Featured faculty: Wu Xian
Written by Putro Harnowo

Against all odds, China managed to rack up record-breaking exports last year with a US$1.2 trillion surplus. It was quite unprecedented, given the US mounting tariffs for months. The tension eventually calmed following the October truce, but a bigger problem is brewing closer to home. The world factory has experienced sustained deflation since 2023.

In contrast to inflation, deflation is a broad decline in the prices of goods and services. While it is not always harmful, deflation may spiral into weak consumer spending, lower business profits, and increased unemployment. The government has committed to stimulating domestic consumption by lowering benchmark interest rates to encourage spending.

“When deflation happens, the government normally wants to boost the economy by lowering the interest rate to raise the inflation rate mildly. However, at some point, the interest rate will hit the floor and cannot be lowered further,” says Wu Xian, Assistant Professor of Finance at the Chinese University of Hong Kong (CUHK) Business School.

To shift away from heavy reliance on traditional interest rate adjustments, the central bank can utilise unconventional monetary policy tools. For instance, the People’s Bank of China, between 2013 and 2014, injected liquidity into the banking system by allowing certain bonds to serve as collateral for commercial banks to borrow. This tool is called collateral-based monetary policy or collateral framework.

“Collateral framework is not unique to China. It has also been adopted widely across the world, for example, the Federal Reserve’s term asset-backed securities loan facility and the European Central Bank’s long-term refinancing operations. However, its impacts were hard to measure,” Professor Wu adds. “There’s a lot of endogeneity in economics, so we couldn’t tell whether the change in markets is due to this policy or other factors, like bond characteristics or the unobservable economic shocks.”

A study by Professor Wu titled Collateral-based monetary policy: evidence from China, in collaboration with Fang Hanming of the University of Pennsylvania and Wang Yongqin of Fudan University, is the first ever to measure the causal positive effects of the collateral framework on the real economy.

Professor Wu and her collaborators find that the collateral framework significantly decreases the bond spread, or the yield gap between a corporate bond and a safer government bond, and provides companies with more capital to invest and pursue other business activities. This tool also has broader and long-term effects. For instance, follow-up studies show that a collateral framework targeting green bonds can stimulate more investments in green initiatives.

Lessons learned from Chinese bonds

China’s central bank provides lending programmes for commercial banks based on loan terms, including the standing lending facility or short-term liquidity operation for immediate cash, the medium-term lending facility with three to 12-month terms, and the pledged supplementary lending with three to five-year term loans to support specific sectors.

To obtain these loans, banks need to put down securities as collateral. Since 2013, the central bank has accepted treasury and local government bonds, as well as AAA-rated corporate bonds, as collateral. This framework was extended in June 2018 to include AA and AA+ rated corporate bonds. While AAA bonds are more secure, an AA rating offers a slightly higher yield for a marginally higher risk profile.

Interestingly, many Chinese bonds are traded on two venues, despite having the same fundamentals. Bonds listed in the interbank market for qualified institutional investors are also available on major exchanges, such as the Shanghai and Shenzhen exchanges, for non-bank financial institutions and retail investors.

Only bonds in the interbank market are eligible as collateral, since the interbank market is regulated by the central bank. Professor Wu and the team use these bonds as the treatment group and the same bonds in the exchange market as the control group. “This allows us to establish a causal relationship between the collateral framework and bond prices, which is not possible in other financial markets.”

The team examines daily bond trading from January to September 2018 and finds that the collateral framework increased the value of eligible bonds. Before the collateral expansion, banks could use the AA and AA+ rated corporate bonds to borrow from other financial institutions in the repo market. The repo market participants don’t lend money based on the full value of the bonds but reduce them by a few per cent.

“Companies can borrow at a lower cost as long as they can issue at least AA or AA+ rated bonds. This allows the central bank to support and ease funding to the real economy.”

Professor Wu Xian

Being included in the collateral framework trims such reduction by three per cent, boosting the collateral value and the prices of these bonds. It reduced the spreads of the newly eligible bonds by 37–53 basis points, equivalently, 10–15 per cent of the average spread in the secondary interbank market, where previously issued bonds are traded among qualified institutional investors.

