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Outlook: China’s Financial System Faces Danger

[Editor’s Note: Outlook Newsweek published an article stating that China’s financial system is facing great risks. These risks range from an abundance of financial service offerings to an increasing number of companies involved in financial activities; from local government’s excess borrowing to the central government’s providing insufficient supervision. The following are some excerpts from the article.] [1]

On February 6, 2013, China’s central bank published the “China Monetary Policy Report 2012,” which showed that, in 2012, China’s M2 (a broad range of money supply) was 97.4 trillion yuan (US$15.6 trillion). China’s GDP for the same year was 51.9 trillion yuan (US$8.3 trillion). The M2/GDP ratio was 188 percent, a new record high. In comparison, the U.S. M2/GDP ratio was 57 percent. This means that in China, every dollar in the money supply can only create 0.5 dollars in GDP, but in the U.S., every dollar can create near 2 dollars in GDP.

The M2/GDP ratio is a primary indicator to measure the financial maturity level of a nation’s economy. Normally its upper limit should be 100 percent. The higher the number is, the higher the monetization level of the economy [2] will be. Though this ratio is not a perfect indicator, the fact that China’s ratio is significantly above the U.S.’ and also above the normal upper limit (100 percent) shows that China’s financial system faces high risks.

I. According to Authoritative Experts, China’s Current Financial System Faces Three Major Challenges

First, China’s goals of having stable economic growth, expanding domestic consumption, adjusting industrial structures (from low value-added manufacturing to high value-added products and services), developing new towns, and strengthening its financial services to agricultural, industry, and small businesses all require raising a huge amount of capital.

Second, as the financial industry is growing rapidly, it is getting increasingly complex; the reforms of the interest rate and the exchange rate are speeding up, making risk management increasingly difficult. Financial organizations are more dependent on each other. Private fund raisers and loan guarantee businesses have transferred their risks to banks. These also increase risk.

Third, some banks blindly pursue a high volume of savings and lending. Their internal control mechanisms and information technology (IT) levels are relatively weak. The problem of “heavy on expansion but light on management” is quite serious.

Wang Yuanlong, a Board member and Deputy Secretary-General of the International Finance Forum recommended that, as the financial industry has developed rapidly since the onset of the global financial crisis, China must be cautious about the risks it faces in the financial industry. These risks will accumulate over time. By the time they are eventually exposed, it will already be too late. Therefore China should take care of them soon. For example, the trust sector in China has surpassed the insurance sector to become the second largest sector in the financial industry. The trust sector may already have accumulated too many risks.

When former Prime Minister Wen Jiabao spoke at the National Financial Work Conference on January 6, 2013, he said, “There are some outstanding problems and risks in our financial industry.” He emphasized that China should stick to the principle of using the financial industry to serve the real economy; it should focus on developing the real economy and prevent bubbles in capital products and industrial hollowing-out [3].

II. A Complex Situation for the Government to Supervise

According to the latest statistics, at the end of 2012, China’s financial industry had 143.94 trillion yuan (US$23 trillion) in assets. Those assets were divided as follows: the banking sector had total assets of 131.26 trillion yuan (US$21 trillion); the insurance sector had 7.35 trillion yuan (US$1.2 trillion), the mutual funds sector had 3.6 trillion yuan (US$576 billion), and the securities sector had 1.72 trillion yuan (US$275 billion).

Yin Zhongqing, Vice Chairman of the Financial and Economic Committee of the National People’s Congress, said that the total value of risky off-balance sheet assets in China’s commercial banks exceeded 7 trillion yuan (US$1.12 trillion). The “shadow banking” [4] industry has more than 15 trillion yuan (US$2.4 trillion).

More and more financial organizations have become super enterprises that engage in comprehensive financial businesses such as banking, insurance, securities, trusts, lending, and investment banking. Holding companies have three primary models to control financial corporations: controlled by commercial banks, controlled by non-bank financial organizations, or controlled by corporations in the industrial sector.

