January 28, 2017    7 minute read

Can the Post-crisis Regulations Save a Debt-ridden China?

Mired in Problems    January 28, 2017    7 minute read

Can the Post-crisis Regulations Save a Debt-ridden China?

Regulatory policies could mitigate the frequency and severity of financial crises. However, they alone do not guarantee an ultra-safe financial environment.

Regulation After the Great Recession

Asian countries were dealt the Asian Financial Crisis of 1997. Malaysia, for instance, saw GDP growth of 7.7% in 1997 tumble to -6.4% in 1998. In the aftermath of the crisis, Asian countries recognised the importance of regulatory policies for bolstering a sound economic environment.

These countries further implemented fiscal and monetary policies to boost trading competitiveness and implement internal structural changes, with regulatory changes put in place to address the problem of illiquidity and other associated financial bottlenecks in the crisis.

The importance of these regulatory policies cannot be understated. During the Greek crisis, IMF offered loans despite low credit scores. In return, Greece had to accept conditions including fiscal austerity, privatisation, and structural reform of its pension and tax systems, affirming how vital regulatory policies can be.

The closure of banks and defaults on loans not only affected the US economy but the whole globe, too.

Concerns Shift Eastwards

In 2016, the concern shifted to East China. China has conventionally been the main engine of world growth, accelerating global GDP growth after the Great Recession. However, recent figures are alarming the business leaders and governments. Its Debt-to-GDP ratio has surged from 150% to approximately 260% in the last ten years, while bad debts account for 5.5% of its total loans.

260% is China’s debt-to-GDP ratio

It currently faces an obstacle that could result in something similar to the “lost decades” occurred in Japan. Poor regulation is a huge contributor to this potential crisis.

Hopefully, lessons from the Great Depression could be applied in China. Credit booms are a common cause of financial crises, associated with rapid financial expansion. This happened in 2008 due to the sub-prime loans in the USA, with a high proportion of debts going ‘bad’.

China’s worsening loan quality is worrying, with an nonperforming loan (NPL) ratio of 1.7%. Not to mention the hidden numbers – especially those in shadow banking, and those in early-stage loans, for which the NPL ratio can be as high as 8%.Therefore, it is necessary to revise current lending practices. This can be done by expanding the government agency authority, for example.

The Problem of Shadow Banking

Shadow banking, however, is difficult to regulate because it is not recorded on balance sheets. Why does shadow banking have such a great impact?

Shadow-banking is primarily manifested in Wealth Management Products (WMP) – instruments to lend money at higher interest rates. The low interest rates in the current economic environment strengthened these WMPs, because Chinese investors have limited options for investment and WMPs are an alternative for achieving significant potential returns. According to HSBC:

“If WMPs continue to expand, it will account for a third of the retail funding activities.”

This is an extremely dangerous situation because cash flows involved can’t be tracked. Should a credit boom occur while NPLs accumulate, this will certainly be a stress point that transforms into an economic fault.

‘Too Big to Fail’ – Ten Years On

Based on lessons from previous crises, sound regulatory policies create an environment to weed out inefficient firms, leaving behind an environment with only strong institutions. This contrasts with some of the ‘Too Big to Fail’ sentiments that have been resounding through the post-crisis years.

19% of China’s big businesses’ interest payments exceed their profits

Crucially, what is at stake here is that regulatory policies serve to prevent herd behaviour from accumulating into too strong a force for the system to bear as a whole. Currently, 19% of the largest 1000 Chinese businesses are paying out more in interest than they receive in profit before tax. This might be analogous to the “lost decade” in which the number of zombie firms grew, as large businesses were provided bank lending and loans in spite of the fact that they ended up becoming nonperforming loans.

A possible outcome is that the Chinese banking system breaks down and requires an enormous injection of capital into the system. According to The Economist:

“Sources of comfort are fading away. This is a government, no so much guiding events as struggling to keep up with them. In the past year alone, China has spent nearly $200bn to prop up the stock market: $65bn of bank loans have gone bad, financial frauds have cost the investors $20bn and $600bn of capital has left the country. To help pump up growth, officials have inflated a property bubble. Debt is still expanding twice as fast as the economy.”

In essence, regulations are able to create a safer financial market, but there must be a proper prevailing condition for this to happen. A distinctive characteristic of the Chinese market is that it has a strong government which, under the party’s leadership, has been able to identify and solve problems efficiently.

China’s Policy Barriers

Moreover, the government has the authority to intervene the market since it isn’t fully opened to private sector. The fact that banks and debtors are mostly state-owned – the “Big Four” – also provides more time to fix the problem. China could be safer due to its political status and its strict supervision on the financial market.

3

(Source: Deloitte)

This matrix helps explain the barriers of policy-makings. The left box of the “knowns” and “actionable” are the sections that could be easily regulated. In those areas, there are basically sufficient regulations to monitor the financial activities. The center part of the matrix is the shadow-banking sector, in which only part of the problem could be tracked.

And the lower part is the area for which there is limited data, and thus regulations are lacking. What China lacks is the incentive to impose regulations and a more system-wide view in the supervision of financial market. The risk and uncertainty nevertheless will remain.

How China Can Save its Future

2016 is important. Stated in its thirteenth five-year plan, China will continue to transform from an export-led economy into an investment-led economy. This has to be done by providing sufficient skills to displaced workers and creating productive investments. In the meantime, the financial market will become more mature, as there are more investment options in the market after the incidents of 2015. People would like to spread their risk, diversifying their investment portfolios.

People are now able to invest through online sites and find advisers that are trust-able. Also, new regulations will allow more international businesses to have their own brokerage operations in China. According to Xi Jinping, China is going to be more centralised; this includes merging the state-owned companies. This will all increase uncertainty to the financial market.

In a nutshell, China’s financial market could be safer and greatly improved through post-crisis regulatory changes. But regulation itself could be difficult to implement, such as for the shadow banking system where information is missing. Other factors – for example, political status, structural changes in the economy, and development of brand-new financial products – could thread the financial markets. As per the table, “Knowns” and “Actionable” determine whether a regulation is feasible.

It is certain that the post-crisis regulatory changes led to a safer financial market. But what China is facing is more than what regulatory changes could handle. In particular, the renminbi liberalisation and the opening up of the financial market and service sector will require thorough efforts. To enhance stability, world leaders have to negotiate and launch more macroeconomic measures, such as the G20’s Mutual Assessment Process and the IMF‘s Surveillance of Macroeconomic Policies. The G20 summit in Hangzhou was China’s chance to take the initiative.

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