This effect can further pass through to newly issued bonds in the primary market and allows bond issuers to secure a lower borrowing cost. It reduces the spread of the eligible bonds in the primary market by about 35-56 basis points. This means the bond issuers can borrow at a cheaper rate than before.

“Companies can borrow at a lower cost as long as they can issue at least AA or AA+ rated bonds. This allows the central bank to support and ease funding to the real economy,” Professor Wu adds.

Wider effect in the market

After 1 June 2018, issuing new eligible bonds is cheaper in the interbank market than in the exchange market. Firms can take advantage of this policy and choose the best market to issue bonds. Eligible bonds are more likely to be issued in the interbank market than the exchange market.

By the end of 2018, the People’s Bank of China’s lending facilities totalled more than eight trillion Chinese yuan, about 25 per cent of the monetary base.

“Collateral framework is crucial when interest rates are low,” Professor Wu adds. “This way, the central bank can conduct policy expansion by allowing commercial banks to borrow more and lend to other institutions and businesses.”

The 2018 collateral framework also made the People’s Bank of China one of the first central banks to specifically target green bonds. While her study doesn’t explore the impact on green finance, Professor Wu sees that follow-up studies have shown that green firms received more loans because of this framework.

Furthermore, as the interbank and exchange markets coexist with a shared bond structure, Professor Wu plans to understand more deeply whether this arrangement is efficient. Her next study looks into which type of assets should be traded in the decentralised interbank market, which holds 86 to 90 per cent of all Chinese bonds.

“There’s some benefit to keeping both markets, as each has its own strengths,” she adds. “A centralised market is more transparent, but you can find dealers to trade in large quantities in the decentralised exchange markets. How to design these markets is an interesting direction to explore in the future.”

The post How China fine-tunes bond values to spark economy first appeared on China Business Knowledge.

Featured faculty: Jiang Wenxi and Gao Zhenyu
Written by Putro Harnowo

During an economic downturn, central banks normally launch a stimulus package to boost economic activity by lowering interest rates. Commercial banks as lenders adjust their interest rates based on the benchmark set by the central bank. Reducing interest rates eventually translates into smaller monthly mortgage payments, allowing households to spend more and boost consumption.

When the US central bank cut its interest rate in September 2024 for the first time since 2020, consumer sentiment soared as they found relief from high loan payments. The same measures were also taken in Chinese Mainland. The People’s Bank of China has adjusted its benchmark interest rate, the loan prime rate (LPR), multiple times from 4.25 per cent in September 2019 to 3.1 per cent in March 2025, to stimulate economic growth.

Oddly, lowering LPR doesn’t seem to help domestic spending much. A new study finds that an interest rate cut doesn’t directly and smoothly translate into more money at the household level. It turns out that many Chinese Mainland households responded to the reduced LPR with mortgage prepayment, or paying off their mortgage early, and cutting their consumption.

“We observe a negative correlation between interest rates and mortgage prepayments in Chinese Mainland,” says Jiang Wenxi, Professor of Finance at the Chinese University of Hong Kong (CUHK) Business School. “In cities where more households prepay their mortgages, essential and non-essential consumption declines in the following months.”

In his latest study, Mortgage prepayments in China and monetary policy transmission, Professor Jiang and his colleague from the same department, Associate Professor Gao Zhenyu, examine what motivates households to prepay their mortgages. Caixin has reported that total mortgage prepayments in 2022 reached 4.7 trillion Chinese yuan (US$700 billion), accounting for 12 per cent of all outstanding mortgage loans, and continued into the first half of 2024.

Professors Jiang and Gao’s study discovers households that prepay their mortgages on average use up more than 70 per cent of their savings and reduce their spending by 2.3 per cent. “This explains why, despite monetary easing efforts since 2019, consumption growth and economic stimulus in Chinese Mainland have been weaker than expected,” says Professor Jiang.

“Households with greater wealth, higher levels of education, and better credit scores are more responsive to the gap between their mortgage rates and LPR, making them more likely to prepay their mortgages.”

