Thursday, 5 November 2020


 Ending China’s dependence on debt-fueled growth may be the easy part of Beijing’s financial reform. Dismantling the complex and opaque system that grew up to satisfy the country’s insatiable demand for borrowing will be harder and more dangerous.

Chinese President Xi Jinping has been trying to get a grip on the country’s financial system since he took office five years ago, with Beijing’s efforts ramping up in the last year. The government pricked asset bubbles by pushing up interest rates while injecting cash to contain the damage. It issued new rules to rein in largely unregulated financial products that boosted lending while promising big returns.


This is part of a series of Heard on the Street columns on investing in China in advance of the country’s every-five-year leadership transition.

Yet the scale of the problem remains daunting. China’s economy has grown increasingly dependent on its shadow banking sector for credit, boosting its assets to nearly $20 trillion at the end of last year, according to Nomura—a sixfold increase in just six years.

Banks have been the biggest enablers of the growth of the system’s dark underbelly. Recently, they have found important allies in nonbank financial institutions—a raft of trust companies, insurers, fund-management companies and securities firms that collectively hold some 20% of Chinese financial assets, according to Moody’s, up from 9% in 2010.

Gaining GroundComposition of China's financial sectorTHE WALL STREET JOURNAL.Source: Moody's Investors Service
%Big BanksMid and SmallBanksOther depositorycorporationsNBFIsCentral bankassetsOthers201020160102030405060708090100Mid and Small Banksx2016x25%

In sturdy financial systems, nonbanks help fill gaps left by banks. In China, though, they add to the system’s peculiar distortions. Banks can sell bad loans—mostly made to struggling infrastructure-related or state-backed companies—to a nonbank. It can then package them as investments that it can resell back to the bank. Such transactions help banks artificially reduce nonperforming loan levels and capital requirements.

Nonbanks have also helped banks issue so-called wealth-management products. Banks sell these high-yielding investments to Chinese savers, pocketing the fee income but shuffling the funds off balance sheet—often to a nonbank—to be invested into various markets.

There are two main risks. These products are usually short-term, leveraged investments that often put their money in longer-term assets like bonds, creating potential maturity mismatches. And while banks have only explicitly guaranteed around a third of the products they’ve sold, there’s a high probability customers would demand compensation if products fail.

Yield-hungry small- and medium-size banks have become big buyers of these products too, adding to the circularity in China’s financial system. Outstanding wealth-management products held by banks rose to 20.6% of the total in 2016, from 3.3% two years earlier, Moody’s says.

Claiming CreditChinese banks' claims on non-bank financial institutionsTHE WALL STREET JOURNALSource: Wind Info.

Mr. Xi’s big task is to rein in credit growth and eliminate the distortions in China’s financial system without slowing economic growth. That will be tricky. So far, every time China has tightened liquidity, cracks have appeared and markets have tumbled until the government eased its grip.

If banks are forced to start recognizing more of the bad loans they have have shifted off balance sheet, they will likely cut back new lending, hurting debt-laden state-owned companies the most. And clamping down on wealth-management products may help with transparency, but will mean banks taking a hit to their income.

Sure, Mr. Xi will have more control over the system after party meetings this week. Earlier this year, he created a cabinet-level committee to focus on financial stability, led by the central bank. He has plenty of capital and a mostly closed financial system to help deal with these problems.

If Mr. Xi doesn’t take the pain needed to tame the financial system now, its hydra-like growth will add further distortions to the economy. If he does, the risk is that the Chinese economy slows significantly, potentially creating social unrest and hitting the still vulnerable global economy. Reforming the Chinese financial system may be the greatest challenge of Mr. Xi’s second term.

No comments:

Post a comment