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Alibaba’s Money Market Fund Poses a Dilemma for Chinese Policymakers

Can Beijing liberalize interest rates and free up financial innovation without unleashing instability?

Amid all the hype over Alibaba’s planned initial public offering, one detail has been overlooked. The blockbuster deal, which could be the biggest Internet IPO ever, apparently won’t include the Internet giant’s fastest-growing business, the money market fund Yu’e Bao.

Launched less than a year ago to capitalize on the cash balances that merchants leave in Alipay, the e-commerce company’s online payment system, Yu’e Bao has grown at a phenomenal rate. At the end of March, just nine months after it opened, the fund boasted 541 billion yuan, or $87 billion, in assets. Yet the business didn’t get a single mention in the 341-page prospectus that Alibaba Group Holding filed with the U.S. Securities and Exchange Commission last week.

I mention this fact not to cast doubt on Alibaba’s complex corporate structure or to flag the potential risks to investors in the IPO, of which a great deal can and has been written, but to point out the stunning overnight success of Yu’e Bao. The fund’s growth underscores the tremendous appetite among Chinese investors for yield and diversification after decades of financial repression. What’s not yet clear is whether Yu’e Bao’s success will free up those forces and hasten financial liberalization in China or prompt Beijing to keep one foot firmly on the brake.

A recent visit to China offered a glimpse of the ferment that bubbles just below the surface of the country’s sprawling financial system. Last November, President Xi Jinping and Premier Li Keqiang signaled a fresh commitment to reform by endorsing a policy blueprint promising that market forces would play a “decisive role” in allocating resources. That’s essential if China is to make the transition from an investment-driven export model to a consumer-led economy. But market forces entail the kind of instability that Beijing fears and loathes.

Meet with a Chinese financier these days, and talk will quickly turn to one of two topics: corporate bond defaults, and Yu’e Bao and the rise of online finance.

In January investors in the 3 billion yuan Credit Equals Gold No. 1 wealth management product were forced to take a writedown when the mining company behind the instrument ran into financial trouble. And in March the country experienced its first corporate bond default when Shanghai Chaori Solar Energy Science & Technology Co. was unable to make an interest payment on a 1 billion yuan bond. The incidents hint at potentially large losses in the wealth management market, a 10 trillion yuan sector that sprouted in recent years after the authorities sought to curb credit growth at banks.

The consensus in Beijing and Shanghai is that the number of defaults will grow but that China runs no risk of a so-called Lehman moment. As one fund manager put it, the authorities will permit defaults to occur in industrial sectors with overcapacity, such as solar panel makers or iron and steel producers, and among issuers of institutional, rather than retail, paper. China’s bond market has grown rapidly, and fund managers are eager to enhance their credit assessment capabilities, but most firms still assume that Beijing will keep market forces on a very tight leash. In short, this is a bond market with very Chinese characteristics.

Yu’e Bao elicits envy and distaste from Chinese fund managers and bankers: envy from fund managers, whose equities businesses have languished under the weight of a five-year bear market; distaste from bankers, who don’t like an upstart challenging their supremacy in China’s financial system.

A senior executive at one leading bank dismissed Alibaba’s money market fund as a flash in the pan while, in the very next breath, criticizing it for taking advantage of an uneven playing field. It’s easy to understand this banker’s ire. The People’s Bank of China sets a ceiling on the rates that banks can pay to retail depositors, currently at 3.3 percent for one-year deposits. Yu’e Bao exploded in popularity by offering rates more than twice as high, although they have since declined to levels closer to 5 percent. Adding insult to injury, from the banks’ perspective, Yu’e Bao invests most of its funds in time deposits at the banks, through deals struck on the interbank market. In effect, the banks are financing the rise of a new rival.

Yu’e Bao’s ascent has been meteoric, but rivals are quick to ask, How would it cope with a sudden demand for liquidity? The fund entails a classic maturity mismatch, investing in term deposits to gain higher yields while offering investors the ability to withdraw money whenever they like. U.S. regulators discovered how toxic that imbalance could be when the $62 billion Reserve Primary Fund broke the buck in 2008, causing a run on money market funds that nearly crashed the financial system. Chinese regulators appear to be waking up to the risks. With other Internet operators such as Tencent Holdings and Baidu looking to get in on the action, top officials at the People’s Bank of China have called in recent weeks for tighter supervision of money market funds, and even suggested imposing reserve requirements on them.

The authorities will have to balance these risks and competing interests as they move to gradually liberalize interest rates and rebalance the economy. It won’t be easy.

One Shanghai-based fund manager predicts that the authorities will establish a deposit insurance system later this year as a prelude to starting to liberalize deposit rates in 2015. But don’t expect change to occur overnight, he cautions: Interest rate liberalization took a decade to play out in the U.S. in the 1970s and early ’80s. (Left unsaid was the role that liberalization played in causing the savings and loan crisis of the late ’80s.)

By their statements and policy hints, Chinese officials seem to want to enjoy the yin of market-based dynamism while preserving the yang of centrally planned stability. They are unlikely to be so lucky. Tough choices lie ahead.

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