China’s Corporate Debt: On the Way to Crisis? Part 3

Challenges Posed by Recent Shifts in the Composition of Chinese debt

21 May by Alice Jetin Duceux

The Bank of China Building under construction in 1988 (CC - Wikimedia)

As we have seen in the previous part of this study, despite the government’s spectacular stimulus plan, growth has been continually slowing over the past decade. Massive investment and growing corporate debt can no longer maintain a high rate of growth. Some party leaders have euphemistically dubbed this trend the “new normal”. Slower growth is not only the result of a complex international situation, but the consequence of the structural change and the necessity to enter a new stage of development, which we have dubbed an intensive growth regime—it consists of high productivity stemming from research and development. The Chinese government is aware of this necessary shift and has adopted an official “Made in China 2025” program, which calls for global leadership in various technological sectors, and in particular semiconductors, by 2025 (Kynge, 2018b). This ambitious program will be buffeted by the structural headwinds that are winding down on China’s export-based model.

See the first part of this report: An Overview of Chinese Debt:
See the second part of this report: A Little History of Chinese Economy:

Another important problem China is facing is that demographic trends are now more unfavorable than ever. Single children must care for their parents and four grand-parents, whether or not their elders benefit from dismal pensions—the labor force itself is getting older and there will soon be much fewer workers in China. To face the question of old-age, the authorities will have to invent a comprehensive pension system.

A third issue is that the motors of Chinese growth are spluttering. Heavy industry is struggling with overcapacities and must come to terms with labor movements and environmental regulations. The real estate market, a major driver of Chinese growth, is saturated. After breakneck expansion in the 2000s and the start of the 2010s, the sector is facing excess supply. In 2015, land sales in both volume and proceeds plunged by 30% compared to the prior year (Chen, 2015). This dive left many cities and regional governments, who rely on land sales, floundering.

Shadow banking has expanded concurrently. With GDP GDP
Gross Domestic Product
Gross Domestic Product is an aggregate measure of total production within a given territory equal to the sum of the gross values added. The measure is notoriously incomplete; for example it does not take into account any activity that does not enter into a commercial exchange. The GDP takes into account both the production of goods and the production of services. Economic growth is defined as the variation of the GDP from one period to another.
growth and overcapacity building in some industries, shadow banking instruments grew more attractive—they yielded a higher return on investment. PBOC data show that shadow financing in the Chinese total social debt financing has gone from 10% in 2005 to 20% in 2015 (Ma and Laurenceson, 2016). Meanwhile, local fiscal discipline has been lax.

In the face of a slowdown in growth, real estate saturation and increase in shadow banking, the general government has attempted to curb credit expansion. The ratio of non-performing loans to total lending in Chinese banks came to just under 2% at the end of 2017, according to official data (CEIC, 2018). Beijing is cutting off funds to financial companies and banks tied to regional governments in a crackdown on risky debt. The central authorities are tightening fiscal policy by increasing domestic interest rates Interest rates When A lends money to B, B repays the amount lent by A (the capital) as well as a supplementary sum known as interest, so that A has an interest in agreeing to this financial operation. The interest is determined by the interest rate, which may be high or low. To take a very simple example: if A borrows 100 million dollars for 10 years at a fixed interest rate of 5%, the first year he will repay a tenth of the capital initially borrowed (10 million dollars) plus 5% of the capital owed, i.e. 5 million dollars, that is a total of 15 million dollars. In the second year, he will again repay 10% of the capital borrowed, but the 5% now only applies to the remaining 90 million dollars still due, i.e. 4.5 million dollars, or a total of 14.5 million dollars. And so on, until the tenth year when he will repay the last 10 million dollars, plus 5% of that remaining 10 million dollars, i.e. 0.5 million dollars, giving a total of 10.5 million dollars. Over 10 years, the total amount repaid will come to 127.5 million dollars. The repayment of the capital is not usually made in equal instalments. In the initial years, the repayment concerns mainly the interest, and the proportion of capital repaid increases over the years. In this case, if repayments are stopped, the capital still due is higher…

The nominal interest rate is the rate at which the loan is contracted. The real interest rate is the nominal rate reduced by the rate of inflation.
(Cho, 2018b).

This makes offshore fundraising look less expensive by comparison. Chinese businesses offered $87 billion in bonds overseas in the first four months of 2018 as Beijing cut off domestic funding channels (Cho, 2018b). The issuers of foreign debt are mainly financial institutions, but other sectors have also been getting in on the act. Beijing has attempted to regulate gluttonous acquisitions by companies like HNA, who have accumulated external liabilities Liabilities The part of the balance-sheet that comprises the resources available to a company (equity provided by the partners, provisions for risks and charges, debts). worth several tens of millions, in response. But Chinese domestic markets are nonetheless amassing external debt as companies’ and LGFVs’ ties with foreign institutions grow stronger.

What are the structural problems weighing on China’s growth? How could excess supply in real estate threaten to throw China’s fragile debt-equilibrium off-balance Balance End of year statement of a company’s assets (what the company possesses) and liabilities (what it owes). In other words, the assets provide information about how the funds collected by the company have been used; and the liabilities, about the origins of those funds. ? How is the Chinese government tackling shadow banking and excess debt, and how can it hope to control Chinese corporations’ debt as they invest abroad? These are the questions we will be seeking to answer in this part of our study.

1. Structural headwinds

Among the structural problems China’s central government is facing, demographic transitions, a narrower scope for technological transfers, less low-hanging fruits from reforms and liberalization, and a widening income gap are prominent (Ma and Laurenceson, 2016). There has also been a shift in the drivers of growth—state-led investment in the ‘old’ industrial economy is lessening, while ‘new’ private sector investment and household spending gain importance. Moreover, labor costs are rising as workers grow more politicized and obtain more rights, challenging China’s model of cheap labor and extensive exports. China’s growth model, fueled by voracious credit expansion, seems less and less sustainable.

