The hidden tax of zero rates on consumers
Michael Pettis is out with another great piece on the likelihood that non-performing loans (NPLs) will rise in China when the present spate of malinvestment comes a-cropper. What caught my eye were his statements about the hidden ways in which government pays for bank recapitalization in order to deal with the threat of NPLs. Here’s what he had to say about interest rates.
The role of interest rates
The first of the three tools used to manage the banking crisis involved reducing the accumulation rate of NPLs, basically by keeping borrowing rates low. The PBoC actually has been explicit about this policy. Low borrowing costs make it easier for struggling businesses to roll over the debt, and effectively reduce the real value of debt payments. This slows the growth of NPLs by passing on part of the cost to someone else.
Remember that if you reduce the coupon payment on a loan, it is economically the same thing as forgiving part of the principle amount, but this forgiveness is effectively disguised. Those who remember the Brady debt restructurings of the 1990s fully understand how this works. In the main Brady restructurings, creditors were offered equivalent exchanges in which either principle was explicitly forgiven (the so-called Discount Bonds) or, alternatively, for those who found it difficult to recognize or acknowledge the principle discount, coupons were set at very low fixed rates (the Par Bonds). Similarly, by repressing interest rates, the PBoC was able to transfer part of the principle cost onto the banks that made the loans and so obtain debt forgiveness for the borrowers.
But while this helped the borrowers, it did not of course help the banks – unless the banks themselves were able to push the cost onto depositors, which of course they did. The PBoC repressed both lending rates and deposit rates to allow struggling borrowers debt forgiveness and some breathing space. Of course households paid for this in the form of very low returns on their savings (and with few alternative investment opportunities, they had no choice but to accept the cost).
Clearly, this is what has been occurring in the United States and elsewhere too. Zero rates are a hidden tax on savers that act to reduce NPLs and transfer money from savers to debtors and their lenders. I should also point out that zero rates lead to a depreciated currency as the demand for a currency with low interest rates drops vis-a-vis currencies where interest rates are higher. So, in this sense, zero rates are also implicitly a form of currency manipulation, something to remember when thinking about the Chinese and their own currency games.
What is also clear from Pettis’ account is that banking crises are transmitted to the real economy via credit writedowns of NPLs and the distress associated with bankruptcy of large debtors. There is no cost-free way to deal with this; somebody pays the cost of those NPLs. The only question is who.
if a highly insolvent banking system is cleaned up, you cannot simply assume away the cost without identifying who actually paid for it. Here is where the confusion resides. The optimists perhaps assume that the only way that a banking crisis gets resolved is through a banking collapse or an explicit bailout. Since there was no banking collapse in China in the past decade, and what looked like a fairly small and manageable bailout, then clearly there was no real banking crisis, right?
Not necessarily. There are many ways to resolve banking crises, some more visibly and some less so – just no way to resolve them costlessly, and the key is to figure out the true cost and how it was paid. As I see it there were mainly three sets of tools Beijing used to manage the sharp increases in bad loans that threatened the banking system a decade ago, and of the three, the two most important were not explicit and so not easily measured or noticed. All of these required forcing down interest rates so as to pass the bulk of the cost onto bank depositors, and so all of these had an adverse impact on the quality of Chinese growth. In other words the previous cost of the banking crisis was not a banking collapse, but that doesn’t mean the cost was easy to absorb.
Much more on China and the coming wave of bad loans below. Pay special attention to the part about Chinese banks making a killing on the spread between lending and borrowing. That’s where American banks are now finding hidden sources of capital.
Who will pay for China’s bad loans? – Michael Pettis