China will prioritize streamlining and unifying the country’s financial regulatory framework, as well as cracking down on corruption in the sector, over liberalization.
The mounting risk posed by local government and corporate debt will require more ambitious relief programs.
Political sensitivities will delay implementation of certain regulatory reforms until after the pivotal 19th Party Congress, set for this October.
Financial sector reform in China is gaining steam. A number of recent developments point to a renewed push to clean up the country's financial system by chipping away at a disjointed and outdated regulatory system and clamping down on corruption in the banking, securities and insurance industries. Simultaneously, programs aimed at helping local governments and businesses metabolize their enormous debts have expanded rapidly. But while these initiatives hint at a more comprehensive approach to financial reform, with efforts to manage past debts running in tandem with those to tamp down the unsustainable credit growth of recent years, they do not portend substantial liberalization of China's financial system in the near future. More likely, these are early steps in what Chinese authorities see as an incremental, carefully managed program to restructure and improve (but not dismantle) the country's heavily state-influenced financial and economic systems.
The Challenge of Reform in China
Financial reform has long been a stated priority of China's government. In practice, however, efforts to improve the sector's ability to assess risk and allocate capital efficiently – the crux of financial reform in a country where political imperatives weigh heavily on economic decision-making – have often taken a backseat to more pressing concerns such as maintaining stable employment. As a result, despite near continuous pledges by central authorities to rein in the worst excesses of China's post-2009 state-led investment boom, debt of all kinds – including local government, state-sector, private corporate and household – has continued to grow at an alarming pace.
For example, outstanding local government debt has risen from 12 trillion yuan (around $1.75 trillion) to over 17 trillion yuan since 2012, equal to roughly 23 percent of China's gross domestic product (GDP) today. The growth has defied attempts by central authorities to rein it in by tightening controls on poorly regulated private entities called local government financing vehicles.
The scale of local government liabilities pales in comparison to that of corporate debt, which accounts for around 60 percent of China's total outstanding public and private debt load. As of 2016, unresolved corporate debt was equal to more than 165 percent of GDP, while total commitments are now nearly three times the country's annual economic output. (These ratios are comparable to levels in South Korea and Japan, though China's debt has grown at a far faster pace.) Officially, nonperforming loans account for a low 1.74 percent of loans nationwide, while "special mention" loans, which are overdue but not yet considered non-performing, account for another 3.92 percent, according to official estimates. But many analysts believe China's real nonperforming loan ratio is closer to 10 or even 20 percent. (In Japan, this ratio is 1.5 percent.) Though Beijing has built in some safeguards for managing existing debts over the past year or two, it has done little to reform the incentive structure that generated China's explosive debt growth and capital misallocation in the first place.
China's top leaders are now stepping up calls for better integration and enforcement of financial regulations across the country's banking, securities and insurance regulators, as well as urging stronger efforts to root out financial sector corruption. In his comments to the National People's Congress in March, and again in a statement published in early April, Chinese Premier Li Keqiang vowed to severely punish corrupt regulators and executives known as "financial crocodiles," and he called for the creation of a "firewall" against financial risks. These came on the heels of a late February announcement that China's economic regulators, led by the Chinese central bank, would draft new, unified rules to oversee asset management products. The $8.7 trillion industry encompasses a wide range of "shadow" investment tools like wealth management products, through which state-controlled banks channel funds into riskier securities promising high returns.
These and other recent developments illustrate different aspects of China's financial reform mosaic. Broadly speaking, "reform" in this context has three basic meanings: rooting out corruption, addressing local government debt and revamping the country's regulatory structures.
Reining In the Regulators
A major point of focus for Beijing is cracking down on corruption across major financial institutions, and the three agencies tasked with overseeing them: the China Banking Regulatory Commission (CBRC), China Insurance Regulatory Commission (CIRC) and the China Securities Regulatory Commission (CSRC). In an April 25 meeting with politburo members and senior regulators, Chinese President Xi Jinping likewise urged better protections against financial risks. Meanwhile, on April 9, authorities detained CIRC chairman Xiang Junbo on corruption charges. The following week, CBRC deputy chairman Yang Jiacai was sacked for corruption. The state-run People's Daily subsequently warned that "the best show is yet to come," suggesting that Xiang and Yang will not be the last financial crocodiles to fall.
To be sure, the extent to which financial corruption cases like those against Xiang and Yang reflect authorities' genuine interest in fighting graft, rather than providing political cover for Xi's elimination of potential opponents in the sector, remains unclear. As with other targets of the president's anti-corruption campaign, both imperatives are likely at work. But whatever the balance of interests behind the ongoing wave of financial corruption cases, it creates room for appointees whose interests align with Xi's. As a result, cracking down on corruption both advances the president's power consolidation drive and, in theory, lays the basis for implementation of his economic priorities in the future — whatever those may ultimately be. This makes anti-corruption a front line of sorts for financial reform efforts: Though rooting out graft and eliminating potential opponents on its own does little to address systemic faults in China's financial sector, China's leaders clearly see it as a precondition for enforcing reforms that do.