China possesses enormous foreign exchange reserves, originating in its dynamic export sector. But after Beijing’s post-financial crisis stimulus plan, breakneck investment expansion was no longer matched by a commensurate increase in foreign exchange reserves.

US President Trump’s trade wars are set to deal harsh blows to the Chinese economy. The US’ imposed 10 percent tariffs on China concern more than $200 billion of Chinese imports (Office of the United States Trade Representative, 2018). In response, the Chinese government is trying to bolster internal demand to rebalance its economy.

But slower growth and increasing family income inequality are weighing on China’s total domestic consumption capacity, further hindering the rebalancing of the economy. For the first five months of 2018, investment rose by ‘only’ 7.5%. That may sound a lot compared to European economies, but it is weak by Chinese standards, and it is not enough to sustain economic growth. Investment by private firms also fell to a record low, with growth cooling to 3.9% from double-digits in 2017 (World Bank World Bank
The World Bank was founded as part of the new international monetary system set up at Bretton Woods in 1944. Its capital is provided by member states’ contributions and loans on the international money markets. It financed public and private projects in Third World and East European countries.

It consists of several closely associated institutions, among which :

1. The International Bank for Reconstruction and Development (IBRD, 189 members in 2017), which provides loans in productive sectors such as farming or energy ;

2. The International Development Association (IDA, 159 members in 1997), which provides less advanced countries with long-term loans (35-40 years) at very low interest (1%) ;

3. The International Finance Corporation (IFC), which provides both loan and equity finance for business ventures in developing countries.

As Third World Debt gets worse, the World Bank (along with the IMF) tends to adopt a macro-economic perspective. For instance, it enforces adjustment policies that are intended to balance heavily indebted countries’ payments. The World Bank advises those countries that have to undergo the IMF’s therapy on such matters as how to reduce budget deficits, round up savings, enduce foreign investors to settle within their borders, or free prices and exchange rates.

, 2017). This problem is even more dire as private investment accounts for the majority of overall investment in China, about 60% (Roberts, 2016a).

The general slowdown makes it more difficult to maintain employment and to meet expectations of rising income, which aggravates Chinese social inequalities. These inequalities have been sharply increasing since Deng Xiaoping’s 1992 destruction of the iron rice bowl policy. China’s Gini coefficient was already close to of 0.5 in 2006 (Hong, 2008) and has remained close to this dangerous threshold ever since (CEIC, 2016). When the rate of growth was high, these inequalities could be more easily tolerated, since the living standards of all the categories of the population were rising. Now that growth is decelerating, ignoring inequalities will become more difficult, social unrest might become more widespread, and dissatisfaction might give rise to challenges to the stability of the political regime. Finding a new growth model is thus urgent—the central government think that encouraging SMEs in the private sector, particularly the service sector, may be the solution.

2. “Old industry” deadweight and real estate bubbles

The success of those reforms will require cooperation and coordination across agencies. But cooperation might not come easily to affected interest Interest An amount paid in remuneration of an investment or received by a lender. Interest is calculated on the amount of the capital invested or borrowed, the duration of the operation and the rate that has been set. groups like the “old economy” industries. As attention turned to supply-side reform (adjusting industry structure, fostering “competition”), support to SOEs from the central state has wavered (Findlay and Chen, 2016). Though bankruptcy was once unthinkable in China (and indeed the legal process was inexistent), the central government is now letting unprofitable enterprises shut down and liquidate assets. Beijing’s goal is to reduce overcapacities.

The coal, steel or aluminum sectors, previously crucial to China’s growth, are viewed as deadweight. The central government has adopted economically liberal standards and does not look kindly on the public sector’s low productivity: though SOEs represent 10% of Chinese output, they absorb up to 40% of bank loans (Leplâtre, 2017c). China has set targets to reduce coal production to 58% of total energy consumption by 2020 (Chinese Government, 2016). It has implemented various policies to develop non-fossil energy and actively promote electric cars, seeking to become the new leader in the automobile industry at a time when foreign automobile carmakers are mired in pollution emission scandals, and the Chinese population is protesting against air pollution. But China is struggling to reduce its dependence on coal, and its excess capacities in heavy industries like steel. According to Greenpeace, Beijing has even increased its coal production capacity by 36.5 millions of tons in  2016, the equivalent of the annual production in Brazil.

Left without viable alternatives, workers are protesting factory shut downs. Many are old and have worked for one SOE their entire life; there is no guarantee that they will find new jobs and little chance that they will be offered decent pensions considering China’s appalling welfare system. There is cause for discontentment. In the 1990s and early 2000s, as the number of public sector employees declined by 28%, laid-off workers petitioned the government and staged demonstrations (Cai, 2010). Their plight became a national cause and the central government was forced to intervene to ensure pensions were indeed being delivered to workers. Whether or not this intervention had lasting effects with regards to workers’ rights remains doubtful.

Regional authorities are particularly weary of the disruptive social movements provoked by layoffs. Local governments are responsible for ensuring political stability within their provinces, and officials can get in trouble with Beijing for failing to do so. Stakes for mandarins are high. Figure 4 shows that there have been massive waves of dismissals at the end of the nineties. 20 million workers were dismissed in 1997-98, and around 20 million more in the following years up to 2016.

Figure 4: Evolution of Urban Employment in China, 1990-2016

Source: Author’s calculations with data from China Statistical Yearbook 2017, National Bureau of Statistics of China

Millions of jobs in SOEs could disappear in the next years, jobs that are vital for fragile regional economies. Provinces like Heilongjiang, Jilin and Liaoning, in China’s North-East, have particularly suffered recently and do not seem armed to face the future of a transition to a service-based industry (Reuters, 2017b).