Professor Jiang Wenxi

Unique characteristics of Chinese Mainland’s mortgage market

Home loan arrangements vary across markets, but the most common types are adjustable-rate, where the mortgage interest rates fluctuate over time in line with the central bank’s benchmark interest rate, or a fixed-rate mortgage, where the mortgage interest rate stays the same since the loan was taken.

When the central bank lowers interest rates, borrowers with adjustable-rate see lower monthly mortgage payments and more money for spending, making the economic stimulus swiftly affect households. For borrowers with fixed-rate mortgages, they can opt to refinance, which involves replacing the existing mortgage with a new one with better terms.

However, refinancing is prohibited in Chinese Mainland and mortgage rates are mostly adjustable at a very slow pace. Mortgage rate is based on LPR and “local margin” set by the city, which remains fixed throughout the loan term. Local margin varies depending on local rules, but tends to follow the direction of the central bank after a while. Therefore, lower LPR only results in small changes in mortgage rates much later. Researchers called this “mortgage rate rigidity.”

Before 2019, the benchmark interest rate stayed the same for a long time, making the gap between mortgage interest rates and returns on savings relatively small. When LPR was lowered, the rigidity of mortgage rates made the gap with earnings from savings grow more significant, and borrowers started to realise that carrying a mortgage is getting more and more costly.

How interest rate cuts weaken domestic consumption

In the study, Professor Jiang and Professor Gao, as well as Wang Kemin and Ren Haohan from Fudan University, analyse extensive mortgage data obtained from a major state-owned commercial bank in Chinese Mainland. They track borrowers’ payment and consumption behaviour between October 2019 and May 2024 from a randomly selected sample of 100,000 outstanding mortgages.

The researchers find that as the LPR declined, more and more borrowers prepay their mortgages. The prepayment ratio rose to 8.1 per cent by the end of 2021, stalled in 2022 due to the pandemic, and then peaked at 11.5 per cent by early 2023, as shown below. “Borrowers often decided it was best to cut back on both spending and saving so they could pay off their mortgage faster,” says Professor Jiang.

Further analysis shows that consumption of discretionary or non-essential items is particularly affected. “Households with greater wealth, higher levels of education, and better credit scores are more responsive to the gap between their mortgage rates and LPR, making them more likely to prepay their mortgages,” Professor Jiang adds. “The larger the gap between the mortgage interest rate and the LPR, the more likely they are to prepay.”

Designing more effective policy

In August 2023, the People’s Bank of China announced housing credit policies by lowering mortgage interest rates for first-time home buyers and local margin in some cities. The policies expanded the criteria of first-time home buyers, enabling certain borrowers to reset their local margin to a lower rate.

Given the fixed-rate feature of local margin is one of the causes of mortgage rate rigidity, lowering this extra fee helped mortgage rates move closer to the LPR. Around 25 per cent of households in the sample were qualified for this adjustment.

The researchers find that these qualified households were significantly less likely to prepay their mortgage and showed increases in their household consumption. “Policies that directly address mortgage rate rigidity can help monetary policy have a stronger and quicker effect on borrowing and spending decisions, improving how well monetary policy works,” says Professor Jiang.

This finding aligns with the policy initiative introduced in September 2024  by the People’s Bank of China, which aims to further strengthen monetary policy transmission through the household channel. The policy initiative features a new mortgage rate pricing scheme, which allows local margins to adjust to market conditions and shorten the LPR adjustment period from one year to as little as one quarter.

These measures enable the mortgage interest rates to respond more quickly to changes in the benchmark interest rate, reducing rigidities in the mortgage system. “As a result, mortgage prepayment activity has slowed remarkably since September 2024,” Professor Jiang adds.

The post How interest rate cuts could hurt consumer spending first appeared on China Business Knowledge.

Featured faculty: Su Yang
Written by Putro Harnowo

Something lurking in the shadow may sound vicious but believe it or not, “shadow banking” is a legitimate business. Also known as non-bank financial intermediation, shadow banking refers to entities like money-market mutual funds, hedge funds, and private credit that offer financial services similar to traditional banks but with less regulation and oversight.

