CREATING A LEADING FINANCIAL SYSTEM: A WORK IN PROGRESS
In October 2017, during the 19th Party Congress, Zhou Xiaochuan, one of China’s most respected economic leaders, who would retire in 2018 after a fifteen-year tenure as governor of China’s central bank, issued a stark warning about the risks China faced from “excessive debt and speculative investment.” He spoke of a possible sharp correction, known as a “Minsky moment,” so named for US economist Hyman Minsky, who became well known for suggesting that financial risks previously ignored or hidden during an economic expansion could surface unexpectedly, causing asset prices to drop, followed by financial defaults with potential systemic consequences. Indeed, official concern about systemic financial risk had been growing in the leadup to the Party Congress. Multiple factors contributed to official intervention: the confluence in 2015–16 of a negative growth shock, a major stock market boom and bust, a surge in capital outflows to pay for large foreign acquisitions of non-core assets by private enterprises, and associated exchange-rate depreciation. Corporate enterprises were ordered to reduce their indebtedness, banks were ordered to write off bad loans that had accumulated on – and significantly – off their books. Banking and insurance regulators who had operated in silos were merged, replaced with a common supervisory framework to prevent financial risks and manage them if they occurred.
Zhou’s warnings, however, were about a financial system that is a work in progress – a bank-dominated system in which mandates, capabilities, and skills in financial regulatory institutions lag financial innovation and risk-taking in the economy. It is a system conveying mixed signals from political leaders who focused on aggregate growth targets, to be met if necessary by expanding credit, even if such a move magnified liquidity concerns. Only belatedly did their focus shift to preventing and managing the systemic risks of “excessive debt and speculative investment.” China’s financial system and its institutions are rooted in the planned economy, but a modern financial system is based on transparency and the rule of law, which are necessary to manage the volatility introduced by cross-border financial flows. The institutions of the modern financial system supply short-term credit through banks and Internet finance, and long-term direct finance through bond and equities markets. Inevitably, as China’s economy grows, its financial system will become deeply integrated into world markets. How might China proceed as its financial institutions and regulatory practices continue to develop and change, and what are the risks of financial crisis in light of ongoing modernization and opening up?
BACKGROUND
A modern financial system, first and foremost, should support the real economy. It does so by reducing information asymmetries between borrowers, who know a lot about their ability to repay loans on time and in full, and lenders, who do not. A modern system facilitates payments in economic exchange, mobilizes and pools savings, acquires and processes information about potential investments, helps direct savings to productive uses, diversifies and reduces risk, and monitors investments in enterprises as well as the performance of their managers.
China started down this road following its accession to the World Trade Organization (WTO) in 2001, when the banking system was opened and modernized. International investors were attracted by opportunities to acquire stakes in large state-owned banks to help them upgrade their management and introduce market discipline through public listings of their shares. Separate banking, insurance, and securities regulators provided regulatory oversight. Interest rates, initially set by the State Council, were eventually liberalized to improve the pricing of risk. At the same time, regulators tolerated the proliferation of new wealth-management products and trust loans. Other non-bank financial institutions were also attracted by this relatively lighter regulation, and used banks’ branch networks to expand their own supply networks to sell these new products, thereby further expanding credit.
Following the 2008–09 financial crisis, the state injected stimulus through bank loans, rather than through government spending. The removal of credit controls and other restrictions and the approval of an infrastructure spending program resulted in significant loan growth through both bank and non-bank channels. The authorities also set quantitative growth targets in order to maintain employment and economic growth. This emphasis sent mixed signals about the role of market forces and official support for growth by encouraging lending by state-owned banks to SOEs and provincial and municipal governments. Regulators operating in silos failed, however, to provide a consistent incentive framework in the fast-growing and evolving economy. Rather than sharing their goals and priorities or coordinating their actions, regulators competed with one another, creating conditions for regulatory arbitrage and failing to keep abreast of financial innovations.1 The risk of financial insecurity led to a reform blitz by China’s leaders and warnings from both the IMF and the Bank for International Settlements. The latter estimated that, in 2017, China’s debt overhang had reached dangerous levels, with official total debt exceeding 260 per cent of GDP, non-financial sector debt at 235 per cent of GDP, and private sector debt at 175 per cent of GDP.2 By mid-year 2017, Moody’s had downgraded its rating of China’s sovereign debt from Aa3 to A1.
