Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market.

In response to the global financial crisis, the Chinese government unleashed a surge in bank lending to stimulate the economy. For the next several years, both the formal banking system and the shadow banking system grew at an extremely rapid pace. This led to a sharp increase in leverage across the economy and sparked concerns about China’s financial stability. Figure 1 shows the increase in credit relative to gross domestic product (GDP) during this period. In absolute terms, total leverage grew by more than $25 trillion between 2008 and 2017.¹ For comparison, the most recent figures from the Federal Reserve put the assets of the entire U.S. commercial banking system at less than $17 trillion.² While household and government debt levels are still at moderate levels, China now has one of the highest corporate debt levels among all the major economies.

Source: Bank for International Settlements.

Chinese regulators were not asleep at the wheel during this period, but new regulations tended to be reactive and inadequate given the proliferation of risks across the financial system. This changed dramatically, however, after a series of financial disruptions throughout 2015 and 2016.

In 2015, Chinese equity markets experienced a rapid run up in prices followed by an even steeper decline. The Chinese government took drastic steps during the summer of 2015 to offset the panic overtaking the stock market. Investors accused of illegal trading were arrested, hundreds of stocks were suspended, and state investment funds spent billions of dollars purchasing shares to prop up prices. Stocks tumbled again in early 2016 as many of the government’s support programs for the market were unwound. Figure 2 shows the drop in the Shanghai Stock Exchange Composite Index during this period, including the more than 40 percent decline in value between June and August 2015.³

Source: Wind.

Past performance does not guarantee future results. It is not possible to invest directly in an index.

China’s financial system was further destabilized in August 2015 by currency depreciation. A change to the exchange rate regime led to a fall in the value of the renminbi and sparked fears that a significant devaluation could occur. These concerns contributed to large capital outflows during this period. Over the next year and a half, the People’s Bank of China spent significant amounts of its foreign exchange reserves to support the currency. Capital outflows slowed during 2016 and then reaccelerated at the end of the year, leading to the imposition of capital controls across the economy. By January 2017, foreign exchange reserves had fallen by nearly $1 trillion from their peak in 2014.⁴

Adding to concerns during this period were a series of large scale financial scams that went bust. The most notorious of these was the Ezubao peer-to-peer lending Ponzi scheme that collected more than $9 billion in funds from investors.⁵ These schemes fueled popular discontent and led to public protests by investors in front of bank branches and government offices.

The combined impact of the financial shocks of 2015 and 2016 led to a shift in thinking among Chinese authorities regarding the severity of financial risks facing the country. Policymakers began discussing the need to reduce debt levels across the economy, and deleveraging was incorporated into official policy documents at the end of 2015. The government rolled out efforts to aid heavily indebted state-owned enterprises (SOEs) in overcapacity industries such as steel and aluminum. A debt-for-equity swap program was launched in 2016 and creditor committees were established in more than 10,000 companies.⁶ Creditor committees convene all the lenders for a firm in order to restructure debts under more sustainable terms and prevent situations where the actions of one lender lead to defaults for multiple financial institutions.

China’s top leadership has made clear that controlling risks in the financial system is now a top priority. In April 2017, President Xi Jinping summoned China’s financial regulators to a meeting of the politburo and told them that combating financial risks was a matter of national security. In July of that year, a new State Council group, the Financial Stability and Development Committee, was created to manage risks across the financial system and coordinate the activities of the various financial regulators.⁷ That December, the Central Economic Work Conference stated that combatting financial risks was one of the “three critical battles” to be fought over the next three years.⁸

This push from the top to address financial risks gave support to what is commonly called the “Regulatory Windstorm.” New regulations for the banking, insurance, and asset management industries emerged during this period in rapid succession. In the banking industry, strict new rules were put into place to limit shadow banking activities and reduce the amount of regulatory arbitrage occurring through the interbank market. For the insurance industry, there was a clampdown on the sale of insurance products that acted as vehicles for financial speculation rather than for insuring risk. Regulators also drafted expansive new rules for the asset management industry designed to reduce risks in wealth management products and protect investors. The entire regulatory structure itself was given a shakeup in 2018 with the merger of the banking and insurance regulators into a single, more powerful regulator.

The crackdown has expanded beyond the confines of traditional financial regulation. The Ministry of Finance tightened supervision of public-private partnerships (PPPs) involving local governments and companies. These deals were often structured in a way that disguised debts being accumulated by local governments.⁹ Chinese companies making large debt-financed acquisitions overseas began to attract intense regulatory scrutiny, ultimately leading to the arrest of several CEOs and a retrenchment in outbound investment. Chinese authorities also took steps to close thousands of faltering peer-to-peer lending exchanges and banned initial coin offerings (ICOs) and cryptocurrency exchanges.

These moves have helped defuse risks across the financial system and slow the growth rate of credit, particularly in the shadow banking system. This represents significant progress compared to the conditions of the last few years. The financial crackdown, however, is not without risks of its own. Deleveraging and tougher regulation can have a negative impact on economic growth and, if taken too far, can trigger the risks they are designed to solve. For example, aggressive credit tightening can raise funding costs to the point where it leads otherwise healthy financial institutions to fall into financial distress. To avoid these negative side effects, regulators have been flexible, adjusting implementation timetables and providing liquidity to financial institutions in order to avoid significant disruptions. Despite these precautions, the risks of unintended negative consequences from regulatory actions will remain high.

The focus on financial risks will remain in place for the foreseeable future, but economic concerns may lead to adjustments. China’s top leadership and regulators have reiterated their commitment to the financial cleanup on numerous occasions. Yet the recent fall in the stock market, the depreciation of the currency, and a trade war with the United States may all encourage a more gradual rollout of new regulations. Easing financial conditions in a targeted way without returning to the uncontrolled credit growth of the past will be a tightrope that Chinese policymakers must walk for many years to come.

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

The Shanghai Stock Exchange Composite Index is a capitalization weighted index of all stocks that are traded on the Shanghai Stock Exchange. It is not possible to invest directly in an index.

1. “Long Series of Credit to the Non-Financial Sector,” Bank for International Settlements, 5 June 2018. Author’s calculation.
2. “Total Assets, All Commercial Banks,” Federal Reserve Bank of St. Louis, 29 June 2018.
3. Wind. As of 6 July 2018.
4. Keith Bradsher, “How China Lost $1 Trillion,” The New York Times, 7 February 2017.
5. “Leader of China's $9 billion Ezubao online scam gets life; 26 jailed”, Reuters, 11 September 2017.
6. Dinny McMahon, “The Island of Misfit Toys: Deleveraging and the Evolution of Credit Committees,” The Paulson Institute, 25 June 2018.
7. The body is expected to play a similar role to the Financial Stability Oversight Council in the United States.
8. The other two battles are poverty alleviation and environmental protection.
9. Gabriel Wildau, “China admits to disguised fiscal borrowing risk,” The Financial Times, 2 August 2017.