• China’s period of rapid growth was a golden era for private companies, but it also created significant financial risks.
• China’s battle to tame financial risks and deleverage had profound impacts on the broader economy and led to a financing crunch for private enterprises.
• Political influences continue to distort the allocation of credit in China’s economy, slowing economic growth and reducing efficiency.

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.

Growing financial stresses and the implosion of several large conglomerates are a testament to the fact that China’s battle to control financial risks is still ongoing. While regulators have pursued a crackdown on financial risks with gusto, piecemeal regulatory changes cannot resolve the fundamental weakness at the center of China’s financial system. As long as access to credit is distorted by political considerations, China will struggle to liberalize its financial system without creating systemic financial risks.

A Flood of Credit

After the global financial crisis, China launched a massive domestic stimulus program, driven by a huge increase in credit. At the outset, China’s stimulus was channeled through the banking system rather than through direct fiscal spending. This led to an unprecedented increase in lending and a dramatic expansion of the financial system. Between the fourth quarter (Q4) of 2008 and Q4 2011, total bank credit doubled.¹ This credit-driven stimulus propelled China’s economy to a quick recovery while much of the world remained mired in recession.

However, even after achieving economic recovery, China’s leadership tolerated extraordinarily high levels of credit growth for many years. Figure 1 shows the significant growth in both the total stock of credit and the credit-to-GDP ratio since 2008.

Source: Bank for International Settlements.

Note: Total Credit includes corporate, household, local government, and central government borrowing.

During this period, credit began growing quickly outside of bank lending and other well-regulated channels, referred to as the shadow banking system. Shadow banking emerged as an important source of financing for many Chinese companies, particularly those that lacked access to the traditional financial system. China’s equity and bond markets also boomed during this period, becoming an increasingly important source of financing in their own right.

These years, roughly 2009-2017, were in many ways a golden era for private companies in China. In a system historically tilted toward state-owned enterprises (SOEs), private companies were able to borrow more freely than before due to the flood of capital throughout the financial system. Increased access to credit served as a catalyst for the growth of China’s private sector.²

Growing Financial Stresses

Unfortunately, this period was also a breeding ground for financial risks. The combination of rapid credit growth through poorly regulated channels is often a recipe for a financial crisis. The first warning sign was in 2013 when the People’s Bank of China attempted to curb excessive short-term borrowing by banks in the interbank market, leading to a short-lived funding crisis. Problems then began to accelerate in 2015 as China experienced a string of high-profile financial blowups.

In the summer of 2015, China’s stock markets melted down after a margin-fueled rally unwound itself. Having publicly cheered on the rally, China’s leaders had to quickly intervene to stem the fallout of the crash. Huge numbers of stocks were suspended from trading, government funds were organized to support stock prices, and the authorities threatened to arrest short sellers.

China also experienced significant pressure on the renminbi exchange rate during this period. In August of 2015, the People’s Bank of China announced a new rate setting mechanism for the exchange rate. Following the announcement, the renminbi faced significant downward pressure and China began to experience large capital outflows. To head off the risk of a full-blown currency crisis, Chinese policymakers implemented new capital controls and spent nearly 1 trillion U.S. dollar-equivalent of the country’s foreign exchange reserves.³

In late 2015, China was rocked by the implosion of a major ponzi scheme, Ezubao. One of hundreds of peer-to-peer lending platforms that sprung up during this period, Ezubao raised over 9 billion USD-equivalent from Chinese retail investors. After Chinese authorities began investigating the company for fraud, Ezubao froze investors’ accounts and soon ceased operation. The founder of Ezubao, along with his brother, received life sentences for their roles in the scheme. In the following years, China’s peer-to-peer lending industry collapsed due to widespread bankruptcies and regulatory pressure.

Perhaps more than any other single financial risk during this period, China’s regulators and policymakers began to worry about the rapacious growth of corporate conglomerates, particularly those fueled by high levels of borrowing. Anbang Insurance Group, China Huarong Asset Management, HNA Group, and CEFC China Energy are all examples of fast-growing conglomerates during this period. These conglomerates made heavy use of the shadow banking system to expand their empires, acquire overseas assets, and challenge China’s traditional state-owned enterprises. In the process, they created new financial risks and began to be viewed as a political threat to the primacy of China’s Communist Party. One corporate acquisition struggle in particular embodies this mix of conflicting economic and political risks.

