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China's Next Financial Crisis: A Matter of "When" Not "If"

Analyses - 17 January 2023

This paper is the last of a series analyzing the mechanisms generating financial instability in China: how they are dealt with, why they reoccur, and the risks that they might spread to the rest of the world. Previous papers went through the history of recent episodes of financial instability in China. This final piece turns to the analysis of the root causes of such episodes, and the risk of damage they may cause to the global economy. Given the limited exposure of international banks to the Chinese market, the piece argues that a domestic financial crisis in China could have the most significant direct impact on countries that depend on Chinese lending but could also cause extreme volatility in international financial markets. 

The main factors behind China's recent history of financial instability

The causes behind China's recent financial crises were all internal. How little China was affected by recent episodes of global financial instability is quite striking. China even escaped the worst effects of the 2008-2009 Global Financial Crisis, even though its management of this global crisis through a massive stimulus planted the seeds for future problems, such as local government debt. The table below recapitulates these main instability episodes, together with a classification of the impact of the main causes. 

In all crises, regulatory deficiencies (the first factor on our list) played an important role. The Peer to Peer (P2P) crisis in 2018 was to a large extent caused by regulators’ underestimation of the dangers inherent to digital finance. However this has been a one-off event; financial regulators were unprepared to cope with the risks linked to the restructuring of the corporate sector model inherited from the 90s. 

The regulatory environment has been strengthened, with a sophisticated crisis management toolbox progressively put in place.

But they learned quickly and now have a high degree of risk awareness and meaningful crisis management experience, with some success. In addition, they have significant resources to deploy during emergencies, notably through the quasi-total state control of the banking sector. The regulatory environment has been strengthened, with a sophisticated crisis management toolbox progressively put in place, and inspired by measures taken in the US or the EU after the Global Financial Crisis.

However, a strengthened regulatory environment does not solve all problems. Poor risk management within banks (our second factor) also left a mark on most episodes. The money to finance projects has been too easily available due to poor credit or investment decisions by bankers. At the same time, projects were poorly managed or ill-conceived. Both of these drivers rendered most projects almost destined to fail.

The third factor on the list is Government or Party intervention. Direct intervention by authorities can also lead to situations of financial instability. Banks often encounter difficulties because of poor governance and interference by local authorities in their lending process. Another classic example is the 2015 crisis in the equity and foreign exchange markets which was caused - and later - aggravated by state intervention aiming at influencing markets.

In an economy which has grown so fast for so long, it is not surprising to find the 3 risk factors described above. But they cannot alone account for the whole story, and we need to turn elsewhere to explain the extraordinary recurrence of financial distress in the Chinese economy. The table shows two additional risk factors with a greater impact: (i) a strong appetite among lenders and investors for investment with a high potential return, and (ii) severe misjudgments as to the real risk level of investments, due to blind faith in implicit guarantees of ultimate state intervention. In other words, players in the financial sector assume that the State will not allow debt to default given the associated risks of social instability and even political chaos. 

What makes the Chinese situation unique is the combination of an immense pool of liquidity, a shortage of safe investment opportunities, and a set of distortions hiding the real risk level of many investments, leading to a very inefficient pattern of asset allocation, and ultimately, to financial instability.

An economy driven by savings and investment

The Chinese economy is characterized by a very high savings rate, and the main engine of economic growth has been investment rather than domestic consumption. At 46% for 2021, the gross savings rate is twice as high as the world’s average and has been consistently high (it was between 35-40% in the 1980s, and reached a peak of 52% in 2008). A high savings rate is not inherently negative and is necessary for fast economic take-off. But if carried on for too long or too intensively, the economy becomes unbalanced, leading to unintended damaging effects. Owners of this liquidity i.e. individuals, institutions, and corporations (some State-Owned Enterprises in particular are extremely cash-rich) need to find outlays to invest in. As the economy entered a high growth phase in the 80s there was an abundance of investment opportunities with a high return. 

With time, however, returns have been declining, especially for the kind of infrastructure projects such as highways or urban redevelopment programs that Chinese authorities are fond of. This has been exacerbated by the 2009 huge stimulus plan to mitigate the impact of the Global Financial Crisis, which was based mostly on projects initiated by local authorities and financed by debt provided by the banking system. With decreasing returns and increasing leverage, financial stress started to accumulate in the economy.

