Contents of this Article:
- Evaluating Financial Contagion and Systemic Risk in China’s Current Debt Crisis
- China’s domestic debt has been growing nearly four times faster than its economy
- Is China really too big to fail?
Evaluating Financial Contagion and Systemic Risk in China’s Current Debt Crisis
By Shannon Brandao*, an international attorney and China expert and the editor of China Boss.
Much media attention has been given to the plight of China Evergrande Group – a behemoth property developer with over $300 billion in debt obligations that defaulted on $1.2 billion in foreign bonds last December. But Evergrande’s debt, as eyewatering as it is, belies the severity of China’s current debt crisis. According to Bloomberg, Chinese authorities have been “stepping up efforts to ring fence Evergrande, not save it,” believing “[a] run on property firms in the wake of an Evergrande failure” would be far more dangerous to the overall economy, nearly a third of which depends on China’s property market.
Beijing’s rush to contain the fallout from Evergrande’s insolvency shows that state control over the banking system and news media does not eliminate systemic risk in the Chinese economy. Rather, the urgency to diminish the ripple effects from a failing developer that, according to Reuters, only “accounts for 4% of Chinese real estate high-yields” in the dollar bond market suggests systemic risk is high and that how investors learn about and relate to the country’s economic failures may be different than in systems with independent banks and a free press. I’ll talk more about that later, but first – to evaluate systemic risk and financial contagion in China’s current debt crisis – we’ll need to look at the country’s astronomical levels of indebtedness.
China’s domestic debt has been growing nearly four times faster than its economy
While China’s economic growth from 2010-2019 averaged 7.7%, it also began trending downward, falling in recent years to 4-5%. Domestic debt for the same period, however, skyrocketed to an average annual rate of around 20%, surging even higher in 2020 after the initial Covid-19 outbreak. By 2021, China’s debt had reached “nearly four times” GDP, according to CNBC news analysts.
China’s dangerous levels of domestic debt can be traced to a $600 billion stimulus package – considerably larger than that offered by the U.S. ($152 billion) and Japan ($100 billion) at the time – released in 2008 to ease pressures on national economic growth stemming from the global financial crisis. Although China was somewhat insulated from the downturn in U.S. and European markets, it “still suffered from a sharp decline in exports and a major stock market correction that wiped out an estimated two-thirds of its market value,” according to the Center for Strategic and International Studies. Experts believe that easy access to credit after the stimulus, which was mostly funded by loans from state-owned banks, as well as the government’s infrastructure investment policies, motivated too many Chinese firms to take excessive leverage risks.
China’s corporate debt dwarfs the global average. Most of it, however, is held by state-owned firms (SOEs) in a wide range of industries outside the property sector
When S&P Global Ratings surveyed over 25,000 global entities in October 2021, it found that Chinese firms had a debt-to-GDP ratio of 159% – almost twice that of U.S. firms – and that 91% of China’s construction and engineering firms were dangerously over-leveraged. S&P defines high indebtedness “as a ratio of funds from operations to total debt, or debt to EBITDA as more than four times.”
More unexpected, however, was the finding that high levels of indebtedness could also be seen in Chinese firms in 7 additional industries – transportation (86%), retail (79%), leisure/media/entertainment (67%), business and consumer services (64%), consumer goods (59%), pharmaceuticals (58%), and real estate (57%). Although S&P didn’t analyze firms by ownership structure, a 2019 OECD report found that state-owned enterprise (SOE) debt accounted for over three-quarters of China’s non-financial corporate debt. But the key takeaway is that China’s property sector – although a current news media focus – is not extraordinary for having many over-leveraged firms. More fundamentally, the commonplaceness of over-leveraging across so many industries in China should draw more concern for its increased potential to transmit financial contagion via runs on failing firms.
Chinese banks hold hundreds of billions in bad-debts and non-performing loans, and President Xi is stripping them of their independence
Most commercial banks in China are state-owned or state-controlled and lending decisions are still firmly connected to local and central government prerogatives, rather than market considerations. In July 2021, Liu Zhongrui, an official at China Banking and Regulatory Commission (CBIRC) told reporters that “[o]utstanding non-performing loans in the banking sector stood at 3.5 trillion yuan ($540 billion) by end of June,” and that “Chinese banks are facing the threat of rising bad loans in the future as the current economic recovery is unbalanced and lacks a solid foundation,” Reuters reported.
