World Economy

China Wants to Dismantle Risky Debt, Shadow Banking

Household debt is rising rapidly as people take out mortgages and borrow to pay for goods and services. For Beijing, this means striking a balance between its desire to curb property speculation--especially with borrowed money--and citizens’ desire to own
The Bank of Jinzhou, like many others across China, which was loaded with risky debt, raised over $5 billion  through risk-laden wealth management products.The Bank of Jinzhou, like many others across China, which was loaded with risky debt, raised over $5 billion  through risk-laden wealth management products.

When the Bank of Jinzhou, based in China's northeastern rust belt, went public on the Hong Kong stock exchange two years ago, its finances were a wreck. It had issued 34 billion yuan ($5.36 billion) worth of "wealth management products" that are hallmarks of China's sprawling "shadow" banking sector, and it was owed nine billion yuan by an unnamed borrower who was under investigation by Hong Kong regulators.

The bank, like many others across China, was loaded with risky debt—the kind that China's leadership in Beijing is now determined to stamp out, Nikkei reported.

After a massive buildup over the past decade, the government is waging an all-out war on debt. In December, President Xi Jinping said slashing debt was one of the "critical battles" Beijing would fight over the next three years, along with reducing pollution and poverty.

Regulators have cracked down on the shadow banking sector, and the government has put the brakes on Anbang Insurance Group, HNA Group and Dalian Wanda Group, conglomerates that spent billions on debt-fueled acquisition sprees for trophy assets around the world. On Feb. 23, regulators charged Anbang founder Wu Xiaohui with fraud and embezzlement and officially took over its operations.

Together, such efforts have sent a strong message about Beijing's determination to purge the financial system of excessive risk-taking—a message that is expected to be driven home when the National People's Congress begins March 5. In the process, regulators have helped ease fears that China's debt mountain would lead to a systemic crisis on the order of the 2008 global financial meltdown or the 1997 Asian financial crisis.

Fears Persist

For all this progress, however, fears remain. First, there are lingering concerns over the sheer size of the China's debt pile, which (Switzerland's financial services company) UBS estimates represented 272% of GDP at the end of 2017. But there are also growing worries about the potential unintended consequences of the authorities' efforts to rein in that debt.

The regulatory chill is already having an impact on businesses large and small. Chinese direct investment in North America last year fell 35% from 2016 as a result of the official crackdown on the leveraged purchases of assets such as luxury hotels, premier sports teams and Hollywood studios, according to a report from law firm Baker McKenzie and Rhodium Group, a consultancy.

China's smaller enterprises, many of which had relied on the unregulated shadow banking system for credit, have also been squeezed.

"The effect of intensified regulation is no longer limited to de-risking the financial sector but is now beginning to impact the supply of credit to the real economy," said Michael Taylor, chief credit officer for the Asia-Pacific region at Moody's Investors Service.

The tightening is the major reason analysts have downgraded their forecasts for Chinese growth from 6.9% last year to between 6.6% and 6.7% this year, even as export orders pick up on the back of a global recovery.

Controlling Shadow Banking

Whatever impact the debt crackdown is having on the real economy, regulators remain determined to kill shadow banking activity. They have made progress: In 2017, total shadow banking asset growth was about a tenth that of 2016, according to estimates from Moody's.  

But Bank of Jinzhou and other second- and third-tier banks across China are among those that still pose challenges. Prior to its listing, Bank of Jinzhou seemingly violated every rule of prudent banking. Lending money, which should be the core activity for such banks, was only a small part of what it did. Instead, it invested in and sold the high-yielding, complex wealth management products that the China Banking Regulatory Commission has been attempting to rein in as part of its attempt to control shadow banking.

In its mid-2017 financial report, Bank of Jinzhou was in somewhat better shape than two years earlier. Its listing had provided the bank with more equity to cushion against losses, and it had cut back on wealth management products. But 23 billion yuan worth of them remained on the books.

Even as China tightens control of lending practices, many companies are finding other ways to borrow. Some of them, especially in out-of-official-favor sectors such as property, are raising money in the US dollar bond market, allowing them to avoid onerous requirements at home while taking advantage of the recent strength in the yuan. This, too, carries risks: The currency mismatch could come back to haunt them if the yuan weakens again.

Joys of Debt

Then there are all the households that have recently discovered the joys of debt. If manufacturing-heavy China is to succeed in shifting to an economy based more on consumption and services, its people will have to save less and spend more.

This is happening: Household debt is rising rapidly as people take out mortgages and borrow to pay for goods and services. For Beijing, this means striking a balance between its desire to curb property speculation--especially with borrowed money--with citizens' desire to own their apartments.

Rising household debt has a strong connection with the fast-growing, and far less regulated, world of internet finance. The authorities are putting restrictions on a large group of internet finance companies out of concern that many customers are borrowing from one to pay back another, creating a chain that is only as strong as its weakest link.

"While the emergence of internet finance has helped boost economic growth, it has also resulted in more potential risks, especially given that regulation has often lagged innovation," noted Jason Bedford, an analyst with UBS in Hong Kong.

Black Swan

Today, the Chinese economy looks solid, and fears that it would spark a systemic crisis have receded. Yet the country's leaders continue to sound the alarm about excessive debt--including Xi, who will have even greater control over the economy now that Beijing plans to scrap the two-term limit for the presidency.

In mid-January, Guo Shuqing, chairman of the CBRC, said in an interview with the People's Daily that rising levels of bad debt, poor risk management and shadow banking could lead to a possible "black swan," or unforeseen economic event.

"We need to focus on reducing the debt ratio of companies, restricting household leverage, strictly control cross-financial sector products [and] continue to dismantle shadow banking," he added. "Currently, the overall risk of the country's financial system is controllable, but the financial sector is still in a risk-prone period due to multiple factors and is still facing a tough situation."


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