With decreasing returns and increasing leverage, financial stress started to accumulate in the economy.

Until recently, given the lack of maturity of the financial and life insurance markets, the two main investment options at hand for individuals were bank deposits and the purchase of property. But deposit rates in China have been regulated by the State, with a cap to protect banks from excessive competition between themselves, and set at a level well below inflation. As a result, depositors were sure to lose part of the value of their savings over time. This explains the uncommon appetite of Chinese households for real estate, which has generated the best returns for investors over the last decades. 

Banks remain the main channel through which savings are mobilized and deployed into the economy, as equity and bond markets are relatively underdeveloped (and for the former extremely volatile). They tried their best to fulfill their client's wishes for higher returns on their savings. Inspired by US securitization techniques, the very ones which contributed to the spreading of the Global Financial Crisis in 2008-2009, Chinese banks started bundling various kinds of assets into investment funds, thereby offering returns higher than straight bank deposits. These were often loans to investment vehicles set up by local governments known as local government financing vehicles or LGFVs. This type of product became very popular after 2009 as it satisfied both the desires of investors for higher returns as well as the financing needs of local governments. It also allowed banks to bypass regulatory ratios by removing some assets from their balance sheet. The question of who bore the risks (or what would happen in case there was a problem in the assets underlying the funds) was often left unclear. But there is no doubt that most of the investors who purchased such products in the early days believed, or were led to believe by banks, that these investments were bank-insured and therefore as safe as deposits.

The problem with implicit guarantees

Economic actors in China have high expectations of the State (and the Party). They tend to believe that when economic or social stability is at stake, the State will intervene. Banks and bondholders think that state-owned enterprises (SOEs) or local governments will not be allowed to default, as a default would entail a loss of prestige and credibility for the State. Similarly, with the vast majority of the banking system being state-owned, most people in China (including bankers themselves) trust that a bank cannot go bankrupt and that banking deposits benefit from some kind of "implicit guarantee" from the State. This belief, as we have seen, even extends to the financial products they purchase from the banks, and is to a large extent confirmed by past experience. SOEs are now sometimes allowed to default, but defaults by local governments (or the LGFVs they control) are still extremely rare. A bank deposit guarantee fund has been put in place in 2015, so as to theoretically allow an insolvent bank to be closed or restructured without losses for small depositors, but in practice, only a few small banks have ever defaulted. When problems arose and public demonstrations ensued in relation to financial products placed by a bank, local authorities usually intervened and settled the problem quietly with aggrieved investors and the bank.

Implicit guarantees avoid the risk of large defaults spreading to the whole economy and evolving into a systemic crisis.

Implicit guarantees avoid the risk of large defaults spreading to the whole economy and evolving into a systemic crisis, which could happen for instance if investors were to start fearing that a default by a large bank was a real risk. They are however extremely costly and lead to huge economic efficiencies. In an environment where borrowers do not default because they are ultimately rescued, risk allocation is bound to be irrational, as risk is not properly integrated into investment decisions. 

Projects without any chance to generate returns covering their costs or loss-making companies without any prospect of operating profitably (which is the case of many local SOES) continue to be financed, and therefore destroy value for the whole economy.

Chinese financial authorities are very aware of this situation and of its costs. They are indeed trying to dismantle these implicit guarantees, by progressively allowing more insolvency events to happen and putting in place mechanisms to mitigate their consequences. The task is extremely difficult and dangerous, as the recent unfolding of a real estate crisis shows: authorities were rightly concerned about the real estate bubble, and took measures to puncture it. Their intentions were laudable, but what happened next is that large developers went into financial distress one by one, and their problems spread to their suppliers and to the general public (through the widely practiced presale system of properties). Even worse, the financing of local governments had been based for decades to a large extent on fiscal revenues from the sale of land, and their revenue-raising capacity was badly damaged when sales plummeted. Central authorities held firm for a few months, but have now rolled back most of the restrictions they had put in place to deflate the bubble, and instructed banks to start lending again to developers. 