The People’s Bank of China (PBOC), China’s central bank, had been pushing to move special mention loans – which are those at risk of becoming nonperforming, the number of which is also sharply rising – off balance-sheet in order to lower lending rates and reduce the appeal of shadow-banking in corporate finance. The plan might have worked had Beijing not begun to strip away the financial supervisor’s independent discretion. In October 2021, Wall Street Journal’s Lingling Wei reported that China’s top anticorruption agency was spearheading a “sweeping round of inspections” of “25 financial institutions at the heart of the Chinese economy,” for their ties to “big private-sector players.” PBOC and the Shanghai office of the China Banking and Insurance Regulatory Commission were both targeted in December. The “[i]nspections aim to ensure full Communist Party control over what is seen as the lifeblood of the economy,” Wei said. But Cornell University professor Eswar Prasad, a former China expert for the IMF, told the WSJ: “That notion of operational autonomy is now coming into conflict with a more intrusive role of the government in the economy. The PBOC is losing.”
Local governments’ balance sheets are so debt-ridden, Beijing calls them a gray rhino, but their hidden liabilities are causing greater concern among investors and analysts
During a State Council Information Office (SCIO) briefing in 2017, Wang Zhijun, one of the directors of the Central Leading Group on Financial and Economic Affairs, referred to China’s “shadow banking system, property bubbles, inflated local debt levels and illegal fund raising,” as the nation’s gray rhinos, or serious financial risks that have not been given enough attention. By the end of fiscal year 2020, according to official data, China’s local government debt had ballooned to 25.7 trillion yuan ($3.97 trillion), but that is only the amount reported on their balance sheets.
Local government financing vehicles (LGFVs) – which are investment companies created by local authorities to sell development bonds that are subsequently repackaged as wealth management products for individuals – have accumulated much more than that in debt. Those liabilities, however, have been transferred to the LGFVs’ books even though local governments themselves are obligated. Although estimates of local government debt, including that of LGFVs, vary widely due to irregular bookkeeping standards in China, Nomura analysts have estimated LGFV debt at nearly double the amount on government books, and Goldman Sachs said it is equivalent to half of China’s GDP with 60% of current bonds issued “used to repay maturing debt … rather than [for] new investment.”
Private firms turn to shadow-banking, and ordinary families cannot pay down debt
In a 2018 article, The Hidden Risks of China’s Private Sector Debt Crisis, The Wall Street Journal’s Nathan Taplin argued that China’s “SOEs [had] improved their health partly at the expense of more efficient private companies,” and that, “[i]f this persists, it will mean structurally lower income growth—and precipitate a financial crisis anyway if private firms and households can’t get rich quickly enough to keep subsidizing their state cousins.” Because government-backed SOEs are still heavily favored over private companies in formal corporate lending, up to “80% of [private] firms’ financing goes through informal channels,” most often in China’s unregulated shadow banking industry. Although some analysts think that the trend might boost innovation, others who have examined firm financing patterns in China more closely found that “firms with access to formal bank loans tend to grow faster.” This is probably due to more onerous credit terms for private borrowers – who’ve traditionally been considered high risk in China – like high interest rates and harsh repayment schedules.
Sadly, China’s rising household debt suggests that even ordinary families have fewer funds to cover daily needs and emergencies. While Chinese citizens are typically thought to be thrifty and avid savers, He Huifeng at The South China Morning Post says that over-leveraging is the trend “among upper middle class households who are borrowing to the hilt to invest in China’s economic recovery from the coronavirus pandemic, either by snapping up property or investing in the stock market.” She also talked to “families from across the socio-economic divide” who acknowledged “their cash flow has reached a critical threshold,” but said they were unable to “reduce their debt exposure.”
Is China really too big to fail?
A 2019 Bank of Finland study showed that, in Western market economies, public confidence in a country’s banking sector is “highly sensitive to the industry-level financial stability indicators,” such as “cumulative number of failed banks, depositors affected by such failures and total bad debt in the sector.” In China’s financial system, however, nearly all the nation’s banks are owned and controlled by the state, and the Chinese Communist Party (“the Party”) can suppress data about failing banks and systemically important financial intermediaries by blocking information in its state-controlled media. China also has a Deposit Guarantee Scheme (DGS), which insures deposits in local and foreign currencies for businesses and individuals up to CNY500,000 ($78,000) per depositor per bank. That policy is intended to slow fear-triggered financial contagion, and, as Fitch Ratings has said, act as “the first line of defense for securitization deals against set-off risk in the event of a bank default or insolvency in China.”
