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Financial Instability in China: The Road to Evergrande

Financial Instability in China: The Road to Evergrande
 Philippe Aguignier
Senior Fellow - Asia

Chinese authorities have had to deal with numerous episodes of financial instability since economic reforms put China on a path of fast economic growth in the late seventies. Some of the past episodes turned almost systemic, while some were linked to one-off events and therefore more easily contained. Some were anticipated and preemptively managed, while others were utterly unforeseen. So far, all of them have been successfully handled, although, most of the time, symptoms rather than the deep roots of the problems have been addressed, so instability bouts keep reoccurring. The 2022 episode affecting the real estate sector echoes previous ones which were managed without addressing the root causes of instability. A walk through previous chapters of this story illustrates these points.

This paper is the second of a series analysing the mechanisms generating financial instability in China: how they are dealt with, why they reoccur, and whether and how they might spread to the rest of the world. This analysis sheds light on the key steps of China's financial instability in the last forty years.

The 1990s bank crisis: a crisis managed over time

The earliest and most severe episode since the beginning of the reforms era threatened to take down the banking sector in the second half of the 90s. China started to reform its urban economy in the 80s, and launched an ambitious restructuring and privatisation program in 1992, aiming to implement in-depth reform of its state-owned enterprises. In this new environment where enterprises could and did default, banks provided the financing needed. However, bankers were untrained in credit allocation decision-making and had no risk analysis skills. In the "go-go" environment of the 90s and the privatisations, banks had developed faster than their capacity to assess risks, and non-performing loans (NPLs) accumulated quickly. There are no entirely reliable figures available, but it is certain that true NPL ratios were far above what was officially published and would have been in negative net worth territory if adequate provisions had been passed. 

The Chinese authorities and the financial regulators understood the dangers of the situation early on. They also fully realized the extent of what had to be fixed with Chinese banks: risk culture and risk management systems of course, but also governance, managers' incentives, regulators and bankers' basic training, etc. Quick reactions, a very comprehensive set of reforms, and a bit of luck avoided a complete economic meltdown, even though the cost of the crisis was phenomenal: it has been estimated at an amount equivalent to 28% of the country's 2005 GDP. But with the economic growth of the following decades, this impact was eventually absorbed. 

The cost of the crisis was phenomenal: it has been estimated at an amount equivalent to 28% of the country's 2005 GDP. 

The prudential regulatory framework was reinforced, and an independent regulatory body (the China Banking Regulatory Commission - CBRC) was set up, with massive training assistance from the World Bank. Balance sheets were cleaned up, making use of all previously known techniques and inventing a few new ones, such as write-offs of NPLs, loan restructurings, creation of defeasance vehicles to take over and manage NPL portfolios from the major banks. Individual banks were strengthened through massive recapitalization exercises, or forced consolidation at the provincial or municipal level, with the weaker ones being absorbed by stronger ones.

New governance principles were established, with the professionalisation and increased accountability for management teams and an extended role given to boards of directors.

The risk management control and setup were enhanced, partly through a prudent opening to foreign expertise: Chinese banks were encouraged to let foreign banks acquire stakes of up to 20% in their capital, together with ambitious know-how transfer plans, giving foreigners the possibility to advise to the management of these banks, but no formal management rights.

Finally, the largest and best-performing Chinese banks, such as ICBC, Bank of China or Bank of Communications, started listing on international public markets (Hong Kong, New York), not only to raise funds but also to improve transparency. This was a risky bet because there were still significant uncertainties about how effective banks had been in improving their credit culture, or about the influence of the Party on day-to-day management. But it turned out to be a winning one: at that time the "China awakening tale" was the biggest investment story in the markets, and everybody wanted a piece.

Eventually, the crisis was overcome and the top Chinese banks reemerged only ten years later as the largest in the world. Only one significant financial institution (GITIC) and one very small local institution (Shantou Commercial Bank) failed; it was hardly an issue for the Chinese public, as GITIC was not a bank (so it had not taken deposits from the Chinese public) and had borrowed mostly from foreign institutions, while the depositors of Shantou Commercial Bank were reimbursed. Throughout the whole process, Chinese leaders were fortunate enough to be spared the threat of a "bank run"- at no point did the Chinese public really worry about the possibility of local banks' failure. 

The aftermath of the 2008-2009 world financial crisis in China: danger from all sides

The first part of the 2000s was quieter, until the advent of the 2008-2009 global financial crisis. As is widely known, China managed to avoid its worst effects: its economy kept on growing in the short term thanks to a massive stimulus plan, estimated at RMB 4 trillion, or 12.5% of GDP. However, there were longer-term effects as well: most of the investment projects under the stimulus plan, which often were related to infrastructure and city construction, were financed by debt provided by the banking sector to local authorities. This was an important factor in the overall degradation of the country's total debt-to-GDP ratio (excluding the financial sector), which went from 150% in 2008 to close to 280% in 2020, with the categories showing the most significant rates of increase being borrowings by households and local governments. This aggregate debt ratio level is not necessarily alarming in itself, and unexceptional by international standards, but the rapidity of its rise as well as the composition of the debt are sources of concern. 