An Attempted Hostile Takeover

Vanke was established in 1984 in Guangdong province by entrepreneur Wang Shi. Like many companies of this era, Vanke was initially a subsidiary of a state-owned enterprise that became partially privatized over time and then was publicly listed.⁴ Under Wang’s leadership, Vanke became China’s largest real estate developer.

While ownership of Vanke was relatively diversified, state-owned China Resources Group had been the largest shareholder since 2000. By most accounts, China Resources was a relatively hands-off owner and Wang Shi had a close relationship with the chairman of China Resources until he was arrested in 2014 for corruption.⁵

In 2015, Vanke was the target of a hostile takeover attempt – a rarity in China – by Baoneng Group. A relatively unknown property conglomerate at the time, Baoneng used its two insurance subsidiaries to raise funds from the public through selling high-yielding asset management plans.⁶ These funds were used as part of a levered buyout of Vanke’s stock. By August 2015, Baoneng had become the largest shareholder of China’s largest property developer.⁷

Wang Shi was stridently opposed to the takeover by Baoneng. In December 2015, Vanke’s management suspended its shares as it formulated restructuring plans to fend off Baoneng. China’s financial regulators began to take notice, stating that any transaction would be reviewed to ensure that interests of all shareholders would be protected.⁸ While Vanke’s Hong Kong-listed shares began trading again in January 2016, the company’s Shenzhen-listed shares would not trade for a year and a half.⁹

In March 2016, Vanke announced a deal with state-owned Shenzhen Metro Group as a white knight acquirer. The deal faced opposition from both Baoneng and from China Resources, who feared being diluted by the share-financed acquisition.⁴

In August 2016, Evergrande Group, China’s second-largest real estate developer, began aggressively acquiring shares of Vanke. Using resources from its own insurance subsidiary, Evergrande became Vanke’s third-largest shareholder, potentially challenging both Baoneng and China Resources for control.⁹ Figure 2 illustrates the changing nature of Vanke’s leading shareholders from 2014-2020.

Source: Vanke Annual Reports.

Notes: From 2018 onwards, Anbang was in a state-controlled conservatorship. Other Government includes Central Huijin, China Securities Finance Corporation, and National Social Security Fund.

The State Hammer Comes Down

In the early months of 2017, the Chinese government moved decisively to resolve the Vanke saga. Baoneng’s insurance arms were suspended from selling high-yield investment products and its Chairman, Yao Zhenhua, was banned from the insurance industry for 10 years.¹⁰ Executives from Evergrande’s insurance arm also faced multi-year industry bans and the company was restricted from making investments for one year.¹¹

Soon after the crackdown, one of the insurance subsidiaries of Baoneng announced that it would be forming a party committee to “improve its corporate development capabilities.”¹² The head of the China Insurance Regulatory Commission, Xiang Junbo, was arrested in April 2017 for “serious violations of regulations.”

In January 2017, China Resources Group agreed to sell its stake to Shenzhen Metro Group, reversing its earlier position. Evergrande Group gave up on its effort to capture Vanke, publicly declaring its intention to not seek control.¹³ In March 2017, Evergrande transferred its voting rights in Vanke to Shenzhen Metro as part of a proxy deal.¹⁴ Baoneng failed to win a single seat on the company’s board in the 2017 election.¹⁵

In June 2017, Evergrande sold its shares to Shenzhen Metro at a loss of nearly 1 billion USD-equivalent.¹⁶ After the Evergrande transaction, Shenzhen Metro Group emerged as the largest shareholder of Vanke and was firmly in control of the company. Soon after, Vanke founder and Chairman Wang Shi retired.¹⁷ The following year, Baoneng quietly began unloading its stake in Vanke, a stark contrast to its loud attempts to seize control of the company earlier.

A Regulatory Turning Point and a Political Red Line

The attempted seizure of a prized corporate asset, such as Vanke, through financial machinations had set off alarm bells in Beijing. Regulators were concerned that Baoneng was using its insurance subsidiaries to raise funds from the public by guaranteeing high returns and then funneling the proceeds into risky acquisitions.¹⁸ In December 2016, China’s chief securities regulator denounced “barbarians and bandits” engaged in hostile takeovers, clearly referencing the Vanke saga underway at that moment.¹⁹

Concerns over hostile takeovers and other financial risks emerging across the economy during this period set the stage for a major regulatory turning point. In December 2016, China’s Central Economic Work Conference, chaired by Xi Jinping, emphasized that the country faced accumulating financial risks, called for deleveraging, and denounced speculation in the housing market.²⁰ In February 2017, Guo Shuqing was appointed as head of the China Banking Regulatory Commission and launched a series of new financial regulations that would come to be referred to as the “Regulatory Windstorm.”

