Market Chaos and the Inadequacies of Deleveraging

Discussion about the reform of China’s financial system routinely gets boiled down to one word: deleveraging. And yet, while halting the accumulation of debt—whether it be in absolute terms, or relative to the size of the economy—is vital to bringing financial risk under control, it represents only one part of what Beijing is trying to achieve.

China’s leaders see the challenges posed by the financial system far more broadly than debt levels. As Xi Jinping has said repeatedly since 2015, the “bottom line” of reform is to prevent “systemic risk from occurring.” It is a veiled acknowledgment that, without proper handling, China’s financial system could experience some sort of crisis. More than that, Xi is also making a case for a broader set of financial reforms to make the financial system sufficiently stable and sustainable such that it can continue to support economic growth and to withstand shocks.

The regulators haven’t been sheepish in articulating the scale of the challenges they face amid the litany of problems plaguing the financial system. In mid-January, the China Banking Regulatory Commission (CBRC) published a statement in which it referred to “market chaos” in the banking system and argued that “the deep-seated reasons that generate market disorder basically haven’t changed,” despite having witnessed some progress last year. Here’s a brief look at the sources of financial market disorder that can’t be fixed by deleveraging.

Regulatory Arbitrage: For almost a decade, the financial regulators have been in a game of whack-a-mole with the banks, which time-and-again have used the shadow banking system to find gaps in the regulatory framework to circumvent rules aimed at reining in bank lending and restricting bank lending to certain parts of the economy. Beijing has time-and-again tried to choke off credit to real estate, polluting industries, and local governments, yet these sectors have always been able to find new sources of credit.

Regulatory arbitrage has been made possible by having different regulators oversee the banking, insurance, and securities sectors. In the early days of China’s financial development, that made a lot of sense, but institutions in all three categories are now involved in activities outside of their traditional silos. Further complicating things, local authorities are responsible for overseeing certain financial sector activities, opening up more opportunities for creative bankers to design loopholes. Still, the CBRC doesn’t want to see a return to the days of plain vanilla banking.

“The chaos in the banking industry wasn’t caused by innovation in itself, but by some financial institutions pursuing arbitrage in the name of innovation, thereby disturbing market order,” it said in January.

In short, China wants financial innovation, just not under its current guise and form. To that end, the banking regulator is trying to shut down the biggest of loopholes exploited by bankers by forcing them to bring shadow banking assets back onto their balance sheets. It could mark a major step forward in Beijing’s efforts to impose discipline and exert control over the free-wheeling financial sector. Certainly, the banks seem concerned that the rules will hurt their profitability and crimp their operations. Only with time will tell whether the regulators have finally neutralized the banks’ ability to innovate their way out of regulatory constraints.

Illegal Behavior: Of course, sometimes bank fall short in their bid to find workarounds that are technically within legal boundaries, and instead apply their creative energies to hide their outright flouting of regulations. The CBRC has stepped up its efforts to root out such behavior. In two of the most high-profile cases this year, the CBRC imposed hefty fines on both Shanghai Pudong Development Bank (SPDB) and Guangfa Bank for their creative, but illegal, approaches to disguising bad loans. (SPDB lent money to shell companies, that then lent the funds to delinquent debtors, who used the loans to repay SPDB. Meanwhile, Guangfa packaged its nonperforming loans (NPLs) into wealth management products and sold them to retail customers as high quality investments.)

But the scope of illegal behavior goes far beyond banks trying to avoid regulatory compliance. Criminal behavior can thrive during a prolonged boom because strong growth and easy money readily disguise malfeasance. And regulators might be willing to turn a blind eye, or even collude in such practices, something that the head of discipline at the People’s Bank of China recently alluded to when he complained of “alliances between cats and rats.”

However, when growth slows and credit tightens, criminality becomes harder to paper over. It’s no coincidence that Beijing launched a nationwide crackdown on pyramid schemes last year. Or that it has tightened up on P2P and other online lending platforms after failed lenders like Ezubao were labelled Ponzi schemes by authorities. There has also been a steady trickle of news of retail fraud at banks, most notably involving bankers’ acceptance drafts.