Governor Zhou had argued for modernizing the relatively closed financial sector and integrating it into world markets as a way to achieve China’s long-term growth and rebalancing objectives. Consistent with China’s becoming a leading economy, he argued for the long-term goal of an internationalized renminbi that would follow the completion of carefully sequenced financial reforms – including strengthening financial institutions so that they could withstand the inevitable increases in market volatility as protectionist barriers to cross-border financial flows were removed. Other reforms would allow the exchange rate and interest rates, as key prices, to be determined by market forces, rather than by political decision. These and other reforms would also promote transparency, the rule of law, and modern accounting practices. The IMF decision in October 2016 to add the renminbi to its currency basket making up the Special Drawing Right, the IMF’s unit of account, was a significant step along this road3 and seen as affirming China’s economic potential. To Chinese policymakers, it was an important step towards expanding the use of the renminbi beyond a unit of account in settling international transactions to become a means of payment and eventually a store of value for banks, enterprises, and governments around the world.
Renminbi internationalization would have other potential benefits. Increasing renminbi-denominated trade finance would reduce dependence on the US dollar and the costs of seigniorage.4 But there would be risks. Allowing cross-border transactions would expose the economy to market volatility, which would have to be managed. Strong supervisory oversight and coordination among regulators would be required. Property rights would need to be protected. Changing the incentive structure would free up market forces and encourage a wider range of financial instruments for savings and investment. Short-term bank financing, which had long dominated the Chinese system, would have to be augmented by long-term finance from transparent, sound, and credible bond and equity markets. The banking deposit insurance system introduced in 2015 would have to discipline risk-taking by removing a major source of moral hazard, since lenders could no longer count on government to assume the risks and bail them out of bad decisions. All these features are precursors to the fully open capital account necessary for full internationalization.
In 2016–17 heightened concerns about the possible systemic effects of financial risk on national security and on growth targets deflected the official focus to fighting fires in the leadup to the 19th Party Congress. One of these fires was the increased capital outflows associated with the wave of large offshore corporate mergers and acquisitions transactions in the previous year (see Chapter 4). In several cases, acquisitions were considered risky because they were outside the core expertise of the enterprise; others, such as of hotels, entertainment, and real estate entities, were “frivolous” in that they did not contribute to national growth objectives. The wave of transactions in 2016 also exacerbated the market weakness of the renminbi at a time when the authorities sought to support its value. In response, rather than accept market forces and support the currency, the authorities chose to intervene with capital controls to support domestic objectives, adding to risk and market confusion. Yu Yongding, a former member of the central bank’s monetary policy committee, publicly criticized official indecision about establishing and sticking to, an exchange-rate rule and confusing market participants about central bank intentions towards a market-determined and more flexible exchange rate.5 In other words, renminbi internationalization was not to be – at least not yet.
BANKS, SHADOW BANKS, AND REGULATORY ARBITRAGE
Banks are a big part of the picture of China’s excessive debt and speculative investment problem because of regulators’ tolerance of the buildup of off-balance-sheet activities. At the time of its accession to the WTO in 2001, China had negotiated a five-year window for its banks to learn to compete with foreigners. Chinese banks transferred large stocks of legacy non-performing loans from their books to those of state-financed asset management corporations charged with collecting or calling the loans. The four large state-owned commercial banks listed their shares on stock exchanges, and accepted strategic investments from foreign banks limited to 25 per cent of their equity. All of these steps were designed to change the incentive framework for bank boards and managers to respond to market forces and to become more transparent to market monitoring.
By 2017 the strategic investors had sold their shares (at considerable profit), further foreign investment in the financial sector had been discouraged, and much work remained to introduce market forces into the banking sector. The state-owned commercial banks had become accustomed to fixed interest rates and a generous spread between deposit and lending rates, which allowed them riskless income. Expertise to manage risk was also lacking. The small and medium-sized enterprises that create most of China’s jobs had difficulty accessing bank credit in the absence of incentives for the commercial banks to take on such risky, unconnected customers.
