US Regional Bank Crisis Will Affect How China Manages Financial Risk

While the fallout from the Silicon Valley Bank (SVB) crisis won’t have a direct impact on China, it will affect how Beijing manages risk among its own regional banks. In light of the SVB crisis, Beijing will likely have less appetite for letting local government financing vehicles (LGFVs) default in the near term. Preventing defaults will also protect regional banks that, as we’ve highlighted, are vulnerable because of their exposure to local government debt.

The central government will likely do everything it can to evince an aura of stability in the economy and the financial system. If that means Beijing will have to engage in quiet, below-the-radar bailouts of some of the entities most at risk, then the government will do so to avoid any unexpected shocks from defaults.

At a time of uncertainty in financial markets, this “not rock the boat” strategy can also be seen in Beijing’s recent personnel appointments. Although many were surprised to see the reappointment of central bank governor Yi Gang and finance minister Liu Kun—both nearing retirement age—the top leadership is clearly focused on telegraphing continuity and providing comfort and confidence to markets.

This reappointment does not mean Yi will serve out a full term, as the top leadership can change personnel any time. But for the time being, a steady hand like Yi may be necessary for managing significant change and stabilizing the economy. Having worked closely with previous vice premier Liu He, Yi has the experience needed by a new leadership confronting a tough set of choices. Yi will likely be involved in the financial regulatory restructuring unveiled at the National People’s Congress, a significant overhaul at the central and local levels that will, at a minimum, take most of the year to implement. At the same time, Yi and Liu Kun are also integral to guiding macroeconomic policy to ensure that China’s post-Covid recovery endures.

That means Beijing won’t tolerate financial disruptions or push for aggressive deleveraging until it is more confident that the economy has stabilized and the 5% growth target attainable, which likely won’t happen until at least the third quarter. At that point, Beijing may be sufficiently convinced by economic conditions to pursue aggressive deleveraging that would almost certainly result in regional bank defaults.

That’s because Beijing won’t be able to kick the financial de-risking can down the road in perpetuity, particularly since regional banks are some of the highest levered institutions. Currently, based on our estimate, the average asset/equity ratio of regional banks is higher than 30 based on market valuation. In other words, Chinese regional banks are about as leveraged as US investment banks were before the Global Financial Crisis.

Much of that leverage is a result of being the biggest lenders to LGFVs, which isn’t a problem when regulatory forbearance allows these banks to keep on lending. But in the event of rolling LGFV defaults, these regional banks will have little cushion for absorbing losses because of their low equity positions, threatening their solvency. According to our estimate, about one-third (~$4 trillion) of total LGFV debt are at riskof potential default, a scale that is too big to be bailed out by the central government.

Adding insult to injury is the fact that Beijing has hurt regional banks’ financial prospects by cutting lending rates. That can be seen in regional banks’ net interest margin—the difference between the interest charged to lenders and paid to depositors—which is currently at a multi-year low (see Figure 1). Yet Beijing has cut the mortgage rate to stimulate the property market and recently instructed banks to refinance LGFV debt with significantly lower interest rate—both of which will further squeeze banks’ profitability at a time of growing liabilities.

Figure 1. Regional Banks See Their Net Interest Margins ShrinkNote: Regional banks are composed of city commercial banks and rural banks.
Source: Wind and MacroPolo.

These are serious vulnerabilities that the new leadership needs to deal with, and it is likely one of the key objectives behind revamping the financial regulatory apparatus. This reveals a Chinese government that is concerned about the fragility of parts of its financial system, but a serious reckoning with the problem will have to be held off for now. In an environment of jittery financial markets, Beijing will exhibit immense caution and project stability.

Houze Song is a fellow at MacroPolo. You can find his work on the economy, local finance, and other topics here.