Muzzling China’s money market mania
By John Foley
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.
China’s craze for online money market funds is giving savers a taste of financial democracy. That’s a good thing, if China avoids the mistakes that have given these products a bad name elsewhere.
Alibaba started the frenzy last year when the e-commerce group invited customers to put surplus balances from its online payment service into a fund. In less than twelve months Zeng Li Bao has attracted 542 billion yuan ($87 billion), much of it from China’s state-owned banks.
Lenders have decided the trend is too powerful to fight. Bank of China, Pinga An Bank and ICBC have all started offering online funds. CITIC Group is launching one that customers can invest in through cash machines.
Investors’ infatuation is understandable. The typical deposit account in China pays just 0.35 percent in annual interest. Money market funds offer more than 15 times that rate while still promising investors near-instant access to their cash.
This all works because of China’s restrictive bank rules. Official deposit rates are capped by law – a one-year deposit pays at most 3.3 percent. But money market funds can use a loophole that lets large corporate savers negotiate a better rate for their time deposits. This rate is typically two or three percent above the maximum available to regular savers.
In essence, the funds remove regular deposits from banks and then return them as corporate deposits. In most cases, three-quarters or more of the amounts raised by money market funds are recycled into the banking system in this way. Some of the rest goes into the interbank market, where even overnight deposits can earn a 2.6 percent annualized interest rate.
This is lucrative for money market funds but painful for banks, which lose a source of cheap funding and gain an expensive alternative. Even so, the idea of winning or keeping customers means lenders can’t help but join in.
The money-go-round could be good for the economy, though. China’s four biggest commercial banks hold the lion’s share of retail savings, yet combined loans are just 66 percent of their deposits – well below the 75 percent legal limit. If money market funds help to transfer deposits from these hoarders to mid-sized banks, which are more squeezed, lending could increase.
Danger on demand
So far, regulators have allowed money market funds to flourish simply by not intervening in the industry. But this kind of reform brings risk.
The United States serves as a reminder of the dangers of letting money market funds grow. The American industry established itself in the 1970s, when funds offered a way around rate caps on regulated bank deposits. Even after the U.S. liberalised most deposit rates, money market funds kept swelling, funding companies’ short-term borrowing needs.
The peril became apparent in 2008, when the venerable Reserve Primary Fund shocked customers by allowing its net asset value to fall below $1 per share. Investors promptly shunned some types of fund, which led to a financing squeeze. The U.S. Federal Reserve was forced to intervene.
Compared with the United States, China’s money market fund industry is still small. The main funds issued by Alibaba and rivals Tencent and Suning oversaw less than 700 billion yuan by the end of March, which is around 1.5 percent of total personal bank deposits. But the amount managed by Alibaba’s partner fund doubled during the first quarter of 2014. Citic’s cash-machine innovation, if it catches on, will make it even easier to access the funds.
China’s retail investors are especially flighty, so the most important thing is to ensure funds can meet redemptions. The country’s securities regulator makes managers put aside a share of their fees for that purpose. But when inflows are growing strongly, it’s easy to underestimate how much might be needed if investors suddenly want their money back.
The most obvious solution is to free up China’s bank deposit rates, reducing the interest rate arbitrage that powers money market funds. Even then, however, the funds would have an advantage. They do not have to set aside 20 percent of their deposits as a liquidity buffer, as banks do. If funds faced the same regulations as banks, their returns would shrink.
U.S. regulators are still tying themselves in knots over whether to take this step. China’s watchdogs have a chance to set the pace. If they do, China’s money market funds could be a helpful innovation, not a destabilising fad.