Much of this new debt was structured in a potentially dangerous way, with both banks and borrowers finding ways to circumvent the various regulations and restrictions they were supposedly subject to. Local governments set up ad hoc special purpose entities known as local government financing vehicles (LGFVs), in order to circumvent restrictions that prevented them from borrowing directly from banks or limiting their ability to issue bonds. Typically, local governments would use a LGFV to fund projects such as highways, or housing programs: they inject the projects into a LGFV, which then borrows from the banks, who are supposed to be reimbursed by the cash flow generated from the projects.

Much of this new debt was structured in a potentially dangerous way, with both banks and borrowers finding ways to circumvent the various regulations and restrictions they were supposedly subject to.

Banks often repackaged their loans to LGFVs into investment funds which they sold either to other banks, to non-banking financial institutions such as trust companies, or even to the general public, offering interest rates higher than what they would offer on straight deposits (on which interest rates were capped). This offered banks a way around their balance sheet constraints: once they were packaged as investment products, the loans were off-balance sheet and no longer part of the assets taken into account in the calculation of capital adequacy ratios - an obvious loophole in the regulatory framework which took years to be closed. 

These practices came to be described as "shadow banking", a misnomer since much of the activity was taking place in plain sight in the banking sector. They made lenders and borrowers more fragile in many ways: local governments had started using unconventional financing methods after major tax reform in 1994 had left them with the responsibility of financing a much larger proportion of the State's expenses than the proportion of State revenues they could claim. However, the use of LGFVs became much more prevalent after 2009, with local governments becoming more and more dependent on this financing channel (as well as on various revenue streams related to land and property sales). The total liabilities of local governments exploded, and it became extremely difficult for the central authorities even to keep track and have a consolidated view of how much exactly had been borrowed at the local level. Various estimates put the amount somewhere between 35% and 60% of GDP in 2017. 

Banks were also affected and in particular small ones. Many of them are under the influence of local authorities and had been able to accumulate assets beyond what their deposit base should have allowed them to do through clever financial techniques. They were therefore more exposed in relative terms to LGFVs, and on the funding side, more reliant on interbank funding than larger banks, a source of vulnerability as interbank funding is more volatile than deposits by retail clients.

Another source of danger is that it is often unclear who is bearing the ultimate risk of these assets.

Another source of danger is that it is often unclear who is bearing the ultimate risk of these assets. Most of the loans to LFGVs do not carry an explicit guarantee by the local government. Lenders and investors however assumed that they did, and accordingly did not bother with an elaborate risk analysis, as they assumed that eventually, the State would honour the liabilities incurred by the LGFVs (a clear case of moral hazard).

There are many examples of such assumptions of implicit guarantees in the Chinese economy, with far-reaching consequences in terms of the quality of capital allocation decisions, as projects without a clear economic rationale can get financed nevertheless.

Regulators were well aware of what was going on but did not initially try very hard to stop or even curb shadow banking activities. The Party wanted to maintain a high growth rate, and achieving this depended on the availability of debt, regardless of the methods. They started to voice concerns in 2012, after several incidents where buyers of "fund management products" realised that they were exposed to risks they were not aware of and that the banks or financial institutions that had sold them these products did not guarantee their repayment. There were street protests and a lot of agitation in local social media (as well as in the foreign press). This transformed a financial issue into a political one, as social order was potentially threatened.

Regulators spent the next few years in a "hide-and-seek game" with banks and local governments, every move to tighten regulation being met by some new "financial innovation". The tide turned after 2015, and the regulators received much more support at the central level when maintaining financial stability was promoted as a major political and economic task, with the creation of a dedicated "small working group", headed by Xi Jinping. 

Signs of stress have also appeared in the banking sector, with some small banks encountering liquidity issues. In 2017 and 2018, four local banks in the North and North-East of China had to be restructured or rescued by the State. Holding around USD 100 billion in assets each on average, these banks were nevertheless considered "small" by Chinese standards. The problems in these banks seem to be a mix of bad governance, poor asset quality (with a lot of local projects of dubious viability), and fragile funding structures. Some are undoubtedly linked to the question of LGFV described above, but there is not enough evidence to affirm that LGFVs were the only or even the main cause of the problems. One bank was allowed to declare bankruptcy, for the first time since 2001, while the others were reorganised and taken over by other banks or entities. Lenders and even in some cases, institutional depositors had to take losses, although retail depositors were reimbursed. This established a template to deal with future bank crises, which proved handy in June 2022 when there was another wave of bank failures in Henan.

Other financial shocks: not systemic, but costly nevertheless

Apart from rogue "small" local banks and local government finance, the regulators had to face other challenges and episodes of instability in the last ten years, some of them of their own making, but all of them linked in some way to an excess of liquidity in the economy.

The "crowdfunding" (or "P2P" for person-to-person) bubble is one of these episodes. P2P was born with the development of internet finance. Lenders and borrowers are put in touch with each other through a platform. The platform operators perform some due diligence on the quality of the projects offered to lenders, but usually do not provide any kind of financial support or guarantees to the project.

