Last night the PBoC announced, for the fourth time this year, that they were lifting interest rates in the banking sector. The 1-year deposit rate was increased by 27 basis points to 3.60% and the minimum 1-year lending rate was increased by 18 basis points to 7.02%.
Rising lending rates put pressure on marginal companies who may be having trouble repaying their loans. With real rates in China so low, and the economy booming, there is clearly pressure on the financial authorities to push interest rates higher, but at the same time doing so might push up loan delinquencies, and the banking sector is still much too fragile for it to absorb an increase in non-performing loans.
I have heard a nuber of analysts argue, however, that debt servicing costs are actually declining, not rising. This is because what is going up is the nominal rate, not the real rate (i.e. the nominal rate after the impact of inflation is removed). So far this year inflation has risen much faster than lending rates, so real rates for borrowers are actually declining. If that's the case, the increase in lending rates should have no adverse impact on borrowers -- in fact it should make debt servicing easier, right?
Not necessarily. If real rates are constant while nominal rates rise, the net impact is that the total servicing cost may be the same over the life of the loan, but the repayment has effectively been accelerated. In a higher nominal rate environment, borrowers pay more, in real terms, in the early years and less in the later years -- and this is true even if the loan maturity is short but the loan is continuously rolled over at maturity, in which case the distribution of the real debt servicing cost is the same as that of a perpetual loan.
To give an idea of the impact, let's assume that China's nominal rate is increased by 36 basis points (the last two rate increases) while inflation has risen by 1%. The real debt servicing cost will have declined, in other words, by 74 basis points over the life of the loan.
But this "savings" will not be evenly distributed. Most of the savings will accrue at the time the loan is repaid, but in the earlier years the borrower will actually pay more in real terms. The value of the first three years of debt servicing cost, in this example, will have risen by approximately 3% in real terms.
The numbers get much worse if we assume that the PBoC will continue allowing rates to rise so as to keep real rates constant. If we assume that both nominal rates and inflation move up by 1% (so real rates stay the same), the real value of the first three years of debt servicing will rise by 13%. So far this year the one-year lending benchmark has gone from 6.12% to 7.02%. Inflation has risen by more than 2%, so real rates have declined by much more than 1%. The real debt servicing cost for borrowers has nonetheless risen by over 10% over the first three years.
The lesson is that real rates matter, but so do nominal rates. The fact that real rates have been declining in China creates a lot of problems for an overheating economy, but at least, say many of us, it reduces the burden for borrowers and so relieves non-performing loan pressure on the banks. That turns out not to be true except only after many years. In the short and medium term, rising nominal borrowing costs put real pressure on borrowers. Rising nominal rates and declining real rates are bad all around.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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October, 2007
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