After being centers of industrialization for decades—concurrently witnessing sharp increases in air pollution, water contamination, toxic waste in rivers and fields—these regions are now empty. In 2016, Liaoning was the only region in recession—growth contracted by 2.5% as it was increasing by 6.7% nationally (Reuters, 2017b). Worse still, the biggest industrial SOE in the region, Dongbei Special Steel, was unable to service a debt estimated at 10 billion dollars. The enterprise, which had over 20,000 employees, was forced to declare bankruptcy and go through restructuration reforms (Leplâtre, 2017c).

Under local government pressure, Beijing has accepted to maintain funding for some big companies despite their inability to service debt, or has proposed less drastic reforms, like mergers. Baosteel and Wuhan Steel (WISCO), two giant SOEs, united in 2016 in an effort to lessen overcapacities and diminish the number of companies managed by the state. The number was 102 in 2016, and the Chinese state aims to push it as low as 40 (Reuters, 2016). Urban workers will have to depend on the private sector for employment or go back to the countryside. As 57% of China’s population lived in cities at the end of 2017 (Wenyu, 2017), urban employment problems are especially important. Figure 4 shows that employment in the urban private sector—where SMEs largely dominate—and self-employment have provided the bulk of the new jobs offsetting dismissals in SOEs in the 1990s. It is far from certain that this will be the case in the future, especially if some heavily labor-intensive industries, such as construction and real estate, slow down.

Real estate is important to China’s growth. China has more than 89,000 property developers, contributing about 15 percent of GDP and accounting for 28 percent of fixed‐asset Asset Something belonging to an individual or a business that has value or the power to earn money (FT). The opposite of assets are liabilities, that is the part of the balance sheet reflecting a company’s resources (the capital contributed by the partners, provisions for contingencies and charges, as well as the outstanding debts). investment (Swanson, 2015). The sector witnessed a boom fueled by credit expansion and rising property prices throughout the 2000s. As such, a large part of the post-financial crisis credit boom has been related to real estate. Real estate directly affects about 40 business sectors in China and is a major driver for the economy (Reuters, 2018).

Property prices have grown accordingly in so-called “Tier 1” cities (the most economically developed cities), while downward pressure harmed real estate in ghost towns. Cities like Shenzhen and Shanghai are overheated and vulnerable to speculation—property prices doubled between 2010 and 2017 (Koss, 2018). Residential properties’ prices in prime locations in Tier 1 cities are now comparable to that of Paris and New York.

But the real estate and construction sectors are now facing unsustainable debt and a sharp contraction of demand. In 2015, land sales in both volume and proceeds plunged by 30%, for two main reasons: top-quality land has been sold out during the sector’s boom, and demand fell in 2014, after years of expansion (Chen, 2015). The real estate sector now has to service its debt in an unfavorable economic environment, and this debt is substantial.

Why have the real estate and construction sector contributed so heavily to China’s rising corporate debt?

One of the causes for high leverage Leverage This is the ratio between funds borrowed for investment and the personal funds or equity that backs them up. A company may have borrowed much more than its capitalized value, in which case it is said to be ’highly leveraged’. The more highly a company is leveraged, the higher the risk associated with lending to the company; but higher also are the possible profits that it may realise as compared with its own value. is that these two sectors are more capital-intensive and asset-heavy than the industrial sector on average, as well as the rest of the economy. Another reason is that these sectors have peaked after breakneck expansion in the 2000s, which pressured their corporate earnings and weighed on their share Share A unit of ownership interest in a corporation or financial asset, representing one part of the total capital stock. Its owner (a shareholder) is entitled to receive an equal distribution of any profits distributed (a dividend) and to attend shareholder meetings. of internally-funded capital expenditure. Moreover, rising property prices led the authorities to tighten credit valves, with modest dampening effects.

But it is delicate to obtain more moderation in prices while avoiding damage to a sector that has been driving Chinese growth for years. If the real estate sector were to enter a crisis, the entire Chinese economy would be affected (Ma and Laurenceson, 2016). Deteriorating business could lead banks to withdraw loans and cause a cash shortage—property developers already beset with debt and lacking liquidity Liquidity The facility with which a financial instrument can be bought or sold without a significant change in price. would struggle to repay loans. In this configuration, state-owned enterprises could rely on the implicit guarantees Guarantees Acts that provide a creditor with security in complement to the debtor’s commitment. A distinction is made between real guarantees (lien, pledge, mortgage, prior charge) and personal guarantees (surety, aval, letter of intent, independent guarantee). that they receive from the state to obtain loans from bondholders regardless of economic contraction. But private enterprises, some of which already find it hard to obtain credit from big banks, would be affected. Worse, zombie enterprises, which only survive thanks to the quasi-unlimited credits they get from the state, are crowding private companies out. In 2016, they have captured 14 % of distributed loans, up from 4 % in 2011.

The relative importance of corporate liabilities in the industrial, real estate and construction sectors has varied considerably over time. While the industrial sector has deleveraged somewhat since the early 2000s, the tightly linked sectors of real estate and construction have leveraged up. As a share of GDP, the liabilities of the industrial sector have been broadly steady, remaining at around 80% of GDP since the 1990s. But between 2008 and 2015, the real estate’s debt doubled from 30% to 60%, while the construction’s debt rose from 11% to 18% (Ma and Laurenceson, 2016).

Lending to property developers accounts for about 10% to 15% of unserviced debt. Companies in cement and steel account for a similar proportion of outstanding loans, while mortgages of individual homeowners constitute only 8% of debt in the real economy—as with Chinese household debt, this share is far lower than the advanced economy average.

Local governments are major actors in the real estate sector, as they hold a great deal of land since the Mao era, which they manage through LGFVs. Their strong administrative power over natural resources provided strong incentives for enterprises to mesh with local administrations, with the inevitable result of corruption and bribery as a normal mode of allocation of natural resources (Aglietta and Bai, 2012).

