China’s interventionist approach to financial risk management – The Diplomat
The growing number of Chinese companies with troubled balance sheets poses a significant threat to China’s financial stability. Real estate developers and private conglomerates are overleveraged and increasingly unable to access new financing. Many public enterprises (EPs) are not profitable at all and cannot service their debts without government support. Local governments depend on shell companies to finance their expenses through borrowing and land sales. Some small banks are poorly capitalized and heavily exposed to risky borrowers.
Faced with these threats to financial stability, China has stepped up regulatory interventions to defuse the risks. This approach was not designed in a vacuum; Chinese policymakers have learned lessons from the successes and failures of financial cleanups in Japan, the West, and China’s recent past.
Chinese economists have long focused on the similarities between China’s current economic problems and those of Japan’s bubble economy, particularly high debt levels and an economy overly reliant on real estate. Japan’s inability to quickly resolve corporate bankruptcies and bad debts has exacerbated problems and dampened long-term economic growth.
Chinese economists have also listed a long list of mistakes made by US regulators and policymakers during the global financial crisis. Chief among them was that allowing the disorderly collapse of Lehman unnecessarily aggravated the severity of the financial crisis.
China also learned a great deal from its own experience of restructuring its banking sector in the late 1990s. This financial cleanup came with huge costs. According to some estimates, China had to devote around 30% of its gross domestic product (GDP) to cleaning up the banking system. The failure to address the structural issues at the core of the banking system means that many of the underlying problems have not been resolved and remain today.
A new manual to clean up the financial sector
China’s current approach to tackling financial risks can be attributed to the National Financial Work Conference in 2017. At this meeting, President Xi Jinping said financial stability poses a significant risk to national security. and ordered Chinese financial regulators to take the initiative.
With their new marching orders, Chinese regulators have set out to clean up the financial system. These efforts are shaped by China’s political priorities under Xi: stability, control and self-reliance.
When significant financial risks emerge in a specific industry or company, Chinese policymakers adopt one of three strategies:
Put industries on a diet – China’s first tactic to clean up financial risks is to impose macroprudential controls at the sector level. Regulators set new rules and requirements for an industry. Companies in the industry are compelled to curb risky behavior and improve their financial health by increasing equity and reducing debt. The purpose of this hard-nosed approach is to prevent latent problems from metastasizing into more serious financial risks.
The “three red lines” put in place for the real estate sector in 2020 are perhaps the most influential of these sectoral regimes. The policy sets out balance sheet rules that property developers must follow or face restrictions on their ability to borrow. Many big developers, including Evergrande, fell into financial trouble after the rules passed, proving that emergency diets can create more problems than they solve.
“Arranged marriage” with the State – When dieting isn’t enough to avoid financial distress, regulators need to take more drastic action. In these situations, the government steps in to arrange an acquisition or injection of capital by state-owned companies or private companies linked to the state. The aim is to avoid a destabilizing bankruptcy that could have wider implications for a key sector or the wider economy.
These bankruptcies also offer the opportunity for a reassertion of state control over strategic or sensitive sectors. Private companies or partially privatized public companies are subject to stronger state control.
Funding for the troubled company usually comes from state-owned companies, state-owned investment funds, or state-owned asset management companies, which act as agents of the Chinese government in implementing the restructuring. Sometimes funding comes from private companies linked to the state. These companies are persuaded to provide funding through formal or informal government advice, often referred to as “national service”.
Go into custody – In cases where an arranged marriage is insufficient, even more drastic measures must be taken. In the most serious cases – in which bankruptcy would have far-reaching financial, economic and sometimes political consequences – Chinese regulators will place a company in “state custody”.
Under this mechanism, the government oversees the formation of a creditors’ committee composed of the company’s major lenders. Sometimes a separate risk committee is formed with direct representation from government and important stakeholders. These entities directly oversee the bankruptcy process, guiding it to minimize wider financial and economic disruption.
State-owned companies are entering a form of suspended animation. Payments on debts and other liabilities are suspended. These companies often continue to run their day-to-day operations for years, even though they are insolvent, due to government pressure to minimize disruption.
Behind the scenes, a highly politicized process is working to resolve the bankruptcy. The Chinese government prioritizes the allocation of losses based on political and economic considerations rather than the hierarchy of creditor rights. The imperative is to maintain financial and social stability.
When this process is complete, the business can be restructured, sold in whole or in part to other entities (usually state-related buyers) or reorganized into a whole new entity.
Control is the goal
Although the Communist Party has trumpeted its efforts to strengthen the rule of law and allow the market to play a “decisive” role in the economy, these goals often take a back seat to preventing financial instability.
Regulators are now no longer shy about trying to fundamentally reshape problem industries, including issuing new rules that force many existing players out of business. Life support is withdrawn from struggling businesses and banks. Private conglomerates face visits from government-led risk committees. Weak companies, both public and private, are under strong pressure to merge with stronger entities.
The field of intervention has recently widened beyond the mere consideration of financial risks. Chinese policymakers now talk openly about the government’s role in limiting the “disorderly and barbaric expansion” of capital. Sectors of the economy that are not subject to government control are seen as unstable, sources of risk and potential challenges to the CCP’s influence.
China’s new approach to financial stability should result in a more state-centric economy. For example, in the wake of the repression of the real estate sector, public real estate developers have used their privileged access to finance to carry out major asset acquisitions from private developers. As a result, the real estate sector is undergoing slow nationalization.
Through early interventions, often drastic in nature, policymakers prevented financial risks from escalating into a full-scale financial crisis. However, China’s craze to eradicate financial risks is also hurting the economy’s dynamism. While Beijing has studied the mistakes of past financial cleanups, its current approach risks creating new ones.