Chinese financial circles are buzzing about Zhongnanhai’s decision to convene the fifth National Financial Work Conference this week. One reason for the anticipation is that such conferences are rare—held only once every five years. But more than just rare, such meetings tend to be significant and have, in the past, led to decisions with long-term ramifications. For instance, at precisely such a work conference in 1997, then Premier Zhu Rongji launched reforms of the state-owned banking sector.
Beijing’s policy mandarins have kept mum on the agenda of this upcoming work conference. But from what I’ve gathered, it will most likely deal with two major issues: financial regulatory reforms and local financing and fiscal woes.
- Financial regulatory reform and coordination
It is increasingly apparent that China’s current financial regulatory framework has too many loopholes and remains fragmented. These are legacy issues that policymakers have failed to meaningfully address. For instance, because Chinese financial institutions historically were not allowed to operate in more than one sector, separate regulatory bodies were created for the banking, securities, and insurance industries.
But such a system is increasingly anachronistic and sharpens bureaucratic cleavages. That is, China has a bank-dominated financial system, and non-bank financial institutions are on average much smaller, especially compared to the largest state banks. This naturally creates a tension between the two types of institutions: the latter aim to surpass and out-compete while the former want to defend the status quo.
It doesn’t just end there, however. Chinese regulators have clear incentives to protect the very institutions they regulate. And that means battles at the industry level are also manifest at the policy level.
Of course, financial regulators’ tendency to protect the institutions under their supervision is not exclusive to China. Yet this sort of internecine turf battle is increasingly propelling a race to the bottom on regulatory standards and enforcement, as all three Chinese regulators seek to ensure that the firms they supervise are not disadvantaged.
Recent financial innovations have enabled different types of financial institutions to directly compete with each other for funds. As that competition between different types of financial institutions intensifies, regulators themselves will inevitably feel greater pressure to relax regulations on the institutions under their watch (and they will be susceptible, too, to aggressive lobbying from the financial institutions themselves).
Two examples underscore how financial innovations have led to this sort of regulatory race to the bottom. One is the widespread use of short-term debt instruments to raise funds. Chinese banks have been using wealth management products (WMPs), which are basically short-term debt by another name, to finance their off-balance sheet expansion. What’s more, atypical financial institutions are now getting into the WMP game. As regulations on insurers have been loosened over the last few years, insurance companies have developed their own version of WMPs, the so-called “universal life insurance.” When boiled down to its essentials, this is basically a term life product combined with a promise of fixed returns.
All of these products are now in the mix, competing for funds by offering higher returns, which usually involves investing in illiquid and riskier assets. For a brief period, it appeared that insurers enjoyed the greatest freedom in investing however they wanted. The results of that behavior speak for themselves: between 2014 and 2016, China’s insurance sector saw its total assets grow by a staggering 60%.
Figure 1. Growth of Insurance Sector Assets (in billion yuan)
Source: China Insurance Regulatory Commission.
Put yourself in a Chinese regulator’s shoes for a moment. As you oversee the banking or securities industry, you also bear witness to these circumstances developing in the insurance sector. You might very well feel compelled to compete by similarly relaxing regulations to avoid putting the financial institutions under your jurisdiction into a weaker position. Within that context, the regulators’ rationale may even make sense.
A second example is the proliferation of special purpose vehicles (SPVs). For many years, banks have tried to move risky assets off their balance sheets to conserve capital and circumvent regulations. These moves could be costly, so banks have long searched for the cheapest way to do so. Consequently, trust companies, asset management firms, investment banks, and insurance companies all rushed to set up SPVs to serve banks.
The result has been the perpetuation of relaxing SPV regulations. Even if one regulator tightens the screws on SPVs in the industry under its supervision, that effort would invariably be undone by new loopholes created in other sectors.
If left unchecked, these dynamics will likely continue unimpeded, to the point where regulations are no longer meaningful. And unregulated financial innovations, coupled with a continuous race to the bottom on regulations, will seriously undermine China’s fragile financial system.
It is within this context that the financial work conference will likely aim to reorganize China’s financial regulators and address the “too many chiefs” problem that no longer works.