According to a 2023 report from the Financial Stability Board, the total financial assets of the shadow banking sectors by the end of 2022 was US$217.9 trillion globally, almost half of the total global financial assets in the same period at US$461.2 trillion. In China, the shadow banking industry reached US$12 trillion in 2019, according to a report published by the China Banking and Insurance Regulatory Commission (CBIRC).

Chinese banks operate shadow banking as a wealth management product while other Chinese financial institutions offer it as a trust product, offering interest rates higher than traditional bank deposits. This has driven substantial demand from investors. However, such appeal has been approached cautiously as many prominent players faced devastating fates, such as Xinhua Trust, which collapsed in 2023, followed by Zhongzhi Group and Sichuan Trust in 2024.

Su Yang, Assistant Professor of Finance at the Chinese University of Hong Kong (CUHK) Business School, observes that wealth management products mature in three to six months, but the raised funds are used to finance long-term projects like real estate. Therefore, fund managers need to roll over or renew the products frequently. “To delay default, fund managers will use proceeds from new investments to repay maturing obligations, creating a Ponzi-like game, eventually bursting at a higher cost for investors,” he says.

“The maturity mismatch between the investment and the assets can lead to serious problems on the asset managers’ side, particularly during the recent real estate crisis to which many funds are heavily exposed,” Professor Su adds. “Fund managers will find it difficult to repay maturing debt when the property price falls a lot, and the secondary market of properties becomes illiquid.”

In a study titled Fiscal stimulus, deposit competition, and the rise of shadow banking: Evidence from China, Professor Su, along with Viral Acharya of New York University, Jun Qian of Fudan University, and Yang Zhishu of Tsinghua University, looked into the dynamics of wealth management products issued by Chinese banks and how the competition among banks has fueled such products.

The year of shadow banking rises

The researchers looked at quarterly wealth management activity statements submitted to the CBRIC by 25 major and medium-sized banks in China from 2007 to 2014, as well as wealth management product balances from 135 banks from the CBRIC and individual wealth management product information from the Wind Economic Database.

The analyses found that less than 500 wealth management products were launched annually before 2007, but the number grew to more than 1,170 in 2007 and 4,080 in 2008, then rose to over 55,910 in 2015. The demand for wealth management products increased significantly after 2010. The government stimulus and competition among banks propelled the increase of wealth management products.

“The maturity mismatch between the investment and the assets can lead to serious problems on the asset managers’ side, particularly during the recent real estate crisis to which many funds are heavily exposed.”

Professor Su Yang

Specifically, when the 2008 Global Financial Crisis caused a sharp decline in exports, the government introduced a four trillion Chinese yuan stimulus plan. The Big Four banks, the Industrial and Commercial Bank of China, the China Construction Bank, the Agricultural Bank of China, and the Bank of China, played a crucial role by providing the lion’s share of the funds for the investment projects associated with the stimulus, leading to a large increase in loans and credit.

The Bank of China has been positioned to handle cross-border transactions since its inception. The weakening exports in 2009 threatened its deposits more than other banks. Meanwhile, the bank was also much more aggressive in lending money than other banks to support the stimulus plan. As a result, it became much more aggressive in attracting deposits.

After 2010, the average deposit rate premium offered by the Bank of China was significantly higher by about 0.2 per cent compared to the other big three. Small and medium-sized banks operating in the same region as the Bank of China felt intense competition and experienced lower deposit ratios, forcing them to issue more wealth management products.

“The effect of such deposit competition lasted until at least 2019,” says Professor Su. “Banks that were more exposed to Bank of China’s competition not only issued more wealth management products but also more modes to raise funds from the bank-to-bank lending market.”

The rollover risks of short-lived products

The central bank dictates how much money banks have to keep in their vaults and the limit of money being lent out compared to the bank’s deposits, prohibiting banks from lending more than 75 per cent of their total deposits. Wealth management products circumvent these rules and serve as a substitute for deposits without price control from the central bank.