In April 2017, Xi Jinping chaired a special meeting on financial risks for the politburo that included the Governor of the People’s Bank of China and the heads of all the financial regulatory agencies. During the meeting, he declared that controlling financial risks was a matter of national security.²¹ The meeting represented Xi’s official backing for a regulatory crackdown, imbuing China’s regulators with much-needed authority to tackle financial risks.

In July 2017, a new government body, the Financial Stability and Development Committee, was announced to manage risks across the financial system and coordinate the activities of the various financial regulators. In December 2017, China’s government declared combatting financial risks was one of the “three critical battles” to be fought over the next three years.

In addition to the regulatory motivations for the financial crackdown, there were major political considerations at play as well. China’s political leaders have long been deeply suspicious of large business conglomerates who might use their resources to become competing sources of power. Brash entrepreneurs misusing the tools of finance to build a private empire represented an even greater concern. In the case of Vanke, a private entrepreneur was aggressively pushing out a state-owned enterprise to seize control of one of the crown jewels of corporate China.

China’s residential property market is also an area of particular sensitivity. The real estate sector, one of Xi Jinping’s main focuses since he took power, is deeply linked to corruption in China. China is rife with stories of government officials accepting bribes to greenlight property deals and living in apartments more expensive than their salary could possibly sustain. Chinese authorities have sought to arrest several property tycoons who strayed too close to political red lines, such as criticizing the Party.

The property market had become an issue of social stability itself. Many average Chinese citizens became deeply frustrated as they were priced out of buying a home due to ever-increasing home prices. These feelings became even more potent when combined with anger over stories of official corruption in the property market. The movements in real estate prices and government policy for the property market are followed closely by the Chinese public.

The Aftermath of the Windstorm

The financial crackdown that began unfolding in 2016 and 2017 had a profound impact on the Chinese economy. The banking, insurance, and asset management industries faced a flurry of new regulations during this period. The banking industry adopted stricter rules to limit shadow banking activities and reduce the amount of regulatory arbitrage occurring through the interbank market. The insurance industry was subject to a regulatory clampdown on the sale of insurance products that acted as vehicles for financial speculation rather than for insuring risk. The asset management industry was forced to adopt new rules to reduce risks in wealth management products and other new financial products. The structure of the regulatory system was given a massive shakeup in 2018 when the banking and insurance regulatory agencies were combined into a single, more powerful regulator.

While these actions had a significant impact on reducing financial risks, they also led to a financing crunch for many Chinese companies, particularly private enterprises. Figure 3 shows the impact of the financial crackdown and deleveraging campaign on the leverage ratios of Chinese enterprises.

Sources: 5000 Enterprise Financial Indicator, People’s Bank of China.

The conglomerates that had thrived in the earlier period of easy money began to attract intense regulatory scrutiny, ultimately leading to the arrest of several CEOs and a retrenchment in outbound investment. A long list of corporate causalities began to pile up, including Anbang Insurance Group, HNA Group, CEFC Group, and the Tomorrow Group. Other entities linked to shadow financing, such as China Huarong Asset Management, are facing severe financial stresses and struggling to avoid bankruptcy. For the first several years of the crackdown, Evergrande seemed immune from pressures to deleverage, becoming one of China’s largest and riskiest corporate borrowers. Evergrande’s free pass, however, now appears to be over as regulators target it and other property developers with the new “three red lines” borrowing regulation.²²

Smaller Chinese enterprises suffered from the contraction of the shadow banking system as well. Shadow banking served as a lifeline for many small and medium enterprises, providing credit when traditional lenders would not, albeit often at exorbitant interest rates. The financial crackdown led to a collapse of peer-to-peer lending platforms, bankers’ acceptances, and loans from non-bank financial institutions, all key sources of financing for small and medium enterprises.