This problematic functioning, as mentioned above, dates back to the Chinese socialist period. The Maoist state did not charge any royalty for the extraction of natural resources, “as both the resources and the enterprises that extracted them were state-owned” (Aglietta and Bai, 2012). Today still, China only charges very limited fees on the extraction of natural resources—the internalization of environmental costs suggested by classical economists is hardly conceivable.

The 1994 Tax Reform, though it centralized most taxes and bled local governments of indispensable revenues, left land-transferring fees at the complete disposal of regional authorities (Chen, 2015). Without central supervision, such fees became a major source of income for local governments. Indeed, In China, the vast majority of land is publicly owned and can be claimed by governments at any point in the name of the “common good of Chinese people”. This means that a local government can expropriate farmers to resell it. Farmland is often seized without sufficient compensation to farmers, and then transferred at a high price for residential or commercial real estate development.

As for industrial development, the local governments adopted a different strategy, slashing or annulling land transferring fees (Fan, 2015). Local authorities are so anxious to attract investment that even after Beijing issued national standards of minimum transferring fees of land in January 2007, the price of industrial land was still far under market value. In some cases, local governments refunded the mandatory land-transferring fees in the form of tax rebate or other subsidies (Fan, 2015).

As shown above, local governments have a lot of latitude—officials often use public functions to protect their personal interests. Controlling a municipality allows a family or a clan to cash in bribes, defraud municipal accounts, and directly control local LGFVs. Recycling the proceeds from expropriation and sell-outs in land speculation to prop up land prices enables local governments to service debt. As long as prices were ever increasing, local governments could use land sales to repay debt and keep investing.

However, as we have discussed in this section, both the industrial and the real estate sector are facing important challenges. Not only are private corporations beset with debt; public enterprises and LGFVs are struggling, leading to local government crisis. Three coal-mining and industrial regions of the North-East, Inner Mongolia, Jilin and Liaoning, admitted to faking data over the course of several years until 2016 to mask a prolonged economic slump. Inner Mongolia admitted that its data for “added value of industrial enterprises of a certain scale” were inflated 40 per cent in 2016. Assuming the figures given by Inner Mongolia by 2015 are correct, this means its economy shrank by 13% (Hornby et al., 2018).

One of the most worrying aspect is that, as leverage is increasing, so is the use of shadow banking instruments to mask debt, reshuffle it, and sustain credit-fueled growth. LGFVs and debt-riddled corporations are among the clients of shadow institutions and may contribute to contaminating China’s banking system.

3. Shadow of the banks

While shadow banking in advanced economies has declined since the financial crisis, in China it has been expanding (Goldman Sachs, 2018). According to a study conducted by UBS Group AG, loans worth 22,000 billion renminbi have not been recorded among the totality of loans granted in 2016, increasing from 16,500 billion in 2015 (Leplâtre, 2017a). The use of shadow instruments tripled in the five years from 2010 to 2015, and shadow banking now represented 87% of Chinese GDP then (Leplâtre, 2017a). Shadow credit to borrowers has slowed in 2017 but the use of shadow saving instruments (trust products, for instance) has continued to expand (Bank of International Settlements, 2018).

The rapid growth of the shadow banking sector can indeed be explained by demand for high-yield Yield The income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment’s cost, its current market value or its face value. investment products such as wealth management or trust products. In China, interest rates are tightly regulated by the People’s Bank of China, which has set the maximum rate that banks can offer on deposit at 3.3%. This rate seems very low when we consider China’s 1.6% inflation Inflation The cumulated rise of prices as a whole (e.g. a rise in the price of petroleum, eventually leading to a rise in salaries, then to the rise of other prices, etc.). Inflation implies a fall in the value of money since, as time goes by, larger sums are required to purchase particular items. This is the reason why corporate-driven policies seek to keep inflation down. . Investors thus turn to non-bank institutions to reap a higher yield of investment that can offer 10% to 15% rates (Bank of International Settlements, 2018).

One defining feature of the Chinese shadow banking system is that it is dominated by commercial banks, true to the adage that shadow banking in China is “the shadow of the banks”. Banks, as the dominant players, become closely linked with other financial institutions through shadow credit. Indeed, the banks handle and distribute shadow banking instruments, leading to the expectation that the products are guaranteed. This false impression is so pervasive among Chinese investors that, if they were to incur substantial losses, the central government might have to step in to stave off potential social unrest.

In our analysis of shadow banking in China, we will use the PBOC’s definition of “all financial instruments Financial instruments Financial instruments include financial securities and financial contracts. that fulfil functions of credit intermediation typically performed by banks (such as liquidity, maturity, and credit risk transformation), but reduce the burden of or bypass banking regulation.” The BIS Bank for International Settlements
The BIS is an international organization founded in 1930 charged with fostering international monetary and financial cooperation. It also acts as a bank for central banks. At present, 60 national central banks and the ECB are members.
, meanwhile, also includes “credit intermediation activities performed by banks themselves that lower or circumvent regulatory requirements”. Both are activity-based definitions, not entity-based definitions, as entities performing shadow banking activities can also be part of the official banking system.

Expanding upon this definition, the BIS outlines five characteristics of Chinese shadow banking.

Firstly, shadow banking in China is still of limited complexity. Mostly, shadow credit intermediation in China is a one-step or two-step intermediation process, while it can be a seven-step process in countries like the US.

Secondly, as mentioned above, banks dominate shadow banking in China. The BIS explains this quite well:

  • “All types of commercial banks in China, but especially the smaller joint-stock and city commercial banks, are actively and directly involved in shadow credit intermediation. Besides their direct role, banks facilitate shadow credit in various ways. For instance, since direct loans between non-financial firms are legally not permissible, banks act as the trustee and middleman of the so-called entrusted loans between firms. It either does not take credit risk in the process, or absorbs part of the credit risk through so-called entrusted rights” (Bank of International Settlements, 2018).

