After turbulences in the stock and real estate markets, China’s next speculative asset bubble might be building in the Fintech sector. Stricter regulation won’t solve the underlying problem: the lack of attractive investment options caused by low interest rates and capital controls will keep producing new bubbles.
Asset price bubbles have become a permanent feature of China’s financial system. In 2015, eager individual investors entered the country’s previously lackluster stock markets in large numbers. Share prices rose to record highs over the summer before they crashed. Similarly, speculative investments in the real estate markets have led to rapid price increases, primarily in first- and second-tier cities. Between the onset of the bubble in mid-2015 and May 2017 housing prices in major cities increased by an average of 38.9 percent.
New dangers are already building in the FinTech sector. High-yielding investment vehicles, which are increasingly accessible through online finance, are set to attract a wave of new private investors, opening the possibility of yet another round of dangerous asset price inflation.
The usability and accessibility as well as high returns offered by online Wealth Management Products (WMPs) has made them popular among private and institutional investors. A WMP paying an annualized return above 4.5 percent can be purchased for 1000 RMB per month through the popular mobile phone messaging app Wechat with five clicks. Private households are setting up automatic salary transfers to funds available through Wechat and Alipay. This development has contributed to the rise of Alibaba’s online Yu’e Bao money market fund, which currently manages $165 billion and recently overtook JPMorgan’s US government money market fund as the world’s largest fund. The main secret to its success is that the fund consistently offers rates well above bank deposits (see figure 1).
China’s policy of financial repression is the root cause of market imbalances
China’s financial system is like a steam valve pressure cooker. Credit growth is accelerating, leading to ever more money seeking investment options, but low interest rates for bank deposits and strict capital controls drive investors into riskier alternatives.
Financial repression, a set of policies including controlled bank deposit rates, government ownership of banks, high reserve requirements and capital controls (which limit most Chinese to domestic investments), has been a large part of China’s economic development strategy. Because these policies allow the government to control inflation and to channel funds to government-favored projects, they are often seen as beneficial for economic growth.
However, there are also drawbacks: the combination of low deposit rates and the inability to purchase assets overseas implicitly taxes bank depositors. It thus creates an incentive to seek out riskier investment alternatives, increasing the danger of asset price bubbles.
Since 2007, monthly averages of both real 1-year and demand deposit rates have been mostly either low or negative (see figure 2). More often than not, households lose money by depositing funds in a bank account! It is not difficult to see why apartments, stocks, and increasingly, wealth management products are seen as better alternatives.
The persistently low bank interest rates are also an important reason why an increasing number of individuals seek to move their wealth abroad. This was recently compounded by an interest hike by the US Federal Reserve. In response, capital controls in China have been further tightened to prevent cash from leaving the country.
The arrival of large numbers of non-institutional investors (such as regular Chinese savers who desire higher rates) in a market, which they have little knowledge of, has been a major driver of past bubble formation. The asset purchasing frenzy continues until investors realize that assets are worth less than their prices. This triggers massive sell-offs, and the bubble bursts – often with devastating consequences for the respective sectors of the real economy and for China’s increasingly indebted private households.
Stricter regulation is only a temporary solution
But the Chinese government, due to its overriding concerns with economic stability and lack of trust in market mechanisms, has typically intervened with stricter regulations in the financial and real estate sectors. In the case of the stock market bubble, the combination of selling freezes and government-directed purchases has spooked international investors.
However, as soon as the government starts clamping down, household investors attempt to evade restrictions by exploiting regulatory loopholes or by seeking newly emerging investment opportunities under less regulatory scrutiny. Following this pattern, expect to see stricter regulations in the FinTech sector in the coming months – and expect to see investors trying to find a way around them.
So far, the government has been successful in containing any negative fallout from asset bubbles. However, the institutional deficiencies of China’s financial system will leave it vulnerable, and it is only a matter of time until a bubble inflicts severe damage to the entire system. But if the root causes are not addressed, the vicious cycle will continue. Whenever one bubble is defused or bursts, another one will evolve to take its place.
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