The four state-owned commercial banks are also the world’s largest banks as measured by tier one capital – the measure regulators use of a bank’s financial strength, which consists mainly of equity and retained earnings. Ownership reform is recognized as a necessary objective, but rather than make shares available to the public and to private investors, the government chose to encourage the growth of multiple smaller financial institutions, including rural banks, banking and credit cooperatives, new financing institutions, and private banks, eleven of which received licences in 2016. Although market forces now play a larger role in determining interest rates, state-owned commercial banks continue to rely on SOEs as major customers, along with local governments and other large, well-known, low-risk corporate clients.
In this environment of credit market distortions and inconsistent regulatory frameworks, off-balance-sheet credit creations – known as shadow banking – proliferated. These products create credit using either entrusted loans between companies – transactions in which banks serve only as middle men and take on no risk; or trust loans – where banks serve as a conduit for the proceeds of wealth-management products to invest in a trust plan used by corporate borrowers. Starved for financing from reluctant state-owned banks, small and medium-sized enterprises were among the major customers of these loans.
Shadow banking in turn created distortions that initially escaped regulators’ scrutiny. Bank depositors and customers searching for higher-yield products and higher rates of return sought these non-bank off-balance-sheet credit products because they were largely beyond regulatory purview. As shadow banking became entrenched, these practices spread to financial institutions, which began to lend to one another, and then to the regulators themselves, who began to compete with one another to attract this business. In this way, the problem grew beyond the banking system into the insurance and equities sectors as well.
Burgeoning demand for these unregulated products created new risks of corporate leverage, which were magnified by the popular practice of securitizing the loans and bundling them into products for which no institution seemed liable. Moral hazard was rampant as financial market participants took more risks, assuming the state would bail them out and reduce the consequences of bad investment choices. A comparative study shows, however, that the scale of China’s shadow banking activities is moderate by global standards – at an estimated 10–27 per cent of bank assets in 2012, compared with a global average of 61 per cent.6 The government’s 2017 campaign against financial leverage curbed both lending and bond financing, creating a credit crunch for privately owned enterprises of a severity that, by mid-2018, required a range of actions by the central bank, beginning with the expansion of short-term credit facilities.
The central bank and regulators also took significant coordinated steps in 2017 and 2018, issuing new draft rules to curtail shadow banking by eliminating implicit guarantees and reducing opportunities for regulatory arbitrage and maturity mismatch in asset management. These rules have important implications. First, the incentive system has been changed by merging the banking and insurance regulators into the China Banking and Insurance Regulatory Commission (CBIRC), with one set of rules, thereby discouraging or eliminating regulatory arbitrage. Second, the new rules shift risk to investors from people and institutions. Asset managers will be required to manage transparent portfolios of assets, instead of offering products promising high returns as riskless as a bank deposit. Banks were ordered to bring off-balance-sheet loans back onto their books as a way of returning such activities to them.7 As a result, banks wrote off $780 billion in bad loans and raised substantial quantities of new capital.8 In December 2018, the CBIRC announced that commercial lenders would have to separate their wealth-management subsidiaries into independent operations, effectively abolishing the soft guarantees for loans that had been the main attraction. By the end of 2020, wealth-management products will be marked to market – that is, valuing the wealth-management product at current market prices.9 As well, loan-provisioning requirements have been adjusted to encourage recognition of non-performing loans. In 2018, the IMF noted that the size of China’s shadow banking sector had declined, as had interconnections between banks and non-banks.10
THE RISE OF DIGITAL FINANCE AND FINTECH
Even as financial institutions gradually increase their efficiency and regulators improve and modernize oversight, the new opportunities and risks of the digital revolution have introduced disruptive change to credit markets. As noted in the previous chapter, China’s more than 700 million Internet and mobile device users provide unique scale opportunities for innovation. Computer programs and other technology used to support or enable banking and financial services – “fintech” – have grown rapidly. Morgan Stanley estimates that China now has the world’s largest e-commerce market, accounting for 35 per cent of the global total in 2013; more recent estimates put the share close to 40 per cent.11 On Singles Day 2018, Alibaba’s e-commerce sales reportedly totalled US$30.8 billion in twenty-four hours.12
The rise of fintech seems in retrospect to have been inevitable, given the technological, regulatory, and geographic constraints of China’s traditional banks and their heavy focus on large corporate borrowers and middle-class home owners. Customers were looking for low-cost finance; fintech innovations made it possible for services to respond to customers directly. The breath-taking pace and magnitude of growth in online payments and other financial transactions has led to proliferating mobile applications in consumer finance. Fintech companies are now experimenting with big data in the effort to speed up credit approval based on better customer credit profiles, and are pursuing the underbanked among students, rural households, and blue-collar workers. Customers in micro, small, and medium-sized businesses are also attracted by improvements in credit assessments.
