• Three financial cleanups have shaped China’s current approach to financial stability: Japan in the 1990s, the U.S. in 2008, and China’s own banking crisis in the late 1990s.
• Efforts by regulators are guided by Xi Jinping’s political priorities: reducing financial volatility, reasserting control over areas of the economy that have less government influence, and handling restructurings behind closed doors and with limited foreign involvement.
• Compared to other major economies, China’s financial interventions are earlier, more pervasive, and less transparent.

Weak balance sheets interspersed throughout the economy are threatening China’s financial stability. Real estate developers and private conglomerates are overloaded with debt and increasingly unable to access new financing. Many state-owned enterprises (SOEs) are deeply unprofitable and cannot service their debts without government support. Local governments depend on shell companies to fund spending through borrowing and land sales. Some small banks are poorly capitalized and heavily exposed to risky borrowers.

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 awareness of these financial vulnerabilities has been an impetus for the Chinese government to act. In 2016, China began a massive financial crackdown and deleveraging campaign, which it continues to wage. At the core of the campaign is an effort to defuse the risks contained within the economy’s weakest balance sheets.

China’s strategy for cleaning up financial risks was not crafted in a vacuum. Beijing studied financial cleanups in the West and Japan, incorporating lessons from both successes and failures. China also learned much from its own experience restructuring its banking sector in the late 1990s.

China’s approach draws on the lessons of the past, but it is also new and distinct. The priorities of the Xi administration – stability, control, and self-sufficiency – have suffused China’s approach to regulatory intervention.

The Fragile Five

China’s weakest balance sheets share one common factor: a sharp increase in leverage following the global financial crisis. In 2008, China initiated a massive credit-driven stimulus in response to a slowing domestic and global economy. It led to huge increases in debt among households, corporations, and the government.

Debt levels increased across the entire economy, but the rise has been greatest in five types of firms:

• State-owned enterprises: SOEs are the largest corporate borrowers in China. At the end of 2020, they held 171 trillion Renminbi (RMB) in liabilities, an amount equivalent to about 170% of China’s gross domestic product (GDP).¹ SOEs are risky borrowers because, on average, they are significantly less efficient and profitable (measured by return on assets) than private firms, as shown in Figure 1.² SOEs exist at both the local and national level. Local SOEs are tightly linked to a city or provincial government and rely on them for subsidies and other forms of support. A bankruptcy of a local SOE might imperil the finances of the local government and create significant local unemployment. National SOEs are often massive in size and play a systemically important role in an industry or the financial system. The bankruptcy of a major national SOE could potentially threaten the entire economy.

Sources: National Bureau of Statistics, CEIC.

• Private conglomerates: China’s numerous private and quasi-private corporate conglomerates have become enormous, entering the ranks of the largest companies in the country. Over the past decade, aggressive expansion and dwindling access to finance have strained the balance sheets of many of these conglomerates. In recent years, many conglomerates – including Tomorrow Group, Anbang Insurance, HNA Group, Founders Group, Tsinghua Unigroup, and CEFC China Energy – have gone bust, leaving hundreds of billions of dollars’ worth of unpaid liabilities.
• Real estate developers: China’s multi-decade housing boom has given rise to the largest real estate companies in the world. Many developers have pursued a strategy of maximum leverage, borrowing as much as possible and raiding funds from one project to fund another. As a result, their balance sheets have weakened substantially, leaving them highly vulnerable to disruptions in funding and slowdowns in the property market. Lending available to real estate developers plummeted after new regulations designed to reduce bank exposure to the property market were issued, as shown in Figure 2. The International Monetary Fund (IMF) estimates that Chinese real estate developers have liabilities at risk of default in excess of 12% of GDP.³ The largest developers have individual balances sheets worth trillions of RMB.

Sources: National Bureau of Statistics, CEIC.

• Local Government Financing Vehicles: By law, local governments in China face strict limitations on how much they can borrow. To circumvent these restrictions, local governments have created shell companies called Local Government Financing Vehicles (LGFVs) to borrow on their behalf. The balance sheets of LGFVs are weak because these shell companies often have little in the way of assets or income themselves, relying on new borrowing, implicitly guaranteed by their affiliated local government, to service their debts, as shown in Figure 3. Recently, many local governments have been trying to separate themselves from explicit responsibility for LGFV liabilities, further imperiling their ability to pay their debts. According to an estimate by the IMF, LGFVs had 50 trillion RMB in debt at the end of 2021.⁴

