In addressing a question that was raised by Asher, “how do you think interbank lending and excess local-government borrowing from nonbank lenders interact, and which do you think poses a greater risk to the economy?” I looked up some numbers and what was originally a comment reply turned into a blog post.
To give a general synopsis of the question. Interbank lending has become a concern in China because the rates banks charge other banks has steadily risen evidence that banks distrust each other. At the same time local-government borrowing has reached unprecedented levels with municipalities in the hole for around 3 trillion dollars. Some provinces such as Guizhou has a ratio of debt to GDP of 79%.
I would assume the interaction is that banks are lending at high rates to small businesses drying up the amount of capital in their reserves and limiting the amount they have to lend to other banks. Local governments in competition with one another to fund infrastructure projects have offered high interest rates (8% is a common number) which banks have gobbled up, further reducing the capital at their disposal. With so much of their money tied up in investments banks have to worry over two things namely; default by the municipalities to which they have made loans and keeping sufficient capital in their reserves. With many municipalities running behind on their obligations banks are not receiving money on the schedule that they had planned for. Thus the losses or postponements to their return on investments has put banks at risk for being unable to pay back other banks if something significant effects the markets and causes one of their loans to go bad.
To say that one poses a greater risk to the economy than another misses out on how closely the two are tied together. As competition moves to an all time high and the large amount of economic growth has encouraged more risky ventures banks are susceptible the consequences of risky loans. The failure of several small loans are a few mid-size loans may impair banks to repay larger loans and a chain of defaults can cause a financial crisis. So in that sense their are similarities in the Chinese market now to the conditions right before the collapse in 2008 in the U.S. </p>