What do you do when you are in charge of a command economy and need to preserve economic stability, rein in hundreds of small lenders, address a buildup of private debt and still convince international investors that market forces are playing more of a role? This is the tightrope Chinese officials have been walking in recent years, and it has seemingly gotten a bit more precarious lately. The corporate default rate has ticked up, and the government caused a bit of a stir when it even let a local government financing vehicle (LGFV)—widely considered to have an implicit state guarantee—miss a bond payment. Earlier this year, regulators seized a failing regional bank, warned creditors would take a hit, but then eventually made most of them whole. More recently—and just this week—the state has backed struggling rural banks by having state-owned banks and the national sovereign wealth fund buy big equity stakes. Rumors have dogged other tiny, mostly rural lenders, triggering mini-bank runs that the police broke up. Pundits warn more banking woes are likely next year, and corporate debt fears are mounting. Yet we think a little bit of history and context shows why these events are just part of a widely known, very slow-moving issue—not the sort of fast-moving, huge surprise that could wreck the world’s second-largest economy and trigger a global bear market.
These latest incidents are part of a long-running saga. It begins nearly 10 years ago, when officials faced a challenge: How do you channel credit to small private businesses when the large state-owned banks lend primarily to large state-owned companies? While China is “communist” on paper, it also has millions of small private companies, and officials are well aware these companies are the country’s long-term growth engine. Historically, however, if they needed credit, they often ended up in loan sharks’ clutches, paying nosebleed rates and facing all the personal risk that comes with the territory.
To fix this, officials legalized some private lending and encouraged small regional lenders to take a flyer on private companies. A lot of this lending happened off balance sheet, fueling a massive shadow banking boom. Officials also removed a lot of red tape surrounding corporate bond issuance and opened the market to foreign investors, providing companies an alternate funding avenue. At the same time, to meet local economic growth targets, local governments raised significant funding for infrastructure development via LGFVs, which count as corporate bonds.
The results were a mixed bag. On the bright side, Chinese GDP continued growing, lifting many people out of poverty. Regulators also continued taking small steps toward liberalizing and opening financial markets, even allowing the occasional corporate default—necessary for investors to be able to price risk. But it wasn’t all good. Corporate debt swelled, and so did the shadow banking sector. Slower economic growth and troubles in manufacturing, though partly by government design as part of a planned shift from reliance on exports and heavy industry toward services and consumption, caused non-performing loan ratios to rise. Regulators saw shadow lenders getting bloated and decided to rein them in—get all off-balance sheet debt on the books.
So in early 2018, a crackdown on shadow lending began. This was good from a long-term financial stability point of view. But it also cut off private companies’ credit access, which we think deserves a lot of the blame for Chinese GDP slowing more than expected. Officials seemed to agree, and this year, official policy focused on getting state-run firms to lend more to private companies. A lot of those changes are only just starting to take root, so it is too early to gauge their success. In the meantime, however, officials faced a new dilemma: what to do with all the regional lenders who can’t access funding now that their non-performing loans are out of the shadows?
The answer was never going to be easy, thanks to that tightrope we mentioned earlier. Chinese officials have two broad goals. One, preserve economic and social stability in order to preserve the Party’s grip on power. Two, move to a more market-oriented economy that can compete and thrive globally. Allowing market forces to take hold in the domestic economy is critical to the second goal. But doing so also opens the door to defaults and bank failures, which runs counter to the first goal. This was always going to be a trial-and-error process.
You can see this clearly with this year’s bank interventions. The first—the seizure of Baosheng Bank in late May—seems like a clear attempt to take the market-oriented approach. Instead of bailing it out, the government put it into receivership, as the FDIC would with a failing US bank that didn’t have a buyer. Deposits were guaranteed, but officials said investors and creditors would have to swallow losses as they wound down the bank—again, normal in America and Europe. But not normal in China, where officials hadn’t allowed a bank to fail in two decades. This didn’t just rankle the affected investors. It also roiled bank funding markets, which tightened up in June. That seemingly sparked a quiet U-turn, as a state-run media outlet eventually reported nearly all corporate creditors got their money back. With local markets not yet ready for an outright bank failure, officials took a different tack: “strategic investments” from government-backed institutions. These aren’t outright government bailouts, but cash infusions from state-run banks and the sovereign wealth fund. You can think of it as a bailout in markets’ clothing, we guess.
For now, it seems to have helped shore up confidence a bit, and seeing more next year wouldn’t surprise. Rather than signifying a financial crisis, we think it would show the government has found a way to manage a well-known, ongoing problem. Setting aside the approach’s pros and cons, anything that boosts confidence probably isn’t a bad thing right now. Investors never expected China to go free-market overnight. Moral hazard takes time to address.
You can apply similar logic to the corporate bond and LGFV defaults. To us, these are signs the government is letting markets play more of a role. In years past, local governments often stepped in with relief funds to make investors whole after corporate “defaults.” It was a way of having their cake and eating it—let the company go through the pain of a default, but keep investors happy. Letting creditors as well as companies experience some of the pain is just the next logical step. If companies are defaulting without government intervention, that seemingly means officials are comfortable letting market forces take hold in the nonfinancial corporate sector. Considering how focused they are on economic stability, we think this is a strong vote of confidence in the Chinese economy and financial market.
Overall, to us, this recent spate of seemingly bad news seems more like encouraging progress on a long, long road toward market-oriented reforms. That road has been bumpy and will probably remain so. But if China’s economy were in real trouble, we would probably see much more explicit government intervention. They have trillions of dollars in bailout firepower to deploy, if necessary. Continued growth lets the slow, free-market science experiment continue. A little short-term pain for some big potential long-term gain.
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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.