All of these developments signal intensifying competition in financial and consumer goods markets. More competition will spur further innovation, more efficient services, and new products, such as wealth-management applications that allow middle-class savers to manage their own investments. Traditional financial institutions are cooperating with fintech firms in finding innovative, easier, and lower-cost alternatives to their traditional offerings. These e-commerce and fintech innovations, moreover, are still in their early stages. The key will be to excel in providing customer services.
Fintech, however, presents two big challenges. One is fraud. Fintech and e-commerce are vulnerable to operators who fail to deliver authentic goods – or to deliver at all; others engage in fraudulent financial practices. With growing evidence of fraud and illegal fundraising, as well as the high-profile P2P failures in mid-2018 – despite efforts to improve standards and oversight of P2P lending – more and more effective oversight is clearly required.
The second and related challenge is regulatory. A proliferation of IT companies now provide financial services such as lending and payment services and sales of insurance products, but only some of these are licensed. A modern banking system requires prudential regulation of entities that engage in asset management in order to control risk and protect depositors’ balances where these are permitted. Despite the work of task forces headed by the People’s Bank of China since 2016, more effective measures are still required to reduce risk in the online financial sector and, as the central bank has noted, to oversee financial technology in recognition of the speed at which the industry and cross-sector financial risks are growing.
DEVELOPING CAPITAL MARKETS AND DIRECT FINANCE
China’s capital markets are being reformed to make them more open and contestable. Government intervention still occurs, sometimes alarming market participants. This was the case in 2015, when the authorities attempted to halt a collapse in stock prices by banning sales and short selling and by injecting liquidity into the market to prop up indices, which created substantial confusion and uncertainty. Even so, equity markets have been further strengthened by reducing restrictions on foreign investors engaging in China in renminbi transactions. The creation of cross-border investment channels through stock exchanges in Hong Kong, Shenzhen, and Shanghai have enabled investors in these markets to trade on one another’s markets through their own brokers and clearing houses. Restrictions were also eased on short selling, and institutional margin financing was launched to enhance market depth and boost hedge fund operations.
China’s bond market, now the world’s third largest, is also being modernized and opened. Previously restricted to qualified foreign investors in the interbank market, the creation of the Bond Connect link with Hong Kong in 2017 facilitated cross-border investment through financial infrastructure institutions. Moves are also under way to provide direct finance to non-state enterprises. Until recently most corporate bonds were issued by SOEs in transactions largely confined to the interbank market through banks’ fixed-income departments. Foreign participation was tightly controlled by quotas and licensing restrictions imposed on institutional investors. But in February 2016 the interbank market was thrown open to foreign institutions, including central banks. Surprisingly, however, financial institutions displayed little interest in this liberalization – by December, the foreign share was a mere 1.3 per cent of total market value.13 After the disruptive official intervention in mid-2015, foreign investors remained concerned about future government interventions and capital restrictions – as occurred in June 2017.
Since 2014 concerns have also increased about default risks by both state-owned and non-state enterprises. Bond defaults are relatively rare in China, but a high-profile default in March 2014 by private solar panel manufacturer Chaori damaged expectations. A regulatory crackdown in early 2017 squeezed the money market, abruptly raising funding costs for mid-sized companies. Thirteen defaults, including by Dalian Machine Tool Group, occurred in the first half of that year as companies were unable to service their debts, causing concerns about contagion due to the widespread practice of companies guaranteeing each other’s loans.14 By mid-2018 the bond market set a new record for defaults, which increased the cost of credit.
