In the central bank’s quarterly report on monetary policy, released Nov. 17, the term “financial risk” was mentioned 19 times. A few days later, an article titled “Hold the line and do not let financial risks blow out” appeared in the Communist Party’s flagship newspaper, the People’s Daily, penned by central bank governor Zhou Xiaochuan, and was seen as another strong market signal.
Financial risk in China has yet to reach a blowout point, but it has climbed to a level that is certainly not negligible. Therefore, the financial industry should return to common sense and “to its original purpose,” as President Xi Jinping said. That means that financial institutions and local governments should stay away from dodgy or so-called no-cost businesses and practices. The financial industry should also prioritize servicing the real economy, which should be the essence of the industry.
Decision-makers at the top haven’t lowered their guard against financial risk; risk prevention has long been a top policy objective. In fact, it has gained importance since the annual Central Economic Work Conference in December last year, to the every-five-year National Financial Work Conference in July.
Although the market remains divided on the severity of financial risk in China, the issue has garnered more attention recently. Terms that describe risk such as “black swan,” “grey rhino” and “Minsky moment” are entering people’s daily conversation. Shouting about financial risk is not meant to create fear and pessimism, but to make sure preventive measures are in place, such as adopting an appropriate monetary policy, so that China can avoid dire developments.
Though Chinese economic fundamentals are good, we should not overlook the possibility that financial-market risk could flare up as leverage ratios and defaults rise. In the article by Zhou, China’s national leverage ratio stood at 247% at the end of 2016, with the ratio of the corporate sector at 165%, well above the level considered dangerous internationally. High leverage goes against the “common sense” of doing business within your means, an act of chasing after excesses instead of building the real economy.
Local government debts pose the largest risks in China’s financial and fiscal arenas. Worse still, the scale of hidden debts remains elusive. A large portion of such debts is in fact bank loans. Although the central government has tried to rein in local debt issuance and encourage more public-private partnerships, some local governments have resorted to other means – some of which are fraudulent – to work around the red tape.
For instance, they might re-leverage by disguising their debts as equity investments, offering guarantees illegally, with improper procurements. Some industry funds have even become dodgy fund-raising platforms for local authorities. The suspension of the 30 billion-yuan subway project in Baotou city in Inner Mongolia was a result of over-borrowing to fund an overly ambitious project. Projects like this sometimes manage to amortize the financial pressure over time, but if they need to continue to borrow more to cover previous debts, the projects can snowball into so-called Ponzi financing, and almost inevitably a Minsky moment would follow.
It is helpful to look through the lens of the history and function of finance. Once finance deviates from the real economy, it loses its foundation for healthy development. But in recent years, China’s financial industry has shifted even further away from the real economy. Not only are investment returns on traditional industrial sectors falling, small and medium enterprises are facing more restricted or costlier access to funding, which hinders the country’s economic transformation.
On the other hand, many financial institutions are spending enormous amount of energy on profiteering from regulatory and other loopholes. They scramble to expand into shadow banking, asset management and cash loans, while risk builds up underneath stellar earnings figures. Internet finance companies going under and bond defaults are inevitable consequences of deviating from common sense and original purpose. Therefore, it is absolutely necessary for regulators to clean up the industry. Otherwise they are not doing their job.
Returning to common sense and original intent should not be applied to the financial industry only. Behind the financial risk facing us now is a complex web of factors: a structural imbalance of the real economy, unsatisfactory corporate governance, regulators’ inexperience in managing “countercycles,” regulatory loopholes, insufficient market access for foreign institutions, and more. Therefore, any measure requires substantial planning and coordination.
An imminent task ahead will be speeding up financial regulatory reforms, and redefining each agency’s role by activities they oversee, not institutions. As the development of mixed financial services is far ahead of our regulatory structure, financial risk may grow where there is a vacuum or an overlap of oversight. The establishment of a financial stability committee, with an office sitting inside the central bank, will strengthen regulators’ ability to prevent risk from growing. The industry has high hopes for this committee, and expects it to coordinate efforts among agencies and proactively improve their supervisory tools. Meanwhile, decision-makers should take account of evolving market conditions, learn from other countries, and create a better working relationship between the central bank and the three financial regulators. That way we could avoid a situation in which no agency takes ownership during crises, or in which agencies step on each other’s toes during good times.
Prevention or tackling systemic financial risk requires a thorough knowledge of actual risks. Governments at various levels should rein in their budgets, taking account of intergovernmental fiscal relations and the modernization of governance. Research also shows that while corporate debts are piling up, state-owned enterprises are more indebted than private ones. Therefore, it is of paramount importance to forge ahead with state-sector reform, restructuring or bankruptcy of “zombie companies.” We should also widen funding access for small to medium enterprises, by getting rid of systemic and policy obstacles, in order to better service the real economy.
Thanks to strong economic growth, and partial opening of the capital market, China has yet to experience a complete cycle of economic crisis. While that is fortunate, it also explains why we do not have a robust “learning curve.” Therefore, lessons from other countries are valuable to us.
Some people might say that China is not going to have a financial crisis, because governments at every level are sitting on massive assets, particularly land resources. That view is extremely shallow and toxic. Prevention of systemic financial risk requires a framework and strategies. To actually return to common sense and original purpose, we must push ahead with financial reforms, and widen market access for foreign institutions, in order to create our own “anchor” to keep us away from systemic financial risk.