Source: International Monetary Fund.⁵

• Small banks: China’s city commercial banks and rural commercial banks, small banks that are typically concentrated in a specific city or region, grew rapidly over the past decade. They typically have weaker deposit bases and lower capital levels than large banks and therefore more fragile balance sheets. City commercial banks and rural commercial banks had capital adequacy ratios that are 4 percentage points lower than large banks at the end of 2021, as shown in Figure 4.⁶ Smaller banks also often have high levels of exposure to individual risky borrowers, such as real estate developers or private conglomerates. Recently, regulators were forced to bail out several small banks, including Baoshang Bank and Bank of Jinzhou, which were on the verge of bankruptcy. Poor corporate governance has emerged as a major problem for small banks in China. Private conglomerates have taken controlling stakes in many small banks. Once in control, they can use the bank’s balance sheets to lend money back to the conglomerate and its affiliated entities.

Sources: China Banking and Insurance Regulatory Commission, CEIC.

Avoiding the Same Mistakes

Faced with the daunting task of cleaning up weak balance sheets, China has drawn lessons from financial cleanups of the past. The three cleanups that have most shaped China’s current approach are the ones in Japan in the 1990s, the United States during the global financial crisis, and China’s own banking cleanup in the late 1990s.

Japan’s Lost Decade

After the popping of the bubble economy of the 1980s, Japan’s banking sector entered a prolonged period of stagnation. With the blessing of the government, Japanese banks delayed recognition of bad loans for an extended period of time.⁷ The result was the proliferation of “zombie” banks and enterprises – entities that were effectively bankrupt but persisted because their bad debts were not recognized. The Japanese government was forced to recapitalize the banking sector almost a decade after the problems first emerged, a stunning indication of how long the country’s banking problems had dragged on.⁸ Japan avoided the harsh consequences of a full-blown financial crisis, but its economy was weighed down by unproductive companies and hobbled banks for years.

Chinese economists have long focused on similarities between China’s current economic problems and those of the Japanese bubble economy, especially high debt levels and an economy that is overly dependent on real estate. Japan’s problems with zombie enterprises have impressed upon Chinese policymakers the need to deal with these companies earlier and more decisively while taking steps to prevent bad debts from lingering unresolved on banks’ balance sheets for long stretches of time.⁹ The lesson of Japan for China is that allowing bankrupt companies and bad debts to fester can create new costs and drag down long-term economic growth.

America’s “Lehman Moment”

For China, the U.S. subprime mortgage crisis offers an example of the high costs of regulatory inaction. As the housing market deteriorated in 2008, several large banks were on the brink of bankruptcy. U.S. regulators were initially proactive in responding to growing financial distress. The Federal Reserve helped engineer an industry bailout of Bear Stearns early in 2008 to prevent the bank from going bankrupt; later that year, several banks regulated by the Federal Deposit Insurance Corporation (FDIC), including IndyMac, were placed into FDIC receivership and wound down.

This proactive approach to resolving troubled financial institutions did not last, however. Whether through choice or necessity, U.S. regulators did not bail out Lehman Brothers in September 2008. Not eligible to be taken over by the FDIC, Lehman defaulted on its debts and entered bankruptcy. The disorderly nature of Lehman’s default contributed to panic in the U.S. financial system, triggering huge equity market declines, a run by investors on money market funds, the freezing of the commercial paper markets, and major dislocations in the swaps and derivatives markets.¹⁰ Shortly after the collapse of Lehman, Congress approved the Toxic Asset Relief Program (TARP) to stabilize the financial system and provide capital to other large financial institutions on the verge of bankruptcy.

Chinese economists have catalogued a long list of mistakes made by U.S. regulators and policymakers during the global financial crisis. Key among them was that allowing the disorderly collapse of Lehman unnecessarily exacerbated the severity of the financial crisis. Reviewing lessons from the global financial crisis for China, Yi Gang, China’s current central bank governor, identified early and decisive intervention by authorities in dealing with systemic risk as a necessity.¹¹

China’s Costly Bad Loan Cleanup

China’s approach to managing balance sheet restructurings is also informed by its own experience. In the late 1990s, Chinese banks faced rapidly rising levels of non-performing loans from SOEs. Losses from bad loans were so great that the country’s largest banks were technically insolvent.¹²

Faced with the prospect of a financial crisis, the government implemented a massive bailout and restructuring plan for the banks. The Ministry of Finance and the central bank orchestrated large capital injections into the banks. Corresponding asset management companies were set up for each of the four largest banks. These asset management companies purchased the bad loans from the banks at face value, allowing the banks to transfer bad debts off their balance sheets. Banks and SOEs were restructured, leading to massive layoffs. Foreign strategic investors were brought in to improve the operations and corporate governance of China’s banks.¹³ Eventually, the large banks were listed on the Hong Kong Stock Exchange to raise capital and further improve operational oversight.