Long experience in other countries has shown that allowing defaults, rather than intervening to save companies, reduces moral hazard and can provide a welcome reduction in accumulated debt and a means of pricing risk more accurately. Indeed, that appears to be happening. The China Securities Regulatory Commission has identified a number of desirable reforms to speed up bond market development, including a unified regulatory framework to replace fragmentation among regulators and calls for clear approval procedures, disclosure rules for bond issuers, an improved credit-rating system, clearer and enforced penalties for violators, buyer education, an interconnected trading and settlement system, and encouragement of product innovation.15 These reforms also indicate, however, the distance the Chinese economy still has to travel to achieve market depth and soundness. With its market now one of the world’s largest, China has an opportunity to continue to open its bond markets and promote accurate risk pricing as part of the transition to an economy that is less debt- and bank-dependent. Regulatory and other reforms must keep pace.16
RISK OF A FINANCIAL CRISIS?
Will China’s significant debt overhang result in widespread default and bank runs? Given the direction of policy and institutional changes, it appears things are moving in the right direction and default risk has declined. Interest-rate deregulation is particularly significant because of the direct positive effects on household income from higher deposit rates. At the same time, however, the effect on lending rates is to increase the cost of capital for capital-intensive goods manufacturers.17 China has abundant liquidity: the state owns most lenders and borrowers. China does not have a balance-of-payments problem, domestic funding shortfalls, or an asset bubble. Both macroeconomic management and financial regulation are relatively sound. Weaknesses tend to be localized in certain parts of the country and in certain institutions, such as the smaller state-owned banks. As noted earlier, in 2017 the IMF reported that China’s ratio of total non-financial sector debt to GDP was 235 per cent, up from 207 per cent in 2014. This is cause for concern since the debt has built up rapidly as private companies shift from equity to debt offered by the unregulated financial institutions. Excess capacity has opened up in traditional industrial sectors such as coal and iron-related activity in the supply chains of infrastructure and construction industries integral to China’s real estate boom. As some analysts have argued, however, China’s problem is not solvency or liquidity, but capital allocation, and it is mainly a problem of SOEs in debt to state-owned commercial banks. Balance could be restored by shifting from debt to equity through state-approved debt-to-equity swaps.18 The debt/equity imbalance could also be managed by raising more equity.
Some in China ask whether the country is headed down the same road as Japan, whose total debt-to-GDP ratio is similar in size to China’s. Many analysts agree that China’s debt problem differs in that it is not fed by public sector borrowing monetized by the central bank (which can be self-perpetuating); China’s lenders are commercial banks that rely on deposits. This means, however, that a crisis could be triggered if defaults in the non-bank financial sector overwhelmed smaller banks and caused a bank run that froze the interbank market, and sentiment turned negative. Although the People’s Bank of China likely would provide emergency liquidity, the disruption in credit flows would feed quickly through to investment decisions and might also trigger capital outflows,19 threatening national security, as President Xi concluded in 2017. More desirable would be adjustments that avoided such outcomes.
FINANCIAL REGULATION REFORM
Regulatory reform became a high priority when the National Financial Work Conference decided in July 2017 to create a high-level Financial Stability and Development Commission reporting to the State Council, chaired by Vice Premier Liu He, and supported by a secretariat located at the People’s Bank of China. Initially its focus was non-bank lenders, Internet finance, asset management, and financial holding companies, all of which are institutions that facilitated the growth in indebtedness.
Official momentum towards proactive financial sector adjustment picked up steam in 2016–17 once the Politburo signalled the urgency of containing leverage and financial risk. Marked tightening of financial supervision occurred in early 2017 with the promulgation of new regulatory rules in mid-2017. The central bank led the way by tightening liquidity, significantly changing supervisory requirements, and adding shadow bank off-balance-sheet wealth management products to its macro-prudential assessment. Providing a clearer picture of systemic prudential risk, however, had a markedly negative effect on expectations: interest rates rose, accompanied by a credit market sell-off. In June 2017, the central bank moved to moderate sentiment by injecting $53 billion into the banking system; regulators also adjusted the pace of their tighter scrutiny and improved coordination among themselves. As growth continued to slow in 2018, the central bank took a number of other measures. It cut banks’ required reserve ratios, and offered a further $74 billion of medium-term credit of short maturity in an effort to relieve funding pressures on private sector borrowers caused by the contraction of shadow banking credit, the downgrading of smaller lenders, bond defaults, and pressures to repay dollar debt.
