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China’s 13th Five Year Plan makes much of the further development of its financial services sector. But because of the Communist Party’s flawed policies, what is evolving is a system that increasingly looks developed but that functions on none of a developed market’s most fundamental principles.
With the launch of Bond Connect this year (as well as MSCI’s largely symbolic decision to include Chinese stocks in its global benchmark equity index), China appears to be making big strides in the internationalization of its financial markets.
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News in September that the communist party is writing itself into company laws, putting it above state-owned company boards is welcomed as a step towards transparency by some, a surrender to bad practice by others.
Worse, however, is that the state is increasingly forcing its growing middle class to, largely unbeknownst to them, shoulder the risks associated with China’s years of growth.
With the introduction of a revised debt-for-equity swap programme aimed at helping banks get rid of non-performing loans (primarily to bloated and poorly managed state-owned enterprises), the central government is selling out the middle class by making them carry the inevitable equity losses associated with NPL disposals.
In reality, even if the programmes work, it will result in little more than window dressing.
Arguably a much more serious problem in the financial system is Chinese banks’ use of shadow banking products to hide loans either headed toward trouble or that would have breached government lending limits.
In many cases, such shadow loan books exceed formal loan books in size and are still growing. Some believe that recently released revised guidelines for debt-for-equity swaps incentivize further shadow banking activities that could add stress to an already fractured system.
“It’s one of the worst programmes,” says one market observer. “Instead of forcing state actors to acknowledge and handle debt, they’re pushing leverage around the system. Any problems they have there will blow up on private investors.”
Superficially, any move to evolve the financial system into one in which private investors take on risk is progress made toward a developed market. But when the risk that is being privatized is the result of poor state policy – over-borrowing by local governments and state-owned enterprises – and without being entirely clear with private investors about the nature of that risk, it is a step backward.
China’s bond markets have, until recently, been essentially sovereign credit. But in the last few years credit events have spiked. In 2014, there were some 14 defaults, in 2016, 58. One analyst estimated that so far this year, there have been some 100. Chinese investors used to a zero-risk market are, perhaps unknowingly, facing one of, if still low, increasing risk.
“It’s another case of abuse of moral hazard,” says the Hong Kong-based market watcher. “The investor figures there’s a state-entity behind them. The state thinks they are selling private products to savvy investors.”
Moral hazard
And there is another great moral hazard: using the country’s National Social Security Fund – still a minute fraction of the size it needs to be to service China’s aging population – as a piggy bank to facilitate debt-for-equity swap programmes many international investors believe are doomed to fail.
While trying to reduce its contingent liabilities, the government is leveraging the fundamental driver of its transition to a consumption-led economy, the middle class.
Meanwhile, some international investors are making the case that, should there be big defaults, international investors will be kept safe, since, as one research note put it, programmes like Bond Connect act as a window into the Chinese financial system that the government will want to keep pristine. This seems rather optimistic.
The result is China’s attempts to deleverage its sickly financial sector represent a backward step on the road to becoming a developed market.
Fixing this problem now with real solutions for deleveraging, without forcing citizens to bear the costs of the poor behaviour of state actors, is needed.
If left until later, China will find itself having to fix fundamental problems in its financial system at a time when it wants to increase the involvement of international investors.
A bit like trying to replace a leg on a table already set for dinner.