China’s lessons from its own financial cleanup relate to the enormous cost of bank restructuring and the ways in which some of the methods used created new and unanticipated problems. By some estimates, China had to commit roughly 30% of its GDP to cleaning up the banking system.¹⁴ The expenses were painful but ultimately absorbed by the country’s rapid economic growth over the next decade. That same approach is less feasible now, given China’s lower economic growth rate.

The strategic partnerships with foreign investors did not prove durable. The Chinese government was unwilling to give up control over the banks and allow foreign investors to play influential roles within these companies. Most of the stakes were sold within a few years, as foreign partners faced their own financing difficulty or grew frustrated with their limited influence. In addition, overseas listings have not been a panacea for the inefficiency and poor corporate governance of Chinese banks: All of China’s largest listed banks trade at a significant discount to book value, revealing that investors believe that the actual value of banks’ assets is much lower than what is carried on their books, shown using the banks’ price to book value ratio in Figure 5.

Source: Bloomberg.

Note: Ratios are based on H-Share prices.

Bailouts and restructuring failed to solve many of the underlying problems in China’s financial sector. Moral hazard remains rampant, as banks continue to lend to inefficient SOEs. Some of the asset management companies that were set up to help clean up the financial system have become significant problems in their own right. Rather than wind down its operations, for example, Huarong grew rapidly over the past decade to became one of China’s largest non-bank financial institutions. A wave of bad loans required a massive bailout in order to prevent the company from going into default.¹⁵ Its chair was convicted of large-scale embezzlement and subsequently executed.

China’s Playbook for Balance Sheet Cleanup

At the National Financial Work Conference in 2017, Xi Jinping declared that financial risks represented an important national security risk.¹⁶ He ordered China’s financial regulators to take the initiative in preventing financial risks, improving early warning systems, resolving problems quickly, and strengthening financial emergency response systems.¹⁶

With marching orders to clean up the financial system, regulators have sought to strengthen the weakest balance sheets in the Chinese economy. These efforts are shaped by China’s political priorities under Xi: reducing financial volatility, reasserting control over areas of the economy that have less government influence, and handling restructurings behind closed doors and with limited foreign involvement.

The Chinese government does not intervene in all bankruptcies; most bankruptcies and defaults are settled by conventional methods and the courts. However, when a company or industry begins to threaten financial stability or is viewed as strategically important by the government, the government uses the methods described below.

Putting Industries on a Diet

China’s broadest approach to cleaning up weak balance sheets is to address risks at the sectoral level through macroprudential controls. Regulators lay down new rules and requirements for an industry. Companies across the industry are forced to curb risky behaviors and improve their financial health by increasing equity and reducing debt. The goal of this blunt approach is to prevent latent problems from metastasizing into more serious financial risks.

The most far-reaching effort is the corporate deleveraging campaign. China has pushed the corporate sector at large to reduce debt and increase equity. A special focus of the campaign has been SOEs, which on average have higher debt levels than private firms. Chinese regulators have been somewhat successful in stabilizing corporate debt levels over the past few years, as shown in Figure 6.

Sources: Chinese Academy of Social Sciences, CEIC.

The past several years have seen a variety of “diets” targeting specific industries. Banks have been forced to increase capital levels, abandon shadow banking activities, and recognize more of the bad loans hiding on their books. Between the end of 2016 and the end of 2021, bank net capital increased by 12.7 trillion RMB, the level of shadow banking credit outstanding decreased by 5.2 trillion RMB, and banks wrote off 5.1 trillion RMB in bad loans.¹⁷ Certain industries, such as the peer-to-peer lending industry and the cryptocurrency industry, have been forced onto crash diets. Draconian new rules have forced most companies in these sectors out of business.

Forcing Arranged Marriages

When going on a diet isn’t enough to stave off financial distress, regulators must take more drastic action. In these situations, the government steps in to arrange an acquisition or capital injection by state firms or state-connected private enterprises. The goal is to avert a destabilizing bankruptcy that could have broader implications for a key sector or the wider economy.

These bankruptcies also offer an opportunity for a reassertion of control by the state in strategic or sensitive industries. Private enterprises or partially privatized SOEs become subject to firmer state control.