After analysing information on wealth management products from the Wind Economic Database from 2007 to 2014, the researcher found significant clustering of products maturing exactly on the last day of the quarter. This timing coincides with the CBRIC’s inspection of the deposit ratio, indicating a deliberate setting of maturity dates so the issuing banks can boost total deposit balances on the inspection days.

When wealth management products mature, banks transfer funds from the investors’ accounts to their savings or deposit accounts, temporarily boosting the bank’s deposit balance. However, if a large amount of wealth management products mature on a particular day, banks will have to raise capital within a short window by rolling over new products. With the increasing scale of products to renew, banks would have to offer higher interest rates on new products to attract enough investors quickly.

“Increased reliance on shadow banking has two main problems compared to formal banking,” says Professor Su. “First, unlike deposits, which are the most stable source of funds for banks, shadow banking products are typically short-term and need to be rolled over frequently. Frequent rollover leads to more liquidity pressure and can lead to liquidity distress in bad times.”

“Second, bank depositors are protected by insurance and will not run on banks. However, shadow banking products are not insured in any way,” he adds. “When the shadow banks fail to deliver expected returns or investors lose confidence in them, investors will run on the shadow banks, and bank runs can sometimes force bankruptcy of even financially healthy institutions.”

To prevent unnecessary bank runs, Professor Su suggests strictly implementing information disclosure for transparency between shadow banks and investors. Investors should also realise the underlying risks of investing in wealth management products. “However, this needs to be built on the premise that the shadow banks themselves do not guarantee the investment return in the first place,” he adds.

The post The risks and rewards of Chinese shadow banking first appeared on China Business Knowledge.

By Jaymee Ng, Principal Writer, China Business Knowledge@CUHK

The rapid development of financial technology, also known as FinTech, in recent years has transformed how people use financial services. On the one hand, the increasing use of automation in banking services has brought with it greater convenience for consumers. On the flip side, the advent of new technological developments such as cryptocurrency, high frequency and algorithmic trading, the rise of the digital wallet or peer-to-peer (P2P) lending, are all examples of FinTech that have brought new challenges to traditional financial service providers to some extent. Given the disruptive influence of FinTech, it was only natural that a group of researchers sought to closely examine its effects on the stability of traditional financial institutions. What they found was that the result very much depended on the market.

The stability of financial institutions usually refers to the ability of these institutions, such as banks, brokerage firms or credit unions, in performing their roles in financial transactions or other intermediation functions without assistance from external forces such as the government. The promise behind FinTech is that it would help financial institutions to enhance transparency, efficiency and make its services more convenient for users. For example, mobile banking has allowed consumers to conduct their daily financial activities, such as transferring funds or paying bills, without the need to talk to a teller or visit a bank branch.

“Regulators should give up on the idea of a one-size-fits-all regulation for FinTech.”

Prof. Jason Yeh

On the downside, Fintech could amplify volatility in financial markets and make the financial system more vulnerable. For instance, the speed and ease of moving cash between banks in response to financial market performance enabled by FinTech can increase volatility. The heavy reliance on third-party service providers for the FinTech activities could also pose a systemic risk to financial institutions. Finally, online lending platforms often fail to conduct effective credit checks on borrowers, which can lead to higher default risk.

For example, China’s P2P lending industry, once the world’s biggest, has completely collapsed in just a few years. Many Chinese P2P lending platforms were plagued by fraud, defaults and even alleged Ponzi schemes, which eventually led to a government crackdown. The Deputy Governor at People’s Bank of China Chen Yulu announced in January that it had eliminated all P2P lending platforms in the country, however more than 800 billion Chinese yuan in debt is still left unpaid, state media Xinhua News reported.

More recently, two of China’s homegrown fintech champions, Ant Group and Tencent, are coming under intense regulatory scrutiny by domestic regulators over business models that some worry will lead to a dangerous accumulation of systemic financial risk.

