China is getting real about the dangers lurking in its financial system. While de-risking has been the government’s mantra since 2015, the country’s most powerful politicians have been weighing in this year amid a flurry of directives on everything from excessive borrowing to speculation in equities. Those efforts have gained further momentum since October’s Communist Party Congress, where leaders renewed a pledge to make controlling financial risk a top priority. The challenge for authorities is to maintain financial stability while tackling the massive leverage they have singled out as a threat to economic health.
1. Why is this time different?
President Xi Jinping chaired a gathering to discuss “safeguarding national financial-market security” in April, a day after the worst losses this year in Shanghai-traded shares. The meeting was attended by members of the 25-person politburo, made up of the top politicians in China. While the central bank governor and the various regulators were also there, the fact the Communist Party’s premier decision-making body met and decided to act on financial risk suggests there’s consensus at the very top.
2. How serious is the threat?
China’s central bank governor, Zhou Xiaochuan, has pointed to a buildup of risks that are “hidden, complex, sudden, contagious and hazardous.” By the end of 2016, total borrowing had ballooned to about 260 percent of the size of the economy, up from 162 percent in 2008. China accumulated its record debt pile after the global financial crisis, when it sought to avoid the economic slumps that ravaged the U.S. and Europe by binging on credit. Pessimists say the risks to financial stability are mounting. Kyle Bass, founder of Hayman Capital Management, has warned of a looming crisis. Jim Chanos, the hedge fund manager who predicted the 2001 collapse of Enron Corp., has said Chinese banks are showing signs of loan stress. The International Monetary Fund warned that China might eventually suffer a “sharp adjustment” unless it addresses its indebtedness. And both S&P Global Ratings and Moody’s Investors Service cut China’s sovereign credit rating in 2017 for the first time during the current millennium, citing the risks from soaring debt.
3. And what about the optimists?
They argue that the authorities would bail out distressed lenders before any crisis threatens the financial system. Failed banks might even be dealt with quietly before anyone outside China knew, according to former China Minsheng Banking Corp. Director James Stent. Some argue there’s little chance of a financial meltdown because the biggest slice of China’s debt pile is carried by state-owned enterprises. In the worst case, the government could take over some liabilities and sell them to distressed debt operators, said Huang Xiaoguang, Australia and New Zealand Banking Group Ltd.’s top banker in China.
4. How much of China’s leverage is in the shadows?
One of the main concerns is that much of the financial action takes place beyond the reach of regulators. China’s shadow banking sector -- unregulated loans mostly -- is hard to quantify with any precision, but analysts agree it has the potential to put the financial system at risk. The sector has ballooned in the past four years largely due to the proliferation of wealth management products, hugely popular investments that offer superior yields to traditional bank deposits but carry higher risks. Nomura Holdings Inc. estimates WMPs account for the single biggest slice of the 122.8 trillion yuan ($18.5 trillion) shadow-banking sector. UBS Group AG also notes a profusion of loans disguised as investments, a ploy to get around lending restrictions. Analyst Jason Bedford estimates there are 14.1 trillion yuan of such shadow loans. More recent indicators suggest the campaign to tame shadow banking is having an impact: The sector stopped growing in the first half of 2017 as WMP issuance declined, according to Moody’s. And UBS said in November that even though China’s finance sector had amassed 253 trillion yuan of off-balance sheet items by the end of 2016, most of them are relatively harmless components such as custodial funds and untapped credit-card limits.
5. What have the regulators done so far?
- August 2016-present: The People’s Bank of China starts offering funds to banks at longer tenors and boosting money-market rates as a way of deterring companies from borrowing.
- March 2017: The banking regulator asks lenders to submit reports on entrusted investments -- funds that Chinese banks farm out to external asset managers.
- April 7: China says it will issue guidelines on how to improve banks’ efficiency in serving the real economy, requiring lenders to speed up bad loan disposal and crack down on illegal funds flowing into the real estate sector.
- April 10: The CBRC issues guidelines on stepping up risk control in the banking industry, requiring lenders to ensure stable asset quality, improve liquidity risk management, strengthen their bond and investment businesses and improve interbank operations.
- July 15: President Xi says the central bank will play a stronger role in defending against risks and safeguard the financial system. China will set up a commission under the State Council to oversee financial stability and development, according to Xinhua.
- Aug. 31: The PBOC bars financial institutions from issuing negotiable certificates of deposit with maturities longer than one year. NCDs, introduced in 2013 to help smaller lenders compete with big state banks for funding, have morphed into a way for banks to fund purchases of each other’s debt.
- Sept. 30: The PBOC announces rewards for banks -- in the form of reduced reserve requirements -- if they lend to small business and rural borrowers. It’s seen as a direct challenge to the shadow banking industry. Citic Securities Co. estimates the move could free up about 600 billion yuan in new lending.
- Nov. 17: Sweeping rules are proposed to curb risks on shadow banking products, partly aimed at breaking an implicit government guarantee that’s driven investment into WMPs. The regulations, set to take effect in 2019 after a consultation period, mark the “beginning of a new era” in Chinese financial supervision, according to Citic Securities Co.
6. How have markets responded?
The slew of measures in April spooked equity investors. There was anxiety over how far the crackdown would go and concern that the authorities would start allowing more defaults. Some $315 billion of stock market value was lost over a period of just six days and banks started pulling money out of entrusted investments, forcing non-lender institutions to sell their bond and equity holdings. But concerns eased as 2017 progressed, with stocks rebounding strongly and the big state banks outperforming the market on speculation that a shadow banking crackdown will squeeze smaller regional lenders.
The Reference Shelf
- Shadow banking risks are easing as stricter regulations damp growth in wealth management products: Bloomberg Intelligence.
- Analyst Charlene Chu says China needs to do more.
- A QuickTake explainer on China’s ticking debt bomb.
- UBS notes the concentration of shadow loans in one particular province.
- QuickTake Q&As on China’s entrusted bonds and WMPs.
- Chinese think the government will bail out the WMP sector.
- Ex-finance minister says local governments should be allowed to default.
- The Chinese government’s English portal.
— With assistance by Tian Chen, Angus Whitley, Dingmin Zhang, and Jun Luo