But what if that first line of defense falters when systemically tested? What if China’s regulators are losing control of social media algorithms to young techies or foreign actors with other political or commercial agendas? What if hordes of Chinese netizens gather in secretive investor groups on Weibo, on foreign trading platforms, or on the dark web where they are free to share financial information on Chinese banks and firms, as well as ways of getting money out of China? What if the authorities blunder in their attempts to calm fears during the debt crisis, as they blundered at preventing the panic during the initial coronavirus outbreak in Wuhan? What if the government’s own off-balance sheet liabilities are so great that it has no way to absorb the debts of systemically important firms and industries at risk of contagion without significant economic or political disruptions? What if all the above becomes apparent at the same time an overambitious and politically insecure former bureaucrat makes a series of policy missteps at home and abroad that cause investors to lose faith in his ability to govern?
In other words, China’s industry-level financial stability indicators are connected directly to the state and when the lights blink red, investors can only infer the degree of sovereign failure – the prospect of which is inherently more unsettling than the collapse of a single firm or industry. Consequently, investor panic and financial contagion in China’s economy is dicier and, potentially, more volatile than in market economies with independent banking sectors. Furthermore, although the Chinese Communist Party has long sought to tightly control information so that it can govern without dissent, there is plenty of evidence of the use of circumventions, and it is naïve to think that methods of obtaining information relating to the financial interests of individuals and groups in China do not exist.
A 2019 Bank of Finland study revealed that in Western market economies, public confidence in a country’s banking sector is “highly sensitive to the industry-level financial stability indicators,” such as “cumulative number of failed banks, depositors affected by such failures and total bad debt in the sector.” In China’s financial system, however, nearly all the nation’s banks are owned and controlled by the state, and the Chinese Communist Party (“the Party”) can suppress data about failing banks and systemically important financial intermediaries by blocking information in its state-controlled media. China also has a Deposit Guarantee Scheme (DGS), which insures deposits in local and foreign currencies for businesses and individuals up to CNY500,000 ($78,000) per depositor per bank. That policy is intended to slow fear-triggered financial contagion, and, as Fitch Ratings has said, act as “the first line of defense for securitization deals against set-off risk in the event of a bank default or insolvency in China.”
But what if that first line of defense falters when systemically tested? What if China’s regulators are losing control of social media algorithms to young techies or foreign actors with other political or commercial agendas? What if hordes of Chinese netizens gather in secretive investor groups on Weibo, on foreign trading platforms or on the dark web where they are free to share financial information on Chinese banks and firms, as well as ways of getting money out of China? What if the authorities blunder in their attempts to calm fears during the debt crisis, as they blundered at preventing the panic during the initial coronavirus outbreak in Wuhan? What if the government’s own off-balance sheet liabilities are so great that it has no way to absorb the debts of systemically important firms and industries at risk of contagion without significant economic or political disruptions? What if all the above becomes apparent at the same time an overambitious and politically insecure former bureaucrat makes a series of policy missteps at home and abroad that cause investors to lose faith in his ability to govern?
In other words, China’s industry-level financial stability indicators are connected directly to the state and when the lights blink red, investors can only infer the degree of sovereign failure – the prospect of which is inherently more unsettling than the collapse of a single firm or industry. Consequently, investor panic and financial contagion in China’s economy is dicier and, potentially, more volatile than in market economies with independent banking sectors. Furthermore, although the Chinese Communist Party has long sought to tightly control information so that it can govern without dissent, there is plenty of evidence of the use of circumventions, and it is naïve to think that methods of obtaining information relating to the financial interests of individuals and groups in China do not exist.
President Xi’s “common prosperity” crackdowns, alienation of trading partners and zero-Covid policy are already prompting investors to rethink China
Chinese leader Xi Jinping’s “common prosperity” campaign is a new twist on the old Communist-era social contract with the Chinese people. But one could just as easily describe it as a backflip on market reforms that were supposed to open China to competition. Xi has been moving quickly to reassert the state’s control over Chinese firms in pursuit of a “dual-circulation” state capitalist system that he says will boost domestic consumption and advance home-spun technologies for national rejuvenation.