Asset Quality: With an NPL ratio of 1.74%, the stock of bad loans at China’s commercial banks is relatively low. However, not even the CBRC believes that figure is a fair representation of delinquent loans in the financial system. In its mid-January statement, it outlined a number of ways in which banks disguise bad loans as being healthy or use the shadow banking system to hide them off-balance-sheet.

As I wrote here, the banks are making significant strides in dealing with bad loans by writing them off and selling them to third parties, but it’s difficult to assess how significant that progress is without having a fair accounting of the actual extent of the problem. That’s important so that banks have enough capital to ensure their financial health. Clearly, the CBRC is trying to force a more accurate accounting by fining banks for their transgressions.

Meanwhile, Beijing has allowed a secondary market for NPLs to develop—something I will write about in more details in the weeks ahead—giving banks new outlets through which to dispose bad loans. The market is nascent, but the CBRC is certainly hoping that the innovation that has wreaked havoc elsewhere in the financial system might actually be deployed to help shore up the financial system by helping banks better deal with their NPLs.

Interconnectedness: Traditionally, China’s banks were able to fund loans entirely from deposits. Today, a significant number of banks rely heavily on funds borrowed from each other and from other financial institutions. That’s in part because many of the methods by which banks circumvent lending restrictions involve complicated financial structures whereby money passes through multiple banks and shadow banking institutions, creating a complicated web of interconnected loans that’s not so dissimilar, albeit on a smaller scale, to the one that spread contagion throughout the US financial system following Lehman Brothers bankruptcy.

Paring back this interbank market was one of the great successes of 2017, with the value of wealth management products banks had bought from each other falling by 3.4 trillion yuan ($536 billion). Vitally, that contraction had no discernible impact on economic growth. According to Guo Shuqing, head of CBRC and likely new central banker, that was possible because the funds were being used for speculation.

“These areas mainly involved idle funds…so overall, dealing with the financial chaos has had relatively little impact on the real economy,” he said in October.

Speculation: The financial system has helped fuel asset price inflation in stocks, bonds, property, and commodities. However, unlike the problems outlined above, speculation can’t be overcome by regulators imposing their will upon financial institutions. That’s because China’s money supply has ballooned over the past decade, and the real economy has struggled to accommodate it with productive investments. Nonetheless, the financial sector still needs to find somewhere to park those funds.

Consequently, wealth management products and other shadow banking platforms have been used to direct savings into speculative activity, a phenomenon known as “casting off the real for the empty.” At its most extreme it refers to industrial companies diversifying into financial services, a surprisingly widespread occurrence. At the other end of the spectrum it refers to companies investing more and more of their cash into wealth management products. The challenge for Beijing is that whenever it has tried to squeeze out speculation from one area of the economy, the money—in a never-ending search for yield—has flowed into another part.

None of the problems outlined above are new. In fact, regulators have been complaining about them for years. What’s different this time is that the regulators seem imbued with a determination we haven’t seen for years—perhaps decades—seemingly emboldened by support from President Xi who seems to be genuinely concerned with the state of the financial system. The question is whether political support will remain robust in the face of slowing growth.

In the meantime, Beijing seems comfortable with the idea of a slower economy—after all, at 6.9%, 2017 GDP growth is far below the 8% that for years was a non-negotiable lower limit—but unquestionably there is a level at which growth will prove too slow for Beijing to stomach. And of course, there is also the risk that efforts to make the financial system more stable might have the reverse effect and trigger instability, at which point political support for reform could dissipate.

Regardless of what happens down the line, the campaign launched by the financial regulators is best thought of as “de-risking” rather than “deleveraging.” Consequently, the way we judge the success of that campaign shouldn’t solely come down to whether Beijing manages to move the needle on the level of debt-to-GDP. Of course, determining whether the financial system has been made more safe and sustainable is incredibly difficult to assess, not least because the regulators are targeting so many different, and seemingly unrelated, problems. Even as the appeal of using deleveraging as the key metric to judge financial reform will likely persist, Beijing is moving aggressively to fortify and rectify the system in so many other ways.