Over the last couple of years, a cryptic idiom has crept into the way China’s top leaders talk about risks in the country’s financial system: tuo shi xiang xu (脱实向虚), which loosely translates as “casting off the real for the empty.” Premier Li Keqiang warned against it at his press conference at the end of the 2016 National People’s Congress (NPC). At this year’s NPC, Li inserted this very expression into his annual work report. And in April, while on an inspection tour of Guangxi, President Xi Jinping used the term, saying that China must “unceasingly promote industrial modernization, raise the level of manufacturing, and not allow the real to be cast off for the empty.”
Such an odd turn of phrase is easy to overlook, but it belies concerns about a significant shift in the way that China’s economy works. What Xi and Li were warning against is typically called financialization in developed economies. It’s when “real” companies—industrial firms, manufacturers, utility companies, property developers, and anyone else that produces a tangible product or service—take their money and, rather than put it back into their businesses, invest it in “empty”, or speculative, assets. It occurs when the returns on financial investments outstrip those in the real economy, leading to a disproportionate amount of money being routed into the financial system.
It appears China’s politicians are now echoing what the nation’s economists have warned of for years.
“For many companies sales are stagnant, business is difficult, and the ability to earn a profit has sharply declined, so more and more manufacturing companies have started to subsidize their losses by getting involved in real estate or with financial investments,” Xiang Songzuo, former chief economist at the Agricultural Bank of China, wrote in the state media in 2013. “Almost all big manufacturing companies have, to a certain extent, gotten involved in real estate.”
Profits in many Chinese industries were long ago driven into the ground by overcapacity, and have since been further eroded by rising labor and land costs. Consequently, diversifying into finance or real estate is a logical decision for many businesses. But that has raised the specter of contagion spreading throughout the whole economy if something goes wrong in the financial system or property market. Moreover, it makes it difficult for the government to stimulate the economy because new credit gets diverted into speculative pursuits, rather than being used to generate real economic activity.
Since Xiang wrote his column, financialization has in fact worsened as economic growth has slowed. In a speech at Peking University late last year, former Sinopec chairman, Fu Chengyu, said the process has advanced so far that China’s economy has already “cast off the real and become empty.”
“Today everyone is playing in finance—state firms, private firms, everyone. Those without a financial license all want to apply. With a license, you can immediately get rich. The real economy can’t compete,” he said.
As the economy slows, so should the demand for financial services, and yet in China the finance sector has ballooned. At the end of 2015, China had more than 7,100 leasing companies, 11 times that in 2012 when the economy first started slowing. By the end of 2016, there existed 4,500 P2P platforms, up from only 200 at the end of 2012. The volume of funds invested in wealth management products increased by about 20% in 2016 and 56% in 2015.
Meanwhile, the Chinese press is filled with examples of companies with no experience in finance but nonetheless diversifying their businesses into financial services. At one end of the spectrum small, private business people are setting up online lending platforms; at the other, state-owned firms are busy buying shares in bank and trust company.
Finance has come to occupy a disproportionately large share of the economy. In a speech in March at the China Development Forum in Beijing, Yi Huiman, the chairman of the Industrial and Commercial Bank of China, warned that China faced “excessive financialization,” and noted that financial services currently represent 8.3% of GDP, having more than doubled its share from 2000 to 2005.
“That’s already higher than most developed economies,” he said. (In 2015, finance and insurance represented 7.2% of the US economy, but given differences in calculation, that may not be a perfect comparision with China’s figure.)
And yet, it’s likely to prove difficult to prevent China’s level from rising even higher. The country has created an incredible amount of liquidity over the past decade—and continues to do so—and that money has to go somewhere. In a perfect world, the real economy—the industrialists and manufacturers—would be able to use the liquidity productively, to grow and develop their businesses. Instead it flows into a financial system that redirects it into real estate, stocks, bonds, and commodities, and uses it to rollover loans to debtors that can’t repay.
That’s one of the motivations behind China’s supply-side structural reforms, and why Xi, in the above quote, called for industrial modernization and manufacturing upgrading in the same breath as warning against financialization. Xi hopes that by shutting down excess capacity, and cultivating new, high value industries, companies will again have reason to invest in the real economy, rather than go looking for opportunities in finance and speculation.
That’s the hope, at least. But until it happens, Beijing must contend with the lure of empty investments continuing to feed a growing and increasingly risky financial system.