Yin Versus Yang

“Where there is light there must also be shadow,” says Jason Yeh, Associate Professor in the Department of Finance at The Chinese University of Hong Kong (CUHK) Business School, and one of the authors of a new study. “Given the disruptive nature of technology, the rise of FinTech is bound to have an impact on traditional financial institutions. So it’s kind of fitting that we find that the bright and dark sides of FinTech seem to offset each other and the promotion of FinTech doesn’t necessarily make financial institutions more vulnerable.”

Titled Friend or Foe: The Divergent Effects of FinTech on Financial Stability, the study was co-conducted by Prof. Yeh with Profs. Derrick Fung, Wing Yan Lee and Fei Lung Yuen at The Hang Seng University of Hong Kong.

To examine the impact of the rise of FinTech on the stability of financial institutions, the researchers looked at the introduction of FinTech regulatory sandboxes. A FinTech regulatory sandbox is a way for a financial regulator to allow companies to try out new business models, products or services (under a controlled and supervised environment) that are not covered or permitted by existing legislation. The first such sandbox was introduced in the U.K. in 2016. Since then, 73 similar initiatives have been set up in 57 countries around the world, according to the World Bank.

The team sampled all listed banks worldwide that were active on the Thomson Reuters Datastream platform between 2010 and 2017. Their final sample included 1,375 banks from 84 countries. Using a common measurement of bank stability, the research team found that the introduction of sandboxes did not have a statistically significant impact on the financial stability of the institutions in the same jurisdiction.

They found that the positive and negative effects of these FinTech sandboxes on financial stability tended to offset each other after discounting for the characteristics of individual firms or markets, or macroeconomic and other bank-specific factors. In general, they also found that FinTech increases the stability of financial institutions in emerging financial markets and decreases it in developed financial markets.

Boosting Stability and Profits

Looking at specific market characteristics, the study also found that the promotion of FinTech through the setting up of regulatory financial sandboxes can at the very least enhance the stability of financial institutions if the market has low financial inclusion, with

• A bank branch ratio of less than 11.7 per 100,000 adults;
• A central bank assets to GDP ratio of less than 1.6 percent;
• An industry-wide bank net interest margin of less than 2.4 percent, or
• A provisions to nonperforming loans ratio of less than 44.2 percent.

On the other hand, the launch of financial sandboxes in markets with high financial inclusion can undermine financial stability, the study found.

Moreover, Prof. Yeh says that FinTech can also improve the stability of financial institutions by boosting profitability. According to the study, when a country has fewer bank branches than 11.4 branches per 100,000 people, a central bank assets to GDP ratio of less than 1.7 percent, bank net interest margin of less than 2.2 percent, or a provisions to nonperforming loans ratio of less than 45.6 percent, promoting FinTech by setting up regulatory sandboxes can increase the profitability of financial institutions.

But why does FinTech enhance the profitability of financial institutions in emerging financial markets? The authors speculated this may be due to three reasons. First of all, FinTech has been widely adopted in emerging financial markets and has greatly increased the profitability of the banks that invested in these FinTech start-ups. Second, the operational efficiency of the banks in emerging financial markets improved as a result of collaboration with technology companies. Third, the products provided by FinTech companies are often complementary to the existing services provided by banks. These banks gain more customers as a result, and the complementary effect is greater in emerging financial markets.

“FinTech is disruptive but it is also a force for emancipation. Not only has it democratised the access to financial services for the masses in emerging markets, but it also plays a pivotal role on the road to greater financial inclusion,” Prof. Yeh says.

Policy Implications

As the FinTech industry continues to grow, policy makers and financial institutions are seeking ways to reap the benefits of technology further. Prof. Yeh and his co-authors think that their research findings can help policy makers and regulators to better utilise FinTech in different markets.

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For developed financial markets, the researchers advise regulators to focus on implementing measures that can address the instability caused by FinTech. In contrast, regulators in emerging financial markets should consider designing specific measures to promote FinTech innovations.

“Regulators should give up on the idea of a one-size-fits-all regulation for FinTech,” Prof. Yeh comments. “What they need is to come up with a tailor-made framework that matches the characteristics of their own financial markets.”

The post Fintech: Friend or Foe to Financial Stability? first appeared on China Business Knowledge.