Tackling Local and Corporate Debt
In addition to rooting out graft, financial reform also refers to the central government's long-running efforts to create institutional mechanisms to help local governments and businesses repay their existing debts and absorb nonperforming loans. To this end, Beijing established in 2015 a local debt-bond swap program, in which local governments trade a portion of their outstanding loans for slower-maturing, lower-interest municipal bonds (held primarily by state-owned banks). More recently, it has begun emphasizing corporate debt-for-equity swaps, in which state-owned banks buy back loans in exchange for equity stakes in debtor companies. Both programs have expanded rapidly. Since 2015, local governments have swapped roughly 9 trillion yuan worth of loans for bonds, with authorities planning another 6 trillion in debt-for-bond swaps by the end of 2017. Likewise, in the first quarter of 2017, Chinese businesses traded 238 billion yuan in outstanding loans for equity stakes (to be held by the creditor banks), up from 203 billion, 30 billion and zero in the fourth, third and second quarters of 2016, respectively.
Despite this growth, serious questions remain about the efficacy of both programs. Though corporate debt-for-equity swaps are rising, reaching 480 billion yuan by March, they represent a tiny fraction of total corporate debt outstanding, which now stands at between 17 trillion to 18 trillion yuan. Moreover, unless paired with significant industrial and corporate restructuring efforts to make companies, especially in the state sector, more productive and profitable, debt-equity swaps do little to limit the state-owned banking sector's exposure to corporate bankruptcies. This concern explains, in part, why many banks initially balked at the initiative. Likewise, though local government debt-bond swaps help bolster local government finances in the short-term by lowering debt-servicing costs, the program does little to address how localities (which often face intense funding pressures) will actually repay the principal on their outstanding debts. Both programs lower the risk of widespread corporate and local government bankruptcies in the short-term, but neither offers a solution to the looming question of how to metabolize a decade's worth of unpaid debt, much of which is likely unpayable.
Eliminating Regulatory Silos
The third area of financial sector reform refers to central government efforts to improve financial regulation. In the 1990s and early 2000s, as China's economy took off (especially after China joined the World Trade Organization), this endeavor led Beijing to create separate banking, insurance and securities regulators to better manage the financial system's growing complexity. In recent years, improving financial sector regulation has moved in the opposite direction, toward building a unified regulatory framework encompassing banks, non-bank financial institutions (such as trusts and mutual funds), and insurance companies.
The primary thrust behind this shift has been the rise of regulatory arbitrage as banks and other investors take advantage of discrepancies in regulations among banking, securities and insurance sectors to channel funds into a wide array of opaque and risky products. This regulatory arbitrage became acute when authorities, in an effort to prevent China's economy from overheating, tightened controls on bank lending in 2011 and 2012, leading to the growth of informal lending tools such as wealth management products. Because they were sold by non-bank financial institutions under the jurisdiction of the CSRC (which, at least initially, placed fewer controls on investments into high-risk assets like real estate), these tools gave banks new avenues to channel investor funds into otherwise prohibited assets.
Despite Beijing's periodic efforts to rein in wealth management products and other so-called shadow lending devices, there has been a proliferation of a wide range of those tools as banks and other financial institutions seek new ways to evade regulatory shifts. As indicated by numerous anecdotal reports, by 2015, arbitrage among the different regulatory regimes of CBRC, CSRC and CIRC was an important feature of most major financial firms' ordinary business operations. Naturally, as state-owned banks relied increasingly heavily on non-bank lending tools to generate higher returns for their investors, they (and the trust and insurance companies into which they invested, along with commissions charged with overseeing them) developed a strong interest in preserving their access to them, and thus in combating any move to unify and tighten regulation of these products. This began to shift in late 2015 after the stock market collapse sparked calls from senior Chinese officials for a single "super regulator" to replace the existing tri-partite regime. The February 2017 announcement that the People's Bank of China would draft unified regulations for asset management products, particularly wealth management products, marked the first concrete step toward building a super regulator.
It is unclear when the draft rules for asset management products will go into effect. In a move to soften potential push back from banks and other investors, authorities in February said the rules would apply only to new products, not existing ones. Even so, to the extent that effective enforcement might threaten banks' bottom lines, implementation likely will not begin until after the political sensitive 19th Party Congress, set for this October, and even then, it likely will be gradual. Further major moves toward regulatory integration during the remainder of 2017 are unlikely.
Finally, it remains unclear how the above facets of Chinese financial reform will relate to the more common meaning of reform: liberalization. Throughout the past decade, China has used this lack of clarity to mobilize support from international observers and markets for initiatives that did not clearly contribute to liberalization. Indeed, some "reforms" have pushed in the opposite direction, toward consolidation of state and party control over key pillars of the country's financial system. The current wave of financial reform, particularly efforts to streamline and unify China's regulatory framework, may pave the way for greater liberalization ahead. But if past is precedent, that outcome is far from guaranteed.