Is China’s Debt War Exacerbating Systemic Financial Risk?


The deleveraging campaign and shadow banking crackdown which currently lie the core of China’s financial policy settings could be exacerbating systemic risk, due to the reckless business practices and heavily indebted state of the country’s smaller lenders.

Beijing has been pursuing a heavy-handed campaign against debt and the shadow banking sector for more than a year now, in order to shrink the mountain of debt accumulated over the past decade.

The stimulus measures launched by Beijing in the wake of the Great Financial Crisis have pushed China’s national debt levels to as high as 272% of GDP as of the end of 2017, according to research from UBS.

Analysts are already seeing or anticipating the impacts of Beijing’s deleveraging campaign on overseas investment as well as financing for China’s real economy.

Outbound foreign investment levels plunged in 2017, after the central government introduced capital curbs and ordered banks to staunch lending for the debt-fuelled overseas buying sprees of Chinese companies.

The deleveraging campaign is also affecting the domestic economy, by starving SME’s of access to financing which they have traditionally obtained via the shadow banking sector.

Moody’s estimates that shadow banking asset growth in 2017 fell to a tenth the figure for the preceding year.

“The effect of intensified regulation is no longer limited to de-risking the financial sector but is now beginning to impact the supply of credit to the real economy,” said Michael Taylor, chief credit officer for the Asia-Pacific region at Moody’s Investors Service.

For this reason analysts are already downgrading their forecasts for China’s GDP growth to between 6.6% and 6.7% this year, despite a recovery in the global economy boosting export levels.

In addition to softening economic growth, China’s deleveraging campaign could also be exacerbating risk in the financial system by impeding the health of the country’s smaller sized banks, which engaged in reckless, debt-fuelled business practices in order to rise through the ranks.

A noteworthy example is the Bank of Jinzhou which was publicly listed just two years ago, and which according to the Nikkei Review has “seemingly violated every rule of prudent banking.”

“Lending money, which should be the core activity for such banks, was only a small part of what it did.

“Instead, it invested in and sold the high-yielding, complex wealth management products (WMP) that the China Banking Regulatory Commission (CBRC) has been attempting to rein in as part of its attempt to control shadow banking.”

The crackdown on the shadow banking sector now threatens severely undermine the prospects of these smaller lenders by starving them of access to funds.

China’s smaller lenders, including 12 nationally licensed joint stock banks and over 100 municipal commercial banks, rely upon shadow banking activities such as wealth management products (WMP) and interbank borrowing to obtain funds, while also making extensive recourse to the financial products of intermediaries to channel capital towards high-return projects.

So important are WMP’s to the operations of smaller lenders that the unveiling of new asset management regulations last year prompted leading members of the Chinese banking sector to plead for the new rules to be watered down in order to avoid compromising financial stability.

Patricia Cheng, head of China financial research at CLSA, recently said to Reuters that this shadow banking dependence makes the Chinese finance sector highly vulnerable to systemic risk, as one major shadow banking default could undermine public confidence and staunch access to fresh funds, triggering a cascade of defaulting WMP’s.

“The funding chain would collapse,” said Cheng. “This in turn could lead to panic and a liquidity crunch.”

The Nikkei Review concurs with this view, pointing to a recent report from UBS saying the shadow banking crackdown will raise the likelihood of defaults due to the heavy debt burden of financial institutions and companies.

“At the end of 2017, interbank assets and liabilities dropped for the first time since 2010. This prompted widespread concern among analysts and investors that a lack of credit could prove fatal to some businesses, setting off a cascade of collapses among smaller financial institutions and their clients.

“What exists now is a cat-and-mouse game between the regulators and the regulated, leading to shadow lending and other activities that jeopardize the very financial stability that the controls are meant to achieve.”