Thirdly, shadow banking provides alternative savings instruments and credits to underserved sectors. Banks in China do not like lending to private or small enterprises. Their preference for large SOEs reflect historical relationships and high creditworthiness due to implicit or explicit government backing, reducing the credit supply to potentially more productive private firms. As such, private companies and SMEs can find it hard to borrow. But trust funds, which represent 6% of total financial assets, can invest in riskier products. Trust funds are institutions that perform credit intermediation functions but are not subject to the same regulations as commercial banks. They will lend to those with limited access to bank credit, particularly new and smaller firms. Company-to-company lending (entrust loans) are another common form of lending to private companies.

Risk in entrusted loans can only grow as industry sectors face overcapacity crisis. According to the PBOC, 56% of recent entrusted loans in the Shanxi province were concentrated around the old guard economy, which is facing overcapacity and declining profitability, as we have discussed multiple times in this report.

A fourth aspect detailed by the BIS is that shadow banking generates tight financial system interlinkages. A large share of bond Bond A bond is a stake in a debt issued by a company or governmental body. The holder of the bond, the creditor, is entitled to interest and reimbursement of the principal. If the company is listed, the holder can also sell the bond on a stock-exchange. issuance is funded by shadow saving instruments, creating strong linkages between the bonded market and shadow banking activities. Moreover, the use of shadow banking products allows banks to reclassify on-the-balance sheet loans and debt securities in order to avoid or reduce regulatory burdens.

The BIS concludes with a fifth and worrying feature of Chinese shadow banking: perceived and actual guarantees are pervasive… the expectation that the government will rescue financial institutions that are important to growth and stability provides implicit guarantees to investors and creditors. If a state-owned bank gets into trouble, customers may expect a bail-out from the part of the government.

As mentioned above, banks use shadow banking to shuffle their accounts in order to bypass regulations, especially the required provisions for the NPLs or the loan-to-deposit ratio. As NPLs have become unescapable, necessary regulations for new and old loans have become increasingly strict. Moreover, the growth of bank deposits slowed, meaning that banks could no longer lend much if they were to keep abiding by the government-imposed loan-to-deposit ratio. A reclassification of existing loans leaves wiggle room for the banks. But funneling their loans into other banks or trust companies to clear their balance sheets creates supplementary link between banks, trust companies, as well as securities firms, increasing systemic exposure to debt. In much the same manners, entrusted loans between companies, with banks acting as the middleman, has multiplied exposure in private sector companies.

4. The Central Government’s Deleveraging Efforts

In recent years, likely following government directives, large state-owned banks have been issuing less wealth management products (WMPs). This is part of a broader deleveraging effort led by the Chinese government. As early as 2013, Xi Jinping was calling for institutions to “forestall systemic financial risks”.

In October 2014, the State Council announced a ban on the use of local government financing vehicles. They planned to swap a substantial portion of the $1.7 trillion financing vehicle debt into municipal bonds. But such a swap-plan does not provide sufficient financing for local governments—in the long term, a comprehensive tax reform will be needed for regional authorities to raise their own revenue. One option would be for them to impose property taxes, which are widely used around the world, provide a stable revenue stream, and are easily administered. Pilot programs were put in place in Chongqing and Shanghai, but so far, they contribute less than 0.5 percent of tax revenue (Fran and Wang, 2017).

The national Ministry of Finance also told national banks to give out less loans to LGFVs. It said the banks cannot expect local governments to repay the vehicles’ loans.

In 2017, according to official data, the ratio of nonperforming loans to total lending among Chinese banks came just under 2% (CEIC, 2018). It would seem that the policies that China has put in place to reduce the number of toxic loans has been efficient. But many SOEs in overcapacity industries such as coal mining and real estate, as well as LGFVs upon which fragile regions such as Liaoning are dependent, are in the deep red.

The widespread use of shadow banking still conceals the true extent of the catastrophe. As stated above, according to a study by UBS group AG, 22 000 billion yuan’s worth of loans are not accounted for in 2016’s total credit measure, while Moody’s estimates Chinese shadow banking at 87% of GPD today (Leplâtre, 2017a).

To combat this phenomenon, Xi Jinping has ordered the merger of the China Banking Regulatory Commission and China Insurance Regulatory Commission. Uniting the two commissions will resolve issues such as unclear responsibilities and cross-regulations.

Guo Shuqing, head of the new regulatory commission, has been tasked with reducing these dangerous practices—interbank lending, issuance of uninsured financial products—without provoking a crisis in the second world economy. He has described the Chinese financial landscape as chaotic. “Banks, investment funds Investment fund
Investment funds
Private equity investment funds (sometimes called ’mutual funds’ seek to invest in companies according to certain criteria; of which they most often are specialized: capital-risk, capital development funds, leveraged buy-out (LBO), which reflect the different levels of the company’s maturity.
, courtiers and assurance companies manage similar assets, but submit to different regulations. It’s like the far west!” (Leplâtre, 2017a).

Authorities listening to liberal economists have been focusing on making China’s banks more efficient and competitive—as China’s financial system is centered on banks, cleaning them up seems to be the first step to rationalizing the entire economy.

With the approval of Xi Jinping, Guo Shuqing conducted an audit of the country’s main financial institutions. The regulatory commission targeted financial activity that did not translate into growth in the real economy, such as structures enabling fund transfers between financial assets. An official of the country’s most important commercial bank, Minsheng, was probed for defrauding 1.65 billion yuan allegedly invested in WMPs (Tongjian and Yi, 2017). This case highlights the lack of internal control.

According to Asian Nikkei review, “authorities appear to be focusing most heavily on regional banks. Zhongyuan Bank in Henan Province was penalized for letting loans be used for unauthorized purposes, such as property investment. Harbin Bank was fined 500,000 yuan for increasing lending to struggling businesses in an attempt to keep their older loans from going sour” (Cho, 2018a).