CONCLUSION
Proactive financial market reforms by the Chinese government have reduced the risk of a Minsky moment, but more remains to be done. Mortgage lending and shadow banking are still concerns following China’s lengthy property market boom. The high-level Financial Stability and Development Commission now has a mandate to promote financial stability and coordinate financial oversight across all financial regulators as well as the central bank – as would be expected of a modern financial system.
The People’s Bank of China’s decision to establish Nets Union Clearing Corp. (NUCC), a central clearing platform, and issue appropriate regulation and supervision of online finance is another promising step. NUCC, which became fully operational on 1 July 2018, is now the national platform for processing online transactions undertaken by all third-party payments providers that involve bank accounts. Until then, such transactions among these third-party firms or with banks had escaped regulatory oversight. The platform also brings all online transaction data under the supervision and regulation of the central bank.20
These are significant developments, but uncertainty among investors about China’s growth prospects persists, as reflected in the Moody’s June 2017 downgrade. There remains substantial ambiguity about the relative roles of the state and market forces in the functioning of the financial system. The future of renminbi internationalization, capital account opening, and China’s integration into the global financial system are other sources of uncertainty, along with rising tensions with the United States over trade and investment. Given the size of China’s financial system, domestic developments and disruptions will affect its international transactions, cross-border trade, and financial flows.
President Xi’s speech to the Boao Forum for Asia in April 2018 signalled China’s intention to introduce significant reforms and market opening in the financial sector, further exchange-rate regime reform, and moves toward capital account convertibility and increased regulatory capacity. The next day, central bank governor Yi Gang announced further financial sector opening and changes in FDI policy, which became part of the FDI law adopted by the National People’s Congress in March 2019. These changes include permission for the pre-establishment of national treatment of foreign investors, the adoption of a negative list – whereby access is permitted in all sectors except those on the list – actions to open the financial sector further to foreign participation by changing ownership regulations, and the removal of foreign ownership caps for banks and asset-management companies. The foreign ownership limit of securities companies, life insurers, and others has been increased to 51 per cent, and will be removed entirely. Joint-funded securities companies are also now allowed.
Other measures to open up the sector include increasing the daily quotas of Shanghai, Hong Kong, and Shenzhen cross-border investment flows to increase stock market connectivity; ownership changes to permit eligible foreign investors to provide insurance and loss-adjustment services in China; and national treatment of foreign-invested insurance brokerage companies. Governor Yi promised further removal of ownership restrictions in a number of financial sectors, along with commitments to permit foreign banks and securities companies to expand their business scope and to ease restrictions on insurance companies wishing to enter the Chinese market.21
In late 2018, following speeches by Xi Jinping and Liu He, further new measures were introduced “to improve the business environment” by easing available funding for private enterprises, small and medium-sized enterprises, and micro-enterprises. The State Administration of Taxation followed up with measures to reduce the tax burden. The People’s Bank of China outlined a “1-2-5” policy directing that at least one-third of new corporate loans from large banks go to private firms, two-thirds of new loans by smaller banks go to private firms, and at least half of all new corporate credit from banks to go to the private sector for the next three years.22 As well, a negative list of sectors closed to foreign investors was published as part of the effort to increase competitive dynamics, and administrative and tax burdens were simplified. These commitments conveyed official concerns about the erosion of private property rights and the crowding out of investment by the state that had been ignored since the Third Plenum dictum that the market will decide the allocation of resources. The persistence of state subsidies to uncompetitive state companies and the dominant state role in MIC 2025 still send conflicting signals. As some analysts have argued,23 China’s leaders seem to have accepted reduced profitability, slower growth, and the heightened financial risks of high leverage as part of the price of maintaining the Party’s position and achieving the state’s strategic objectives.
Finally, even as the chances of a Minsky moment diminish and renminbi internationalization is delayed, a new source of uncertainty and volatility has appeared. China’s large current account surplus is shrinking – from 10 per cent of GDP in 2007 to 0.4 per cent in 2018 – as its rebalancing strategy increases consumption relative to investment.24 This change means that Chinese demand for US financial assets such as US Treasury bonds will shrink at the same time as US financing requirements expand with the growth of the fiscal deficit. In short, US reliance on Chinese demand for Treasury bonds will increase just as that demand shrinks. The United States might be about to face some hard choices.