The Problem of Partial Liberalization

Over the past several years, China has made progress towards taming many of the wilder areas of its financial system, but at the cost of slowing growth and damaging the private sector. The efficiency of credit allocation within China has noticeably worsened, with connected state-owned enterprises continuing to access financing while private companies, both large and small, have struggled. The large corporate conglomerates that grew so rapidly previously are now struggling to survive.

The political red lines in China’s financial system have become even more apparent. Beijing’s efforts to crush Baoneng’s takeover of Vanke presaged a wider crackdown on conglomerates. It is now abundantly clear that business tycoons that use financial institutions to build their own personal empires do so only at the pleasure of China’s political leaders. An entrepreneur perceived as challenging Beijing’s authority or creating social and financial problems will soon find themselves at the mercy of a regulatory offensive. Jack Ma’s challenge to regulators in late 2020 precipitated a massive rectification campaign that saw Ant Finance brought to heel and its business empire partially dismantled. Financial regulation in China continues to be heavily influenced by political considerations.

China will struggle to maintain strong economic growth as long as the financial system exists in its current suboptimal state of partial liberalization. In theory, China’s banking, insurance, and capital markets have largely been liberalized. In reality, significant distortions exist due to the government’s role in influencing credit allocation. Despite lower levels of productivity, state-connected borrowers have easier access to borrowing and pay lower interest rates than private firms.²³ Moreover, state-connected firms benefit from an expectation of government support if they encounter financial difficulties. One rough indicator of this can be seen in China’s bond market. As shown in Figure 4, private companies account for the vast majority of bond market defaults, despite state-owned companies dominating total issuance of bonds.

Sources: Goldman Sachs²⁴ and Seafarer.

The political distortions in China’s financial system cause credit to flow to state-connected borrowers, who are generally less productive and therefore ultimately riskier. Private enterprises are forced to borrow in the less regulated corners of the financial system. Without resolving this fundamental problem, efforts by Chinese regulators to stamp out financial risks amount to a never-ending game of whack-a-mole. Once one risk is addressed, a new one pops up almost immediately. Chinese policymakers can only hope that they move swiftly enough to address the risk du jour before it becomes systemically important for the entire financial system. Addressing the deeper systemic distortions requires rethinking the role of government in the economy, a topic above the paygrade of any regulator in China.

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.

As of June 30, 2021, the Seafarer Funds did not own shares in the entities referenced in this commentary.

1. “Credit to the Non-Financial Sector,” Bank for International Settlements, 29 June 2021.
2. Nicholas Lardy, Markets Over Mao: The Rise of Private Business in China (Washington, D.C.: The Peterson Institute for International Economics, 2014).
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4. Lynn S. Pain, Charles C.Y. Wang, Dawn H. Lau, Anthony K. Wu, “China Vanke: Battle for Control (A),” Harvard Business School, 8 January 2021.
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7. “China Vanke Moves to End Potential Takeover Battle,” MarketWatch, 21 December 2015.
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10. Summer Zhen and Xie Yu, “Shenzhen Tycoon Yao Zhenhua Barred from Insurance Industry for 10 Years,” South China Morning Post, 24 February 2017.
11. Hu Chuhui “Evergrande Life was Restricted from Equity Investments for 1 Year, Two Executives were Banned from the Industry and Two executives Were Ordered to be Replaced (恒大人寿被限制股票投资1年，两高管被禁业两高管被勒令撤换),” The Paper, 25 February 2017.
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15. Chai Hua, “New Vanke Board Swears by New Biz Model,” China Daily, 1 July 2017.
16. Celine Ge, “Shenzhen Metro to Become Biggest China Vanke Shareholder as Evergrande Cashes Out,” South China Morning Post, 9 June 2017.
17. Ryan Mcmorrow, “Vanke Founder Wang Shi, Chinese Property Developer, Steps Down,” The New York Times, 21 June 2017.
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22. “What China’s Three Red Lines Mean for Property Firms,” Bloomberg, 8 October 2020.
23. Emilia Jurzyk and Cian Ruane, “Resource Misallocation Among Listed Firms in China: The Evolving Role of State-Owned Enterprises,” International Monetary Fund, 12 March 2021.
24. Kenneth Ho and Chakki Ting, “China Default Watch: Focus on Idiosyncratic Issues, Recovery Prospects and Keepwell Developments,” Goldman Sachs, 17 June 2021.