Guo Shuqing’s massive audit is a part of Xi Jinping’s nationwide anticorruption campaign. The president started “hunting tigers” in 2013, a short time after coming to power. Industry leaders, like the boss of Fosun (the conglomerate that bought Club Med) Guo Guangchang, mysteriously disappeared and reappeared a few days later, totally reformed. Others have not resurfaced. In January 2017, the businessman Xiao Jianhua was abducted from the Hong Kong Four Seasons Hotel in which he had taken refuge (Forsythe and Mozur, 2017). Politics are never far from business in China—Xiao Jianhua was part of the Jiang Zemin faction, a group in the communist party opposed to Xi Jinping. Zhou Yongkang, another star fallen from grace, was also a member of this faction. Under the pretense of fighting corruption, Xi Jinping is targeting his political enemies.

On top of deploying a strong regulatory commission, one of the important measures Xi Jinping has taken is to raise interest rates. Rising interest rates tighten the valves of credit in a given country and dampen debt-fueled borrowing and speculation. But adjusting capital prices is a tricky game. Sharply rising interest rates would be catastrophic, especially in such an indebted economy. A sudden tightening of liquidity and financial cost would push many enterprises into bankruptcy and lead to massive unemployment.

Another measure is to invite companies to swap short-term bonds for long-term bonds. Struggling SOEs that no longer generate any profits and companies with a poor credit-rating are among those on the blacklist in the swap plan. The central government has declared it will not bail out companies for any losses under the plan, which is still optional for now.

The guidelines of the swap plan also called for “acquisition and restructuring to reduce debt levels” and encourage “zombie” companies to go bankrupt (Wu, 2016).

Bankruptcies are still a rather new phenomenon in China. China adopted its basic bankruptcy law in 1986, which mainly applied to state‐owned enterprises. Coverage was extended in 2007 to other types of companies, including enterprises funded by foreign investors and joint ventures. But filing for bankruptcy remains a very tortuous process. The official data show about 5,000 to 6,000 cases per year, less than one‐seventh the number of annual corporate bankruptcies in the United States. Many more Chinese companies simply go out of business.

5. Foreign borrowing

Rising domestic interest rates and stricter regulations make offshore fundraising look more attractive and less expensive. Slower domestic growth is also a factor—China’s growth was as low in 2015 as it was in 1990. This incites companies to invest and sell their products abroad. Their investments are notably welcomed by European markets desiring to open up to Chinese companies. Higher US interest rates also play a role. The 10-year Treasury yield recently topped 3% for the first time in four years, and the two-year yield sits above 2.5%. As businessmen expect the Federal Reserve FED
Federal Reserve
Officially, Federal Reserve System, is the United States’ central bank created in 1913 by the ’Federal Reserve Act’, also called the ’Owen-Glass Act’, after a series of banking crises, particularly the ’Bank Panic’ of 1907.

FED – decentralized central bank :
to continue increasing rates, they are rushing in to get bond offerings.

Chinese businesses offered 87 billion dollars in overseas bonds from January to April 2018 (Cho, 2018b). Debt issued abroad by Chinese businesses nearly tripled from 30.9 billion dollars at the same period a year earlier, based on the exchange rates at offering time (Cho, 2018b). While Chinese businessmen and institutions are among the buyers of Chinese foreign-denominated bonds, overseas investors’ holdings of Chinese treasury bonds still rose to 449 billion yuan in 2017, according to Reuter’s calculations (Reuters, 2017a).

China’s biggest companies are investing abroad. Chem China bought the Swiss enterprise Syngenta while Midea purchased the German robot manufacturer Kuka, both Chinese companies acquiring foreign technology and knowledge in the process (Leplâtre, 2016). Meanwhile, other firms, such as Fosun and Wanda, are betting on Chinese economic transition to services and internal consumption. Wanda has invested in Hollywood and football and Fosun has bought the French company Club Med (Leplâtre, 2016). Chinese funds have announced 219 billion dollars’ worth of investment since the start of 2018, according to Bloomberg.

As such, overseas debt has grown exponentially. According to the Bank of International Settlements, banks in China reported outstanding cross-border claims of 778 billion dollars and liabilities of 918 billion dollars in June 2016 (Bank of International Settlements, 2016). Many of the reporting banks were affiliations of foreign institutions, representing some 35 different nationalities. This makes China the 10th largest cross-border creditor in the international banking market (Bank of International Settlements, 2016).

If we examine the currency composition of the banks’ cross-border claims and liabilities, banks in China were net lenders of US dollars in 2016, with dollar claims exceeding dollar liabilities by 275 billion dollars.

The BIS indicates that foreign claims on Chinese residents, including local claims made by affiliations of foreign banks in China, amounted to 1.2 trillion dollars at the end of June 2015. Though this is an enormous sum, the total amount of claims has actually been decreasing from 1.3 trillion in September 2014.

Most of the growth in foreign claims on China examined by the BIS has taken the form of credit to banks. The outstanding stock of these interbank claims accounted for more than half all international claims. Much like the total amount of claims, the sum of claims on banks has been declining from 660 billion dollars mid-2014 to 532 billion in mid-2015. By contrast, foreign claims on Chinese non-bank private sector has grown continuously, quadrupling to 395 billion. Interestingly, 39% of Chinese banks’ cross-border liabilities were denominated in renminbi (Bank of International Settlements, 2016).

While the issuers consist mainly of financial institutions, as seen previously, other sectors are also getting in on the act. China Eastern Airlines issued 500 billion yen worth of debt on the Tokyo Stock Exchange in March 2018, stocking up on yen for payments as it centers its services on Japan (Cho, 2018b).

