On January 12, 2018, Dr. Sara Hsu gave the talk “China’s Financial System is Threatened by Instability” at the Munk School of Global Affairs. Dr. Hsu is Assistant Professor of Economics at the State University of New York at New Paltz and publishes extensively in Chinese economic development, finance, and shadow banking. She published one of the only English language books on Chinese informal finance and one of the only Chinese language books on Chinese shadow banking. The main event sponsor was the Asian Institute, and the event was chaired by Dr. Lynette Ong, Associate Professor of Political Science at the University of Toronto. In her talk, Dr. Hsu discussed the causes of China’s rising debt levels and explored the associated risks, ultimately arguing that the most likely outcome for the Chinese economy will be slowing growth and stagnation.
Dr. Hsu noted that while China’s household and government debts are not especially high, corporate debt constitutes 162 percent of China’s GDP and exceeds that of the United States, the Eurozone, Asia (excluding China and Japan) and Latin America. She contended that these high debt levels have their origins in the 2008 Global Financial Crisis. The crisis affected China through trade, as reduced demand for Chinese goods in the US and the Eurozone—China’s major trading partners—led to slowed growth. The Chinese government responded in 2009 by unveiling a fiscal stimulus package worth roughly $586 billion.
Much of the 2009 package was used to promote fixed asset investment in infrastructure and real estate, with the central government only providing partial financing. Local governments were responsible for the rest of the financing. The problem with this arrangement was, as Dr. Hsu noted, twofold: firstly, local governments did not have sufficient revenue to provide the necessary financing, and secondly, they were forbidden from borrowing from banks due to previous defaults. To circumvent the latter issue, local governments set up local government financing vehicles (LGFVs) in the form of corporations. High levels of local government borrowing through LGFVs and, to an even greater extent, borrowing by State-owned enterprises (SOEs) allowed for investment in infrastructure and real estate. For some time this investment led to GDP growth, but it also increased risks.
The debt to GDP ratio has risen to 260 percent in 2016 from 164 percent in 2008, meaning diminishing marginal efficiency of credit and consequent diminishing returns on investment. Due to the low and diminishing returns from SOE and LGFV investment in fixed assets, there has been a growth in the potential for risky non-performing loans (NPLs). Banks do not always mark NPLs as such to avoid having to increase capital holdings. State-owned banks will also sell NPLs to asset-management companies to “clean” their balance sheet in order to be able to continue lending. Dr. Hsu argued that due to these mechanisms, it is difficult to accurately measure the viability of current loans.
According to Hsu, transfers of NPLs to unregulated shadow banking institutions also shifts a significant portion of risk to non-bank investors. Shadow banks repackage NPLs with other assets as part of Wealth Management Products (WMPs) sold to domestic institutional and retail investors. Due to past state involvement in the areas of WMPs and the Stock Market, investors assume an implicit government guarantee in case of default. Because of this implicit guarantee, investors are willing to hold WMPs even though they are not necessarily priced to market and may carry significant risk.
Dr. Hsu believes that while China’s debt problem is serious, stagnation is a more likely scenario than crisis under the current circumstances. The government owns a large portion of the banking sector, Hsu notes, and as such views itself as responsible for social and economic stability above growth or reform. State involvement in the financial system appears unlimited, and it is expected that the government will intervene to prevent asset price declines, serious bankruptcies, and losses to consumers. Moreover, high levels of domestic savings make intervention viable. At the same time, asset management companies provide an outlet for undesirable NPLs, allowing banks to continue lending. Furthermore, the potential for capital flight is limited both by capital controls and by the fact that most debt is held domestically and many investors do not have any other outlet for investment.
Recently proposed restrictions would eliminate practices such as the bundling of WMPs and the placing of implicit guarantees on WMPs. These restrictions have so far been ignored, but Hsu argues the “system would explode” if they were enforced. Stock markets would be unable to fund loans, “liquidity would dry up,” and investors could stop purchasing WMPs and withdraw existing funds.
In response to an audience question in the Q&A period concerning domestic savings and state involvement in the finance sector, Hsu contended that if the financial system were allowed to operate as a market-based system, then there would be potential credit and systemic risks dispersed throughout the system that China’s high level of domestic savings would not be able to absorb.
Dr. Hsu argues that in the long run, the only solution to the current debt problem is to orient China’s financial system to the market, gradually eliminate accumulated risk, and eventually impose market reforms to contain institutional defaults.
Daniela Zaks is a first year student at the University of Toronto studying International Relations. She is currently serving as a Event Reporter for Synergy.