But there are problems with Xi’s plan, and knowing when to stop draining the lifeblood out of the Chinese economy is chief among them. In September, China business and tech reporter Chang Che enumerated 18 “common prosperity” crackdowns in a Twitter thread to illustrate his point that “we’re way beyond ‘tech’ now.” Although cast as an effort to build a more equal society, few China watchers doubt Xi is gunning for China’s most successful private companies because he sees the entrepreneurs that run them as rivals. But investors have also begun to question Xi’s motives: At least “$1 trillion has been wiped off the valuation of Chinese firms since February,” and the country’s wealthiest are “running for cover,” Time magazine said.
Adding to the list of uncertainties, President’s Xi’s chest-thumping abroad has increased geopolitical tensions and pummeled China’s soft power. In June, the Pew Research Center found that China’s “international image across 17 advanced economies remains broadly negative” and that “[c]onfidence in Chinese President Xi Jinping remains at or near historic lows in most places surveyed.” Reasons given by those polled were the government’s lack of respect for personal freedoms and its poor handling of the initial Wuhan outbreak. But it’s just as likely that Xi’s “wolf warrior diplomats” are co-piloting the downward spiral in global perceptions. Two of Ministry of Foreign Affairs spokesman Zhao Lijian’s 2020 twitter bombs, in which “he repeatedly promoted an unsubstantiated—and absurd—theory” about the U.S. as the origin of Covid and shared an “illustration of an Australian soldier holding a knife to the throat of an Afghan child”, seem to have done the most damage, Bloomberg’s Peter Martin says.
But MOFA’s international grandstanding is costing China a lot more than just soft power. In January, The Wall Street Journal reported an uptick in China’s stockpiling of essentials and domestic production planning. WSJ’s analyst also noted that the National Development and Reform Commission had introduced a “security-oriented economic agenda” that “is trying to fortify the Chinese economy against a prolonged period of tension” with the U.S. and its allies.
If that isn’t enough to make investors reconsider their China exposure, there’s Xi’s zero-Covid policy, which Goldman Sachs analysts predicted could keep China closed to international travel for all 2022 and possibly part of 2023. Hard lockdowns imposed by local governments to manage sporadic outbreaks of the Omicron and Delta variants are not only causing massive disruptions for millions of Chinese citizens and businesses, but also for global supply chains, and experts say that if quarantine and testing backlogs at the country’s ports – which are among the world’s busiest – continue, companies will seek ways to avoid China as much as possible.
Asymmetry of information: Revelations of hidden debt in firms or industries once thought financially solid can destroy public confidence overnight, and China’s $3 trillion in FX reserves may not be enough to restore it
Recent news that China’s 13th largest developer, Shimao Group, is also struggling sent shockwaves across the property industry. Shimao had not been designated by the PBOC or the Ministry of Housing and Urban-Rural Development – the two supervisors responsible for curbing over-leveraging in China’s real estate market – among firms in danger of crossing any of Beijing’s “three red lines” – rules that restrict new borrowings of heavily indebted developers annually. The sudden default of Shimao’s Shanghai unit on a US$101m project in early January alerted analysts to serious problems with transparency and oversight, leading some to “fear Shimao’s difficulties could be more destabilizing for the Chinese property market than the Evergrande and Kaisa crisis,” according to Aljazeera.
Aljazeera’s reporters also described “a general sense of unease over the company’s lack of visibility” that had emerged after investors learned “that homebuyers who recently purchased 96 Shimao properties in Shanghai were not able to register for the transfer of ownership titles, as the properties had already been pledged to one of Shimao’s lenders,” and that “[f]or many months, Shimao’s onshore bonds were also traded at more heavily discounted prices than their offshore bonds.” The speed of credit down ratings and a sharp plunge of “more than 50 percent” in Shimao’s share prices since November had also “caught investors off-guard.”
The Shimao example also highlights how word of insolvencies, hidden debts and sell-offs in China either spreads too quickly for Chinese censors to effectively block on social media or is passed around in other ways. Experts say Beijing is cracking down on social media algorithms because central propaganda agencies worry about losing control of online content. Consequently, authorities have proposed the “world’s first government regulation dedicated to ‘algorithm-empowered recommendations’ to curb the use of technology, and to hold owners of these algorithms accountable for any content that run contrary to state policies,” The South China Morning Post reported. Nevertheless, a spate of runs on small banks propelled by social media rumors hints that regulators also struggle to prevent liquidity risks that can occur this way.
