A Special Sino Story
China’s market-based economy is still very much in transition but there are three features that make its economy stand out.
1. Direct intervention in credit and capital markets
If you follow China’s financial markets, you can’t help but notice the direct interventions by the central government. In the summer of 2015, for example, the markets fell more than 30 percent in three weeks, which triggered systemic risks. The central government stepped in and injected money but the markets just kept falling. In order to stop the free fall, the government directed police officers to visit the China Security Regulatory Commission (CSRC) to investigate “malicious” short-selling of shares. After that, the market stabilized.
The implicit type of intervention, known as window guidance, is harder to observe. This could happen with a phone call from a senior government official giving orders to government agencies such as the CSRC or the China Banking Regulatory Commission, who then pass on the directions to financial entities and corporations. This kind of guidance can even reach the Hong Kong market, the largest offshore financing market for Chinese companies.
2. Government guarantee of state-owned enterprises
There are more than 150,000 state-owned enterprises (SOEs) with $16 trillion assets, accounting for 38 percent of China’s industrial assets and 17 percent of urban employment.
These SOEs are found in almost every industry. They are in a favoured position over private companies in securing cheap credit, direct subsidies, and other policy support from the central government. In fact, China’s fast growth in debt in recent decades is partly attributed to the extensive borrowing of SOEs. This creates a major problem: the number of non-performing loans is growing at huge rate. China claims that its non-performing loans are around 5 percent of banks’ balance sheets at the moment but others suggest a standing rate of 20 percent.
There are also many zombie SOEs that are not allowed to fail because of the central government’s desire to preserve employment and social stability. When SOEs are unable to repay their loans, banks place them into a special category rather than letting them fail.
There have been some positive moves of late. The central government has started to allow large companies to default and, as a result, the number of defaults and bankruptcies have risen. In fact, the number of defaults in the first two months of 2016 is already more than the total of 2015. Western media and investors perceive this as a negative signal on China’s economic growth, but this is an important step to developing a deep market-based economy. While the implicit guarantees that SOEs enjoy will not stop overnight, China is transitioning to market-based credit solutions.
3. Growth of shadow banking
The shadow banking system in China expanded explosively in the last 10 years. The growth can be attributed to two factors. One, some firms behave as the de facto finance intermediaries due to low funding costs, and there are no regulatory constraints. And two, households have limited investment opportunities and a desire for high returns.
First, the regulation on interest rates in the credit quarter in the Chinese banking system motivates the development of off-balance sheet activities. The shadow banking system activities are prevalent across Chinese firms, especially in SOEs. These large enterprises are important players as they have better access to financial markets and bank credit. They borrow cheaply from state-owned banks and then lend to financially-constrained firms at higher rates. In other words, they borrow in order to lend. It represents considerable income for these corporations. For example, in 2011 about one-quarter of the profits of a large ship building company came from its lending business.
Secondly, the development of shadow banking system is due in part to the tension between the shortage of financial instruments and the increasing demand of households for investment. Chinese households are willing to devote their savings to the shadow banking sector for high returns. Small and medium-sized enterprises starved for funding can now access financing directly. Overall, the shadow bank system acts as important credit provider for these firms.
Wei Wang is associate professor and Distinguished Faculty Fellow of Finance, and director of Queen's Master of Finance-Beijing (Renmin-Queen's Master of Finance) Program.