Yin Zhongqing said, “Financial holding companies have increasingly challenged financial supervision.” The advance in IT and the trend toward diversification of financial products have kept producing new financial derivative products. The boundary of financial services is getting more and more blurred. Even the relatively financially-independent financial holding companies have more complex, diversified, and abstract businesses. The risk to the safety of a holding company’s investments, the risk to the holding company’s financial performance, and the risk to internal transactions within the holding company all make financial oversight difficult.

Yin thinks that the development of China’s legal system lags behind the development of the financial industry. The government’s financial oversight also faces several problems:

First, financial supervision does not meet the need to supervise the mixed services model. Current financial laws are by sector: three primary supervision committees have a fixed set of companies to monitor, but that does not cover all banks and all non-banking financial organizations and it does not cover all the business operations from market entry to market exit.

Second, supervision follows a single model. Effective coordination of the supervision committees is therefore lacking. This can create a vacuum in supervision.

Third, there is no focus on supervision. The current supervision is heavy on permit approval but light on monitoring, heavy on state-owned banks but light on other types of banks and non-banking financial organizations, heavy on savings and lending but light on innovative services. This model does not meet the supervision requirements for companies that provide mixed services.

Yin Zhongqing warned of the risks caused by the banking sector’s expansion of the financial management business, the increase in the size of insurance companies, the removal of the ban on the establishment of guarantee companies, the commodities market, the cultural product trading market and IPOs, the increase of the ratio of funds that the bond market raised over the total amount of funds raised, and Chinese companies’ going abroad. “The risks in China’s financial system are getting more serious and the task of controlling risks is becoming more complex.”

III. Handling Five Major Risks

Authoritative people listed five major risks in the financial industry.

First, the risk of “local governments’ fund raising platform” [5] is increasing. According to Yin Zhongqing, the “problem with the local governments’ fund raising platform is, in essence, the local governments’ fiscal problems.” “Some local governments’ fund raising platforms have problems such as the rapid growth of debt, the need for proper management, the lack of information transparency, and the lack of accountability on paying back debts. If many local governments refuse to pay back their debts (since technically the debt belongs to a company not the local government), then they transfer their problem to banks (since the banks provided the loans). This will cause systematic, regional financial problems.”

The characteristics of this risk are: First, many debts are either due already or will come due soon. About one third of these loans will come due in the period from 2012 to 2015. Of these, one third are due by the end of 2012. Some provinces’ debts have reached 90 percent of their annual fiscal budget. Second, paying back the debt relies heavily on land. Statistics show that a quarter of these loans are based solely on using land to pay back the debt and another one third result from having taken out a mortgage on the land or relied on land usufruct. Now that land prices have fallen, the risk of being unable to pay back the loans has increased. Third, even though some loans manage to come out of the local governments’ fund raising platform, they still have risk. Of those loans, about six percent have a total cash flow from the invested projects that is less than the loan balance. Forth, local governments’ fund raising platforms conduct improper operations. Some have even participated in private fund raising.

Second, the risk of defaulting on mortgages has increased. By the end of 2011, the total value of the loans on real estate in China exceeded 10 trillion yuan (US$1.6 trillion), accounting for 20 percent of the total of Renminbi loans. Sixty percent of these loans are mortgages. So far, the mortgage payment record has been good, but the risk is still there.

The risks that real estate companies face include the following: First, many companies have a high debt. About 50 percent of these companies’ debt-to-asset ratio is over 60 percent; some even have a ratio over 80 percent. Second, many real estate companies are short of money. Most real estate companies listed on the stock market have a negative cash flow. Third, real estate companies have raised money from multiple sources, including real estate private equity funds, trust loans, private loans, and the overseas market. They will face strong pressure when it comes to paying back the loans. Fourth, these companies provide massive loan guarantees for each other. For the largest 60 real estate enterprises, 30 percent of their total loans are cross-guaranteed. Also, the fluctuation in land prices increases the risk of paying back loans that are based on land.

Yin Zhongqing said, “Now all real estate companies are just hanging on (to their high prices) as long as they can [6]. It is a game they play against the central government.” In his eyes, real estate prices can drop. The reason that real estate companies haven’t lowered their prices yet is that they get “blood infusions” from private equity funds, private trusts, and overseas capital.