The regulators had to face other challenges and episodes of instability in the last ten years.

Lenders make their own decisions and earn a remuneration on their loans higher than deposits. In the majority of cases, lenders and borrowers are individuals, and the financings are for small amounts. It became widely popular in the 2000s, including in China, where it was seen as a way to bypass "lazy" banks, more preoccupied with granting loans to large corporate borrowers than with satisfying the needs of small entrepreneurs.

P2P was initially very successful; there were more than one thousand platforms at the peak in 2018, quickly reaching RMB 1,300 billion in assets. Financial regulators, keen on promoting innovation in the sector and in opening alternative financing channels for small businesses, initially encouraged new entrants. Unfortunately, many operators turned out to be incompetent or corrupt or both, and things started to go badly wrong. Many platforms turned out to offer nothing else than classic Ponzi schemes, with early investors being repaid by the funds brought by later ones until the mechanism collapses. Once more there were street protests by disgruntled investors. Regulators intervened in an attempt to control the damage, but eventually, all operators had to be closed or for the more respectable ones folded into more viable entities. 

It is not known exactly how the defaulting platforms were dealt with, and who assumed the losses but it seems that in many cases, local governments were asked to step in and compensate at least partially retail investors, so as to avoid the spreading of social disorders. The cost of this debacle has been estimated at almost RMB 900 billion (USD 115 billion) by the head of the banking regulator. 

It is nevertheless quite unusual to see so many corporate failures of this scale in other countries, and this illustrates the extent to which capital is misallocated in the Chinese economy. 

There were also many one-off incidents during the period. For instance, we witnessed the collapse of several conglomerates, which in most cases had grown quickly - partly thanks to their political connections and to the easy access to financing by large State-owned banks that these connections brought. These cases were huge but not systemic, and the related losses were absorbed (mostly by the banking sector) without triggering a general crisis. It is nevertheless quite unusual to see so many corporate failures of this scale in other countries, and this illustrates the extent to which capital is misallocated in the Chinese economy. It is also remarkable that they happened in an economy that was still growing at a faster rate than elsewhere in the world. 

To take a few examples among many: Anbang, a large diversified conglomerate with its origins in the insurance business had USD 300 billion in assets (liabilities unknown). Hainan Airlines group had USD 170 billion in debt. Both had embarked on spectacular but overpaid and ill-timed acquisitions abroad. When these groups started to default on their debts, State-related entities took over the day-to-day management of these entities, and their liabilities were restructured. Like in the P2P case, the details of these restructurings have not been disclosed, but it is likely that banks and financial institutions bore the bulk of the costs. At any rate, this illustrates the degree of control exercised by State authorities on the banking sector (which remains overwhelmingly State-owned to this day).

The case of Huarong, a financial asset management company majority-owned by the State, deserves a particular mention: it was set up in 1998 to handle part of the bad loans which banks disposed of during the bank crisis of the late 90s. It later diversified into unrelated businesses and accumulated USD 250 million of debt, a lot of which was due to foreign bondholders. Huarong being held directly by an entity of the Ministry of Finance (MoF), international markets became nervous when it transpired in 2021 that Huarong was encountering financial difficulties. The MoF had to stand up and clarify that Huarong’s debt would be considered sovereign.

2015 turmoil in currency and equity markets: a different type of crisis 

The last episode we will mention is also the least understood. By June 2015, Chinese stock markets were overheating, having risen by 150% in the previous year. Optimistic statements about market prospects by political as well as financial authorities had led part of the public to believe that the CCP would not tolerate a market crash as it would cause too much damage to its image. Part of the growth was fuelled by debt. Financial regulators got worried, and an attempt to cool down the market by banning short-selling or stopping new initial public stock offerings in June quickly made investors even more nervous. Authorities then took more measures to prevent a market collapse, restricting the ability of institutions to sell stocks, forcing some State-owned investment funds to buy, and even at some point, requiring directors of listed companies to buy stock in their companies from their own savings. The market only stabilised in early 2016, by which time it had lost around a third of its value. At around the same time, monetary authorities allowed a sharp devaluation of the renminbi, and communicated poorly about their motives and ultimate objectives. In an environment already unsettled by the turmoil in the equity markets, this caused a massive capital flight. 

The People's Bank of China was able to cope by setting up new restrictions on capital transfers, but also by intervening in the currency markets thanks to its extensive official foreign exchange reserves, which decreased by more than a trillion US dollars (a quarter of their value) in less than a year. Economic growth slowed down during the episode, and the government reacted by launching various stimulus plans. These efforts were successful and the instability in financial markets did not translate into a full-scale economic crisis. They however resulted in a new increase in the level of debt, with a negative impact on growth. Looking back on this episode, a 2018 IMF working paper noted drily that "In 2007-08, about RMB 6.5 trillion of new credit was needed to raise nominal GDP by about RMB 5 trillion per year. In 2015-16, it took more than RMB 20 trillion in new credit for the same nominal GDP growth". 

This points to a growing resource misallocation problem. We will turn to its root causes and to how it generates financial instability in the next paper of this series.




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