China’s Financial Brinksmanship

by Phillip Orchard 


It’s becoming something of a semi-annual tradition in China: A major bank or company misses an earnings report or bond repayment, or finds some other way to hint that it may be in dire need of a bailout. 

Regulators remain conspicuously silent as panic ripples through the Chinese financial system, so much of which runs on widespread assumptions that the state, obsessed as it is with stability, will rescue just about any ailing institution to make sure it contains the spread. 

Regulators let market anxieties mount seemingly to the breaking point, the implied message to investors being: 

“The days of risk-free, state-guaranteed financial returns are over. 

Do your own due diligence before blindly throwing money around and making this our problem, please.” 

Eventually, they issue a bland, technocratic statement, and everything calms down as the state starts brokering some sort of solution behind the scenes.

Often someone goes to jail, or worse.

There have been several variations of this story in China in recent years, particularly since 2013, when Beijing first began tepidly addressing the moral hazard endemic to its $54 trillion financial industry. 

And it’s basically what’s been happening over the past month with China Huarong Asset Management Co., a massive, debt-plagued state-owned financial asset management company whose former chairman was executed in January on corruption charges. 

Huarong missed an earnings report at the end of March, sending bond markets into a tizzy amid rumors that it was headed for a painful restructuring, at best. 

But several things about Huarong – chief among them, the fact that the company was originally set up by the Ministry of Finance to metabolize other banks’ toxic assets – make it Beijing’s biggest, most complicated, most fraught game of market meltdown chicken to date.

What Makes Chinese Finance Unique

The Chinese government wants many conflicting things. 

It wants economic dynamism, which requires support for entrepreneurship and innovation, free flows of information, an impartial judiciary and at times a light regulatory touch – all operating in a financial system that allocates capital efficiently and prices risk accurately. 

It also wants control and stability, which means preventing market forces from creating surges of unemployment and social unrest. 

It also means restricting capital flows in and out of the country to head off a meltdown. 

It means preventing the accumulation of wealth by China’s business titans from leading to the accumulation of political power. 

It means Keeping the future in focus relying heavily on a sclerotic, incestuous network of state-owned enterprises and state banks to soak up excess employment and channel capital to party priorities.

Every government navigates these sorts of contradictory desires to some extent. 

The difference in China is the government’s extreme intolerance for instability of any sort – even forms that, over the longer term, improve the system overall. 

So it props up inefficient companies, preserves or even bolsters the state sector, cracks down on information flows, suppresses protests and inserts party committees into private sector conglomerates. 

Beijing tries where possible to have the best of both worlds. 

But when forced to choose between dynamism and control, Beijing almost always opts for the latter.

There are many costs to this approach, especially when it comes to financial risk. 

For example, the domination of the financial system by state banks, which have heavy incentives to prioritize lending to state-owned enterprises and firms with hard assets available for collateral, forces others to rely on alternative, often less transparent or less-easily regulated sources of funding. 

Capital controls limit access to foreign financing. 

Perhaps most problematic, though, it generates widespread moral hazard. 

Put simply, because of Beijing’s existential fear of unemployment and social unrest, lenders and investors understandably just assume that the state will more often than not come to the rescue if things go sideways and pose any degree of systemic risk. 

Such assumptions are particularly common in the state sector, but increasingly they’ve extended into any part of the investment landscape. 

This was illustrated in 2018-19 with the rise of unregulated peer-to-peer lending platforms. 

Many borrowers defaulted, leading to protests by lenders who expected Beijing to make them whole despite the government never making implicit promises to do so.

The risks of moral hazard contributing to a broad financial crisis have increased as debt levels across the Chinese economy have soared since 2008 – and as it’s become more and more difficult for the Chinese economy to simply grow its way out of its debt problems. 

No country in history has amassed so much debt so quickly as China has without succumbing to a financial meltdown, according to the World Bank. 

Predictably, the sense of urgency in Beijing to address moral hazard has surged as well.

The most ruthless way to do so, of course, is to simply let people get burned a few times – to let poorly run banks or firms go bust and to let investors and lenders lose their shirts. 

But China can’t tolerate the costs of such an approach, given just how central implicit state guarantees are to the entire Chinese financial system. 