Third, the risk of legal cases in financing has been increasing. For example, for the past two years, such cases in the banking sectors have been increasing and the percentage of major cases that deal with financing has been increasing rapidly. This is due to the negative influence of outside factors such as private usury and illegal fund raising, as well as issues related to internal factors such as weak management and monitoring and noncompliance with government policies.

Fourth, the risk from the activities of local commercial banks cannot be ignored. By the end of 2012, the value of the total assets that local commercial banks had was 12.35 trillion yuan (US$2.0 trillion), which was 9.4 percent of the total assets of the banking sector, but the total value of the loans that these local commercial banks issued in 2012 was 16.1 percent of all loans. The risk from the activities of local commercial banks is increasing for the following reasons: One, they focus on competing with large banks for larger projects and larger customers. They have less interest in serving the small companies and basic customers. Two, some local governments have too much control over the local commercial banks, with the result that these banks either cannot fill their top management positions or have government officials take their top positions. Thus major criminal activities continue to take place. Third, these banks had financial problems when they were created ten or twenty years ago. They may have overstated the amount of registered capital or bad loans that were given to them when they were set up, but now such funds cannot be recovered. Fourth, they have high risk loans. Their loans concentrated on a small base. There is an increased risk because of their off-balance sheet business and they have a tight cash flow.

Fifth, illegal fund raising presents a risk that needs attention. According to authorities on the subject, recently, private financing has been very active. Some loan guarantee companies and small loan companies have deviated from their business practices, resulting in a frequent occurrence of usury and illegal fund-raising problems. Some have affected local economic development and social stability. Though the risk of nationwide illegal fund-raising can be controlled in general, the possibility that an eruption of illegal funding-raising problems will spread and have a ripple effect in some regions, at some time, cannot be discounted.

IV. Potential Crises

Wang Yuanlong thinks that China’s supervision committees should pay close attention to four areas: First, when financial innovation is not based on the real economy, it leads banks to lose the solid base of their assets and their reliable sources of income. Second, over-complicated financial innovation increases the difficulty in risk management. Third, financial innovation that lowers the qualifications for businesses and other customers creates risk. Fourth, innovation without effective government supervision creates supervisory arbitrage.

[1] Outlook Online, “China’s Financial System Is Facing Risks and Danger Again,” February 25, 2012.
[2] Monetization of the Economy: The total monetary amount paid for goods and labor services as a percent of the total GDP for a nation. Another element is that goods and labor services are either consumed by the producers themselves or exchanged for other goods and services. This means, in general, that the Monetization of the economy cannot exceed 1.
[3] Industrial hollowing-out: refers to a situation in which a nation exports too much of its manufacturing abroad, resulting in service businesses having a larger share of GDP than the manufacturing industry.
[4] Shadow Banking: There is no clear definition for this term in China. It loosely refers to all financial corporations that are not banks but are involved in the lending business or the same kind of off-balance sheet activities that banks perform. They are not regulated as strictly as banks. They provide a secondary channel (besides banks) for companies to borrow money.
[5] Local governments’ fund raising platform (地方融资平台): The local governments in China set up a company or companies to raise money. The government has established requirements on the level of assets and cash flow that a company must meet to be allowed to raise money. Local governments provide assets such as land, stock, holdings of the national debt, or future income to package their companies to meet the requirements. They then use these companies to raise money for local construction or development projects. A common form these companies take is a city-level development investment company.
[6] In 2012, when China’s real estate prices had risen so much that everyday people could no longer afford to buy their own homes, the central government tried to cool down the market. However, since local governments made a substantial profit on the transfer of land, the real estate companies needed to sell high to cover their costs. Therefore, even though the central government wanted to lower real estate prices, the real estate companies tried to maintain a high price and created a situation of “there is an asking price but no buyer.” These companies cannot maintain high prices forever without making any sales. They are only able to hang on, for now, because many companies are using means, whether legal or illegal, to defer their loan payments or they are able to obtain loans from other sources so they can roll over their debt and keep their businesses running.