Although some have speculated that Beijing could take the dramatic action of creating a “super regulator” and effectively abolish the existing three regulators, that might be too far a line to cross at the moment. And a consensus on this solution remains elusive heading into the meeting. A more likely outcome, then, would be to retain the three existing regulators but create a higher-level People’s Bank of China-led financial coordination body to ensure a more holistic approach in policymaking. Still, under the new system, the Chinese central bank and the coordinating body will almost certainly gain power at the expense of the three regulators.
For now, on the eve of the work conference, all of the regulators have resorted to “racing to the top” by strictly enforcing regulations, and in some cases, have even seriously tightened the screws on financial institutions. The intensity of the financial regulatory crackdown will likely persist even after the conclusion of the conference, since details of any new framework aren’t likely to be determined until the 19th Communist Party Congress later in the fall.
Of course, Chinese financial regulators are sophisticated readers of the political zeitgeist and seem to be doing their best to behave accordingly, in part to make a case for why they should not be weakened. That’s because in addition to expected behind-the-scenes bargaining, how well each regulator behaves for the rest of the year could determine how much power each ultimately keeps under a new regime.
Whether this regulatory pressure can persist into 2018 is difficult to say at the moment, not least because the very pace of financial innovation has accelerated in recent years. In the cat and mouse game between financial institutions and regulators, the mouse has been running ever faster.
- Imminent risks are all local
Despite widespread interest in potential changes to China’s financial regulatory system, what is perhaps more interesting is the second key issue on the table for the meeting: preventing a financial or fiscal crisis at the local level.
There appears to be more urgency behind this agenda, as it has been reported that all provincial governors are required to attend the conference. No official explanation has been given for why governors are mandated to attend. But a closer examination of the nature of current challenges offers at least three reasons why it makes sense for local officials to participate.
First, current local debt totals more than ¥24 trillion ($3.5 trillion), with most of the borrowing from banks. Part of the reason for this rise in local borrowing has to do with the slowdown in fiscal revenue growth tied to the general decline in economic growth. The revenue impact has been particularly felt in regions that rely on commodities and heavy industries. For certain provinces, the risk of local default is real, underscored by Beijing’s recent efforts to head off local fiscal crises.
Second, banks also have considerable exposure to local state-owned enterprises (SOEs) and financing vehicles. This has become a more significant problem because local SOEs have accumulated more than ¥42 trillion ($6 trillion) in debt, with the majority of borrowing also from banks. What’s more, local governments often compel banks to grant debt forgiveness to keep certain distressed state firms afloat. This issue has apparently reached such severity that President Xi Jinping has personally included it as one of the six key tasks for the latest round of financial tightening.
Third, local governments at various levels own almost all local or regional banks. Some of these local state-owned banks are also the most fragile institutions at risk of failure. For example, in addition to their risky loan portfolio, China’s small and medium-size banks on average invest around 18% of their assets in “shares and other investments,” a category that usually implies the riskiest loans. In comparison, the more prudently managed large state banks have less than 3% of their assets in this category. If a substantial percentage of such investments go sour, some of the more aggressive local lenders could well go under.
Figure 2. Other Investments as % of Total Bank Assets
Source: PBOC.
For all these reasons, China’s immediate financial challenges are very much a local issue, and it seems that provincial officials are now on the hook to manage their way out of it. Just as Beijing has mandated provincial governments to be ultimately responsible for the debt of lower-level governments, the governors at the conference are likely to get an earful and will likely be told very clearly to closely monitor their local banks and to prevent localized financial crises from creating domino effects nationally.
It is true that China’s current financial challenges are dwarfed by the enormity of the problems the country faced in the late 1990s. Back then, China’s banking system was seriously weak, with official estimates of non-performing loans reaching about 25% of total bank assets. On the other hand, the current financial system is arguably more fragile than at any time in the past decade.
But the very fact that such a conference is taking place at all suggests that top policymakers are sensing considerable urgency to address these festering problems. In 1997, the inaugural financial work conference marked the beginning of Beijing’s successful effort to rebuild an embattled financial system.
Twenty years later, that financial system has been rebuilt, but only partially reformed. It is now much larger and more complex, but it is also generating a new set of problems that could have systemic implications. The question is whether Beijing has the similar political fortitude to replicate its previous success and once again reshape the financial system.