LGFVs are also among those who have raised money with overseas bond offerings in 2018. Investment platforms for the Qinghai Province, the Xinjiang Autonomous Region and the city of Zunyi in the Guizhou Province have taken to foreign markets after Xi Jinping’s crackdown on debt and shadow banking. Low credit ratings mean that these firms are often stuck with very high interest rates which can go up to 8% (Cho, 2018b). Financial regulators are keeping a close watch on their investment strategies.

The bonds issued by LGFVs are essentially exporting China’s problem with local government debt Government debt The total outstanding debt of the State, local authorities, publicly owned companies and organs of social security. . Domestically, such bonds are considered to have the tacit banking of central or regional authorities—local government bankruptcy is illegal. But it is unclear whether Beijing would pay foreign investors back in case of a default on debt. In fact, past experiences point to the opposite scenario. In 1998, a default by Guangdong International Trust & Investment Corp., tied to the Guangdong Province, left foreign banks with enormous losses. Foreign creditors were repaid in accordance with international law, which means they did not recover the totality of their investments (Farley, 1999).

The Chinese government is continuously restructuring Chinese companies and institutions so that they can be listed on the Hong Kong Stock Exchange, which facilitates borrowing abroad. Arguably the biggest development in the past few years has been the advent of Stock Connect, an institutional link between foreign investors and mainland China markets (Dunkley, 2018). Before the implementation of Stock Connect, only professional foreign investors could apply for a special license to invest in mainland shares, and only a limited amount were available for purchase. Non-professional foreign investors now have the liberty to peruse wider segments of the mainland markets.

But a minefield of uncertainties will await fund managers who will be obligated to pour millions of US dollars into mainland shares after MSCI, a New York-based indexing group, decided to include some 200 Chinese A-shares in its main global indexes (Kynge, 2017). MSCI being the most influential indexer of emerging market equities, passive funds, which track indexes and are held by some of the world’s largest pension funds Pension Fund
Pension Funds
Pension funds: investment funds that manage capitalized retirement schemes, they are funded by the employees of one or several companies paying-into the scheme which, often, is also partially funded by the employers. The objective is to pay the pensions of the employees that take part in the scheme. They manage very big amounts of money that are usually invested on the stock markets or financial markets.
, will be forced to invest in the newly included A-shares. Active funds are judged against the benchmark and will now feel great pressure to buy A-shares too (Flood, 2018).

Though MSCI has included Chinese A-shares at a sliver of their value, and though the A-shares will only make one percent of its emerging market index, the move is still provoking major excitement. The two-stage inclusion of A-shares are expected to bring between 17 billion and 22 billion dollars into China’s domestic markets, according to MSCI itself (Sun, 2017). Three mainland companies are particularly popular among investors—Kweichow Moutai, a white liquor producer, Hangzhou Hikvision Digital Technology, a supplier of video surveillance products, and Midea group, specialized in air conditioning. All these companies bet on middle class consumers and internal consumption (Sun, 2017).

Another thing these groups have in common are solid accounting and limited liabilities. Not all of the 222 A-shares included by MSCI can boast the same. Five state-owned city commercial banks included in the list are either unrated or rated as “junk” by international credit agencies because their balance sheets are so weak. Other companies face similar challenges—mainland firms have much progress to make in terms of financial transparency and investor protection, according to major investment houses like Aberdeen Standard Investments (Sun, 2017). Only 57 or the 222 have been selected for investment by the 180 active funds surveyed by Copley Fund Resource, a global advisory firm (Dunkley and Kynge, 2018).

Some Chinese companies use a variable interest entity structure, which favors founders over other shareholders. Furthermore, the ownership risk for foreign investors is increased due to legal uncertainties—some A-share firms have close connections with shadow finance. By objective measurable standards, A-shares are among the most highly indebted, volatile, and worst governed shares in any emerging markets… passive funds, like the California State Teachers’ Retirement System, will be harmed in the case of financial crisis (Teachers’ Retirement Board Investment Committee, 2004).

As such, major Chinese companies have faced major difficulties after borrowing and investing huge sums abroad, worrying Chinese authorities. Chinese giants—grey rhinoceros, as the Chinese press calls them—have started investing in a myriad of sectors and industries often unrelated to their original business. Their gluttony has not gone unnoticed.

Once such firm is HNA. Since 2015, the group has invested more than 40 billion dollars abroad, accumulating liabilities worth 100 billion dollars for a total of assets worth 178 billion dollars (Escande, 2018). The group has acquired 9.9% of the shares of Deutsche Bank, purchasing more than the Qatar Emirate’s family at a time when the shares were low. Chinese investors bet on politics. They wager that since the Deutsche Bank is an institution of paramount importance in Germany, its assets are guaranteed by the German government.

Since politics are never far from economic investment in China, central authorities have called companies like HNA to order. China remains a state-controlled economy. Even private companies cannot invest as they wish if authorities believe their liabilities are unbalancing China’s economy. The government maintains a tight hold on prices and monetary policy, and is making sure outflows from “irrational” companies like HNA and Wanda are being offset by inflows from foreign investors, facilitated by tools like Stock Connect.

Though Beijing initially encouraged state-owned enterprises and other major companies to invest abroad, partially in an effort to lessen overcapacity issues, it is now alarmed by the abyssal levels of debt contracted by HNA. Excessive debt might lead to a liquidity crisis or bankruptcy and disrupt the country’s financial stability.

German and American regulators are also scrutinizing HNA’s structure, trying to find out who its main shareholders are (Leplâtre, 2017b). HNA’s parent company is not quoted in any global stock exchange, unlike many of its subsidiaries. Under pressure, HNA revealed the names of fifteen of its shareholders and the existence of a New York fund that detains 30% of the group’s capital. But this move did not convince regulators—in 2017, Goldman Sachs and Bank of America Merrill Lynch terminated their collaboration with HNA.