The pattern we just described in the case of the real estate sector repeats itself throughout the economy, especially since 2009: liquidity abounds, and even worthless projects can be financed; when a problem arises, more liquidity is thrown at it; in the absence of efficient mechanisms to allocate this liquidity in a rational way, it almost always shows up later somewhere in some unexpected place in the economy, and the authorities have another episode of financial instability to deal with. It is an endless whack-a-mole game.

The "Next One"

Financial stability has been at the forefront of the preoccupations of the Chinese leadership. The first official efforts to reduce the degree of leverage in the economy date from 2015, and the draft of a new law on financial stability published in April 2022

Reinforcing the legal setup to deal with instability may help, but has so far not prevented instability bouts from reoccurring. The root of the problem is in the economic model. As long as the Chinese economy relies on savings and investment as its main driver, and risk allocation mechanisms are dysfunctional, bubbles will keep popping up. Reforming either of these factors has proved out of reach; there have been attempts at dismantling implicit guarantees but they were eventually deemed too risky to be fully carried out. Rebalancing the economy in favor of private consumption has been an economic priority since the last years of the Hu Jintao era, but little has been achieved: the savings ratio remains stubbornly high. 

As long as the Chinese economy relies on savings and investment as its main driver, and risk allocation mechanisms are dysfunctional, bubbles will keep popping up.

The current real estate crisis is the most severe the regime has met for a long time, but the recent new injection of liquidity may buy time and stabilize the market for a while. Even though, another round of instability is bound to occur. Many sectors could be the epicenter of the next tremor: it could be real estate again if it turns out that the faith of the public in ever-rising prices for property has been destroyed for good; or the financial sector, where there are many poorly managed small local banks and where some non-bank financial institutions are not as strongly regulated as banks; or the individual borrowers' segment (household debt has been rising too fast), or parts of the corporate segment (SOE debt is still growing); or perhaps, and most likely, the local governments, which suffer from a dramatic loss of revenues. 

Global repercussions

Trying to guess the source of the next shock is difficult but key to assessing how a crisis could affect the rest of the world. So far global impacts of China’s past financial crises have been mitigated because the country’s degree of global financial integration is far lower than its degree of insertion into global logistics and manufacturing chains. 

First, China does not rely on the external world to finance its economy. The bulk of Chinese debt is denominated in China’s domestic currency and held by Chinese investors (as is the case in Japan). The direct impacts of a Chinese crisis in terms of losses incurred by foreign holders of Chinese loans or securities would therefore be limited. China’s gross foreign debt was officially estimated at around $2,635 billion (USD), or 15.5% of GDP at the end of 2021. But taking into account China’s reserves of more than $3,000 billion (USD), China’s net external position is actually positive. Foreign holdings in China’s main financial markets are currently only 2% for loans (after almost 20 years of WTO…), 3% for bonds and 4% for equity.

The main channel through which a financial crisis is transferred from one country to another tends to be the banking system.

The main channel through which a financial crisis is transferred from one country to another tends to be the banking system. International banks have limited direct exposure to China, with the exceptions of HSBC and Standard Chartered. US banks are estimated to have on average around 0.5% of their assets directly exposed to China, compared to 1% for EU banks. Foreign lenders take a prudent view of the credit risk of Chinese entities and tend to limit their exposure to the most creditworthy borrowers in the least problematic segments. 

For instance, they have very limited exposure to LGFVs or real estate developers, as they remain uncomfortable with their financial statements or their business model. US banks' exposure to China is probably higher when measured on the basis of the revenues they derive from China-related businesses. Investment banks in particular earn substantial revenues from underwriting business, which generates fees but (usually) do not require them to book assets in their balance sheet. They could suffer from a loss of revenue in a scenario of prolonged financial instability in China, but this would be far from a systemic threat.

Chinese banks, with 10% of their assets outside of China, are more exposed to the rest of the world than banks from the rest of the world are to China. A financial crisis in China could force them to reduce their overseas lending activities, which could in turn impact recipient countries. In 2020 they accounted for 7.5% of global cross-border banking flows, but if one looks at emerging countries alone, the percentage was 26%. Therefore, a Chinese domestic crisis could have a significant impact on countries that are relatively dependent on Chinese lending. This said, Chinese lending flows have slowed down sharply since 2020, so the impact may be already felt by these countries (this decrease is most likely due to rising problems in the loan portfolio: official Chinese data probably underreport reality by a wide margin, but up to 60% of China’s sovereign loans have been provided to countries encountering or about to encounter some form of financial distress). 