Finally, that China has the world’s largest foreign currency reserves would be of little comfort in a true financial crisis. As the last guarantee on foreign debt, China’s $3.128 trillion in FX reserves are plenty and then some. But even though Beijing needs to keep amounts high to maintain confidence in the economy, it has a history of burning through reserves fast. In a January 2016 Bloomberg interview, Michael Shaoul of Marketfield Asset Management said China had been using its FX reserves at an alarming rate that he believed was big enough to have an impact on domestic liquidity. Shaoul thought China’s FX reserves were then being used to drive economic growth with additional infrastructure investment and to compensate for “very substantial capital flight.”
Authorities in China have dueled with capital flight for years, using a variety of legal weapons from huge fines on banks and other merchants that help customers move money overseas to bans on cryptocurrencies. But, Bloomberg analysts say, the “battle is more intense than ever,” and the scale of foreign funds that have been flooding into China’s borders post-Covid creates more risk for asset bubbles that “would burst were that money to start pouring out.” On the flip side, permitting increased outflows may reduce the bubble risk, but “increases the potential for money to flood out too quickly — as the country witnessed in the wake of the 2015 currency devaluation,” Bloomberg said.
Decades of over-leveraging, combined with President Xi’s various domestic and foreign policies, now threaten to upend China’s state capitalist system and cause a collapse of investor confidence in China, Inc.
In closing, according to Bloomberg, authorities’ strategy to ring-fence Evergrande and other failing developers rests on plans for the state to absorb the shock by “mak[ing] it easier for state-backed property developers to buy up distressed assets of debt-laden private firms by not counting such loans as debt under rules that cap borrowing.” Beijing has also directed state-owned banks “to issue debt to fund real estate acquisitions,” Reuters said. But for the reasons described above (and as I argue in the January 24th issue of the China Boss newsletter), moves to expand state control over failing private developers are also fraught with risk because SOEs, like China’s state-owned banks and local governments, are brimming with their own bad debts.
But the state has been absorbing debt like this for decades.
While mayor of Beijing in the mid-2000s, Chinese vice president Wang Qishan is said to have compared the constant shuffling of China’s financial and non-financial corporate debt this way to a game of musical chairs that at some point would overwhelm the entire financial system and force Beijing to relinquish control of state entities that comprise 40% of the economy through privatization. See Desmond Shum, Red Roulette: An Insider’s Story of Wealth, Power, Corruption, and Vengeance in Today’s China (London, Simon & Schuster, 2021), p.174, which I strongly urge you to read.
The latter is also what JPMorgan Chase CEO Jamie Dimon probably meant when he joked late last year that his firm would outlast the Chinese Communist Party. No doubt other global investment firms figure the same, though whether they can outcompete powerful locals – who, Wang suggested, were “get[ting] the bullets ready” for that day – is less certain.
In the end, President Xi’s crackdowns on the private sector – the primary source of jobs and driving force behind China’s economy – combined with his zero-Covid approach at home and foreign policy failures abroad may turn out to be catastrophic in the coming weeks and months – especially if economic growth crumbles under the weight of closed borders and hard lockdowns or Chinese trade is ensnarled in blockades as punishment by the West for a two-pronged military campaign against Ukraine and Taiwan. Moreover, that China’s domestic debt is growing at nearly four times the rate of its economy means that Chinese families, themselves strapped with loan payments, are unlikely to spend enough to bailout their government from its own financial mismanagement. But of all the uncertainties in determining if China can prevent system overload in the current debt crisis – whether its trillions in FX reserves would be enough to reassure investors that it can guarantee foreign debt, band-aid over lagging consumption with more investment in infrastructure (which helped to create the current property debt crisis in the first place), and cover the state’s own liabilities while compensating for increases in capital flight when the lights blink bright red on President Xi’s state-led industry-level financial stability indicators is perhaps the most uncertain of all.
*Shannon Brandao is an international lawyer and the founder of China Boss News on Substack and the China Boss Newsfeed with over 20k followers on LinkedIn. A graduate of UCLA (BA Politics with a China focus), and the University of Miami School of Law, she also holds an LLM in International Business Law from the Katholieke University of Leuven in Belgium where she now resides with her husband, two cats, and a bossy terrier that keeps everyone in line.