Chinese authorities have chosen to cut off funds for these “irrational” companies, ordering state banks to stop lending to them. On the 18th of August 2017, the State Council clarified the role of regulatory institutions, stipulating that investing in casinos, pornography, money games, or investing in a manner contrary to the national interests of China was forbidden. Approval of authorities must be granted for investments in sports, real estate and entertainment. However, investing in agriculture, natural resources, or the government’s Belt & Road Initiative is encouraged.

Conclusion: Will Chinese debt levels cause a new financial crisis?

In 2007, the financial crisis was caused by massive credit defaults on toxic loans in the US financial and banking system. A decade later, the potential trigger for a financial crisis could be another significant credit incident, for instance in a highly leveraged and opaque economy like China’s. But would a slowdown or credit defaults in China bring down the world? Pessimists might argue that a crisis in the second world economy would be sufficient to wreak havoc on the world financial system. However, in dollar terms, China’s share of world GDP only represents 15%—it is still smaller than the US’s share, which was 24% in 2018 (Roberts, 2016b). If a credit crisis erupted in China, it would probably not be as damaging to the world economy than the 2007 American financial crisis. We can also look at the past for examples. In 1998, Asian emerging economies faced the deflation of a real-estate bubble, but this did not lead to a global credit crunch.

Is a crisis likely? In the first part of this report, we asked ourselves whether Chinese corporate companies were overleveraged. We can now answer with certainty that this is the case. Being too brusque or a contrario ignoring the rising problem of debt would likely result in a full-scale crisis. In this context, it is difficult to ascertain whether Beijing would be able to contain a full-scale credit incident or banking crisis.

Some argue that China’s pockets are as deep as ever and that the government will not allow major banking institutions or important companies to collapse. As we have shown in the historical section of this study, central authorities have recapitalized national banks in 1991, 1998, 2003 and on other occasions. They could bail-out the banks again in the event of a credit incident. But credit-fueled growth has shown its limits—and buying out all the NPLs accumulated by the banks would not change the system that produces overleveraging, just clear the way for more borrowing.

Beijing is faced with the delicate task of balancing deleveraging with sustained growth. Dealing with these two concerns will require decisive reforms. Not only are companies struggling domestically, but they have exported their difficulties internationally with excessive borrowing. The central governments’ policies have favored this contagion through the Belt and Road Initiative.

The Belt and Road Initiative is China’s answer to US-led globalization. It comprises of a terrestrial “belt” and a maritime “road” which will both run from South-East Asia to Europe via South and Central Asia. In real terms, this financial and commercial integration implies that massive Chinese investments and loans finance the construction of deep-sea ports, train lines, roads and highways, nuclear and coal power plants. As of 2018, 78 countries and international organizations had signed cooperation agreements with China under the BRI (Kynge, 2018a).

A series of controversies have flared in countries such as Malaysia, Cambodia, Pakistan and Sri Lanka with regards to debt sustainability. Sri Lanka has had to cede 80% of its deep-sea Hambantota port to China after it found itself unable to repay its loans. Pakistan is now turning to the IMF IMF
International Monetary Fund
Along with the World Bank, the IMF was founded on the day the Bretton Woods Agreements were signed. Its first mission was to support the new system of standard exchange rates.

When the Bretton Wood fixed rates system came to an end in 1971, the main function of the IMF became that of being both policeman and fireman for global capital: it acts as policeman when it enforces its Structural Adjustment Policies and as fireman when it steps in to help out governments in risk of defaulting on debt repayments.

As for the World Bank, a weighted voting system operates: depending on the amount paid as contribution by each member state. 85% of the votes is required to modify the IMF Charter (which means that the USA with 17,68% % of the votes has a de facto veto on any change).

The institution is dominated by five countries: the United States (16,74%), Japan (6,23%), Germany (5,81%), France (4,29%) and the UK (4,29%).
The other 183 member countries are divided into groups led by one country. The most important one (6,57% of the votes) is led by Belgium. The least important group of countries (1,55% of the votes) is led by Gabon and brings together African countries.
after having contracted unsustainable levels of debt under the BRI.

Not only are the borrowing countries fragile, but the Chinese companies involved in the BRI face debt problems and build, invest and operate projects that are highly leveraged themselves. A study by the Financial Times shows that the top 10 Chinese construction and engineering enterprises operating outside China ‘are nearly four times more highly leveraged than the top 10 non-Chinese companies’ (Kynge, 2018a).

There have been signs of a policy reassessment in Beijing. As we have detailed throughout this entire report, central authorities are seeking to prevent further shaky credit expansion. [1] Another reason for this policy change could be unfavorable conditions for trade and investment globally. The world economy is still very fragile and many countries, including Eurozone countries, have not completely recovered from the Great Recession. The trade wars announced by US President Trump will contribute to this fragility.

Trade wars are a threat towards China’s financial stability. Companies already facing difficulties may not be able to pay the steep tariffs and go bankrupt, threatening Chinese jobs. Since the tariffs were announced on July 6, 2018, China’s currency and stock markets have been unstable, “reflecting investor nervousness about slowing economic growth and the longer-term impact of the trade war between the world’s two largest economies” (Mitchell, 2016). In this context, the central government has recently ordered the PBOC to maintain a very loose monetary policy, undermining the de-risking measures previously taken. But it has stopped short of a stimulus policy, as it continues its crusade against financial risk. In the future, it might tighten the credit valves again in the hopes of effectively reducing China’s credit mountain.

This “stop and start” policy starkly illustrates how difficult it will be for China to reduce leverage after more than ten years of breakneck credit expansion. As a shifting global balance slows China on its way to the harmonious society imagined by Xi Jinping, the central authorities are forced to devise new policies and envision radical reforms. For the sake of the Chinese population, one can hope that the core of these reforms will be worker protection, universal welfare, and ecological transition.


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[1According to the Financial Times, “Some BRI investment deals that are deemed too risky may be unwound, while the pace of new investments may fall off” (Kynge, 2018a).
Alice Jetin Duceux

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