In a similar vein, Chinese banks, including the People’s Bank of China, are large holders of US treasury bonds, which are the main instrument in which China’s reserves are invested. They could be tempted to sell these rapidly in case of a domestic emergency. Their holdings still represent close to 5% of US treasuries outstanding but this share stopped increasing. Chinese banks have been less active in buying US treasury bonds since 2015. If they were to sell them, this could affect the market for a while, but it would be at worst a temporary perturbation.

A default by a Chinese bank is a potentially disruptive event, as illustrated by what happened when Lehman declared bankruptcy in 2008. China’s four largest banks are considered "global systemically important financial institutions" by the Financial Stability Board. However large banks in China are strongly capitalized and closely supervised, which limits the likelihood of a systemic accident in the sector. If problems arise, it is more likely they would involve small local banks as has been the case up to now. 

A default by a Chinese bank is a potentially disruptive event, as illustrated by what happened when Lehman declared bankruptcy in 2008. 

So far the authorities have shown they were able to contain the damage caused by such situations, and in any case, foreign banks do not usually deal with this type of bank, so the problems would remain domestic. Things could get more dangerous if a mid-size Chinese bank got into difficulties. This is not completely impossible but seems very unlikely at this time.

Another possible transmission channel for a crisis is currency liquidity. During the Global Financial Crisis, US dollar liquidity dried up as banks stopped lending to each other after the Lehman default. Banks that relied on the interbank markets for financing faced liquidity issues, which limited their capacity to finance their economies, and in the worst cases, forced them into financial default. A problem involving the American currency became a global one. This is very unlikely to happen with the Chinese RMB, which is still far from being a major international currency.

A Chinese financial crisis could still cause major disruptions: one of its primary effects would be rising volatility in financial markets, as investors would worry about a possible contagion (the 2015 turmoil in the Chinese markets did generate some panic in the global foreign exchange markets). Volatility itself is harmful, as it makes it more difficult and more costly for borrowers and investors to raise funds everywhere in the world. The damage caused would depend on the length and depth of the crisis.

Beyond direct impacts, there are also potential indirect ones, as a financial crisis is often linked to an economic one (causality can go both ways). The global impact of a pronounced economic slowdown (or recession) in China must then be considered. Analyzing this in detail goes far beyond the scope of this paper, as it would take a detailed country-by-country, sector-by-sector and firm-by-firm analysis. Still, much can be learned in this respect from events such as the Covid crisis or the rising tensions between China and part of the rest of the world over Taiwan. It is abundantly clear that economic turmoil in China would be very disruptive for the world, through the disorganization of logistic chains or a suddenly reduced demand for foreign goods and services. One just needs to think about what happened to the tourism and education sectors in countries that depended heavily on China (expenses by Chinese tourists abroad represented more than $250 billion (USD) per year at their peak before Covid hit).

Conclusion

Financial crises in China have happened repeatedly, and with increasing frequency since 2009. They have structural causes, which are unlikely to be successfully addressed in the near future. It is therefore highly likely that crises will keep on happening. Fortunately for China, each crisis taken individually has so far proven manageable by the Chinese authorities given their experience in crisis management and the resources they have at their disposal. Fortunately for the rest of the world, these crises have by and large remained contained to the domestic market. They have not morphed into global events in the way the Global Financial Crisis of 2008-2009 did, as financial linkages between China and the rest of the world are not as strong as industrial or trade ties. Leaders in countries outside of China would do well to remember this and should be mindful of not increasing the financial linkages between their countries and China unless the structural factors which underpin financial instability in China have demonstrably been addressed and become weaker. Moves to promote the use of the Chinese Yuan as an international currency should for instance be monitored carefully, as they could have the unintended effect of facilitating the propagation of a Chinese financial crisis to the world. Unless precautions are taken, a Chinese financial crisis running out of control could be as disruptive an event for the world as the Covid crisis has been. The world should not sleepwalk into an over-dependence on China in the financial sphere, which would also entail overexposure to Chinese domestic financial instability.

 

 

Copyright image: WANG Zhao / AFP

 

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