Financial repression – government policies that create an environment of low or negative real interest rates, with the goal of generating cheap financing for public spending – has long been a key feature of Chinese economic policy. But, with funding costs for businesses trending up, this is finally starting to change.

Early this year, the State Council, China’s cabinet, made lowering funding costs for businesses, especially small and medium-size enterprises (SMEs), a top priority. For its part, the People’s Bank of China (PBOC) has engaged in cautious monetary loosening, which includes freeing up more funds for lending by banks that allocate a certain proportion of their total loan portfolio to SMEs. The PBOC, through its “pledged supplementary lending” program, has also started lending directly to banks that have promised to use the funds for social housing construction.

But, so far, efforts to lower funding costs have had a limited impact. Indeed, the weighted average interest rate on bank credit to nonfinancial enterprises remains close to 7%, while economic growth has edged down from 7.4% year on year in the last three months to 7.3% in the current quarter.

The situation may not be dire yet, but it is far from ideal – especially at a time when the Chinese authorities are pursuing structural reform. The PBOC now faces a dilemma. If it loosens monetary policy further – by, say, cutting banks’ reserve requirement ratio – the momentum for restructuring could be lost; and there is no guarantee that the additional liquidity would flow into the real sector. But if the PBOC refuses to budge, the combination of high interest rates and slow growth may send the economy into a tailspin.

In fact, the PBOC has little choice but to engage in monetary-policy loosening. But it can avoid the pitfalls of such an approach by placing it within a broader, more comprehensive strategy that accounts for the underlying causes of the increase in funding costs for businesses.

The first factor driving up funding costs is the outsize profitability of China’s commercial banks – more than 23%, on average, for the top five last year – which account for some 35% of total profits earned by the 500 largest Chinese companies. Indeed, the average for banks is nearly four times that for Chinese companies as a whole, for which the average profit is just over 6%.

Moreover, slowing economic growth, tighter prudential regulation, and increased liability have made banks much more risk-averse, driving them to demand a significantly higher risk premium from borrowers, who must now not only provide collateral, but also find third parties to guarantee the loans. In many cases, banks are requiring a second group of guarantors to guarantee the first group. This growing aversion to risk makes it particularly difficult for SMEs to borrow from commercial banks, forcing them to turn to the under-regulated shadow banking sector.

Meanwhile, real-estate developers and local government financing vehicles (LGFVs), which offer banks a false sense of security and guarantee of profitability, have acquired a major share of financial resources. And financial institutions, especially banks, have been using a substantial portion of their funds for financial arbitrage. By reducing the amount of funding available to regular firms, especially SMEs, such activities drive up the average interest rate on loans.

Interest-rate liberalization is exacerbating the situation. China has already removed all controls on interest rates on loans. And, though it continues to guide interest rates on deposits, banks can easily evade these regulations by selling depositors off-balance-sheet wealth-management products, on which returns are not capped. Increases in the cost of funds’ sources increase the costs of the funds’ uses – that is, credit to enterprises.

Finally, Chinese banks’ activities are impeded by outdated and unnecessary regulations, including limits on how much credit they can extend in a year and a 75% cap on the loan-to-deposit ratio. In order to evade such controls, banks are moving a larger share of their lending activities off of their balance sheets. But such off-balance-sheet loans involve a larger number of intermediaries, increasing transaction costs.

In fact, the rising cost of intermediation – largely a result of the distortions in China’s financial system – is among the most important factors driving the rise in borrowing costs for Chinese businesses. That is why further monetary loosening by the PBOC, though necessary to address faltering growth, will not be enough.

In order to lower funding costs to a reasonable level, without undermining China’s economic-restructuring effort, monetary policy must be combined with well-designed and concerted financial reform. Only then can Chinese SMEs finally gain access to the funding they need to thrive.

Published in collaboration with Project Syndicate

Author: Yu Yongding is a former president of the China Society of World Economics and director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences.

Image: Chinese 100 yuan banknotes are seen in this picture illustration taken in Beijing July 11, 2013. REUTERS/Jason Lee.