To avoid triggering an uncontainable market panic – or simply to avoid inadvertently creating a credit crunch that grinds economic growth to a halt – Beijing has had 

Keeping the future in focus to move at a seemingly glacial pace and find ways to instill market discipline over time.

Addressing Moral Hazard Head-On

China has been attacking the problem from several angles. 

On one level, it’s been trying to make moral hazard matter less by pushing through an ambitious slate of reforms aimed at whipping banks and state-owned enterprises into shape before they reach a breaking point. 

It’s also installed a much more muscular regulatory apparatus, pairing it with anti-graft authorities tasked with punishing wayward officials and tycoons and hammering local and provincial governments and banks to clean up their books and eschew “shadow lending” practices. 

What the system lacks in market incentives to act prudently, Beijing has been able to offset somewhat by the fear of President Xi Jinping.

But there’s been no avoiding the need to address moral hazard head-on. Its first attempt, made in 2013, went extremely poorly. 

After a technical default between two small banks sent interbank lending rates soaring, Beijing initially refused to inject liquidity into the market. 

Within days, interbank lending ground to a halt, sparking a liquidity crisis that began to spread into the rest of the economy. 

It was the closest China has come to having its own Lehman Brothers moment. 

Beijing capitulated by the end of the month, intervening more forcefully to keep interbank lending rates stable.

The episode effectively deepened the problem of moral hazard for the next few years. 

But a string of near-failures by small banks in 2019 forced Beijing to try again. 

This time, it was more successful. 

In each case, the government ultimately intervened, but for the first time, it forced at least some bondholders to take losses, while the banks themselves were forced to restructure in painful ways that put them on more solid footing going forward. 

The move didn’t spark a broader meltdown. 

Emboldened, Beijing then allowed a string of defaults among SOEs last fall totaling some $12.2 billion worth of local bonds. 

The share of onshore payment failures rose to 57 percent compared to 8.5. percent the previous year, according to Fitch.

Even so, Huarong is different. 

For one, it’s bigger than any of the previous cases. 

In terms of asset size, the two main banks rescued in 2019 are half that of Huarong. 

For another, much more of its debt (an estimated $22 billion or more) is held in offshore dollar bonds, which makes the problem more difficult and expensive for the government to manage.

Most important, Huarong was set up in 1999 as one of four “distressed asset managers” with the specific task of metabolizing other banks’ bad debts. 

These “bad banks” were largely considered successful in helping China avoid the fates suffered by South Korea and several other emerging markets in Southeast Asia following the 1997 Asian Financial Crisis. 

And Huarong’s problems seem stem primarily from its expansion over the past decade or so into other financial services, including shadow banking. 

It’s unlikely, in other words, that its problems indicate that the Chinese system is so overwhelmed with toxic assets that even the bad banks can no longer cope. 

Still, perception matters more than reality in financial crises. 

If enough people believe that Huarong’s problems reveal widespread systemic fragility – and a rise in speculation about problems some of the other distressed asset managers suggests such perceptions may be taking root – then things could get ugly fast.

There’s another critical difference, though, that suggests Beijing is acting with a renewed sense of confidence in its ability to avoid triggering a panic: the fact that Huarong is owned directly by the Finance Ministry. 

This matters because, in previous cases, there were questions about how much regulators were caught unaware of the banks’ problems, a factor that fueled potentially destabilizing speculation that authorities really had no idea how deep and wide the problems in the banking system truly were. 

Given its ownership, and given the fact that Huarong has been under close scrutiny for some time (its chairman came under investigation for corruption charges in 2018 and was executed in January), it’s highly unlikely that its debt problems caught anyone off guard. 

And given its systemic importance, along with the fact that Beijing will have zero tolerance for any kind of financial chaos ahead of the 100th anniversary of the founding of the Chinese Communist Party this summer, there’s little reason to think Beijing would even allow Huarong’s problems to be made public, much less concerns to proliferate about Huarong going belly up, if it didn’t think it was useful to do so.

By letting Huarong twist in the wind for a few months while saying just enough reassuring things (and leaking plans for a potential restructuring) to mitigate panic, Beijing is likely just taking its next step forward in its long, calculated fight against what it sees as an existential problem. 

That’s the charitable view, at least. 

The other possibility – that Beijing is at once overmatched and overconfident and heading for an inevitable financial reckoning – may be unlikely, but staggering in consequence should it come to pass.

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