalize a system with high rewards to capital not well correlated to the actual outcomes of investment you are going to see a lot of money sloshing your way.
A recent study by research group Global Financial Integrity suggests that some US$400bn has made its way into China since 2006 by dodging official channels, much of it effected by reporting falsely high prices of goods sent to Hong Kong. That money can then be brought back into China “legitimately” and put to work.
Not only is that a play on the appreciation of the yuan, it is a path into high-yielding shadow banking investments, and one made all the more attractive by low rates overseas.
China’s primary challenge in coming years is to make a transition from an economy highly dependent on unsustainable levels of investment towards one balanced by a larger consumer sector. While China is right to be concerned about hot money flows, it won’t improve capital allocation by simply blocking them, especially if it rewards and indemnifies dumb money at home.
It is obvious that you cannot offer high returns on lousy investments indefinitely, though it is equally obvious that so far China, with strong central control, has kept this game going.
A slow and steady climbing down from the peaks of moral hazard would be a lot more useful than a Tobin tax in ensuring a happy ending.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at email@example.com)