Funding for the distressed company usually comes from SOEs, state-owned investment funds, or state-owned asset management companies, which act as proxies for the Chinese government in carrying out the restructuring. Sometimes funding comes from state-connected private companies. These companies are persuaded to provide funding by formal or informal government guidance, often referred to as “national service.”

The companies that are on the receiving end of an arranged marriage sometimes continue in their existing form, albeit with new control parties. In other instances, they are reconstituted into an entirely new entity. Recent examples of arranged marriages include Nio, Founders Group, Bank of Jinzhou, Tsinghua Unigroup, China Unicom, and Suning.

Entering State Custody

In cases where an arranged marriage is insufficient, even more drastic action must be taken. In the most severe cases – in which a bankruptcy would have far-reaching financial, economic, and sometimes political consequences – Chinese regulators will put a company into “state custody.”

Under this mechanism, the government oversees the formation of a creditor committee made up of the company’s biggest lenders. Sometimes a separate risk committee is formed with direct representation by the government and important stakeholders. These entities directly supervise the bankruptcy process, guiding it to minimize broader financial and economic disruption.

Companies in state custody go into a form of suspended animation. Payments on debts and other liabilities are suspended. These companies often continue operating their day-to-day business for years, even though they are insolvent, as a result of government pressure to minimize disruption.

Behind the scenes, a highly politicized process works to resolve the bankruptcy. The Chinese government prioritizes the allocation of losses based on political and economic considerations rather than the hierarchy of creditor rights. The imperative is to maintain financial and social stability.

When this process is complete, the company may be restructured, sold off in whole or in part to other entities (usually state-connected buyers), or reorganized as a completely new entity.

Recent examples of Chinese companies that have entered state custody include China Huarong Asset Management, Anbang Insurance Group, HNA Group, Huaxia Life Insurance, and Baoshang Bank. Evergrande Group appears to be on the verge of entering state custody soon.

This Time is Different

China’s approach to repairing the broken balance sheets that threaten its economy reflects lessons learned from the past and the current priorities of Xi Jinping and the Communist Party. Its method for resolving critical balance sheets is not driven primarily by market forces or law. Although the Party has trumpeted its efforts to strengthen the rule of law and allow the market to play a “decisive” role in the economy, those goals often take a backseat to preventing financial instability. China is not unique in this regard. Many countries throw out their rules and procedures when faced with financial crises. China differs from other major economies in that its interventions are earlier, more pervasive, and less transparent.

Since Xi elevated financial risks to a top priority, in 2017, Chinese regulators have taken a more proactive approach to addressing the financial problems that have metastasized across the economy. Being given the green light to act has only reinforced the tendency of Chinese regulators toward intervention. China’s Financial Stability Law, currently in draft form, would formalize the broad scope of powers available to regulators to intervene early in the operations of financial institutions that are deemed a threat to financial stability. It would also create a financial stability fund, a permanent pool of capital to be used in bailouts and restructurings.

Regulators now show little hesitation in trying to fundamentally reshape problem industries, including by issuing new rules that force most existing players out of business. Life support is being pulled from distressed companies and banks. Between 2016 and 2019, the Chinese government forced nearly 700 centrally-owned SOEs that were classified as zombies to shut down.²⁵ Private conglomerates face visits from government-led risk committees. Weak companies, both state-owned and private, face heavy pressure to merge with stronger entities.

The scope for intervention has recently broadened beyond simply addressing financial risks. Chinese policymakers now openly talk about the government’s role in restraining the “disorderly and barbaric expansion” of capital.²⁶ Areas of the economy that are not subject to government control are viewed as volatile, sources of risk, and potential challenges to Party influence. The government’s efforts to reassert control over parts of the economy often result in a larger role for SOEs in targeted industries. The government views these enterprises as playing the role of stabilizers in the economy and reliably implementing government policy.²⁷

There is limited space for foreign firms in China’s current financial cleanup. In the banking sector restructuring of the late 1990s, foreign strategic investors provided significant capital and expertise. In contrast to that period, foreign firms have not played a significant role in any of China’s major balance sheet cleanups of the past several years. Their absence may reflect both China’s disillusionment with the financial expertise of the Western world after the global financial crisis and its view that foreign involvement might compromise the ability of policymakers to prioritize political goals during bankruptcies.

It is still too early to determine the economic outcomes of China’s interventions. Policymakers have prevented numerous financial risks facing the economy from morphing into a full-blown financial crisis. Early, often draconian intervention has stamped out small flames before they have become raging fires. Restructured industries and companies are now less volatile, but they are also less dynamic. The drive of entrepreneurs has been suppressed and the balance of power shifted from private companies to SOEs. China may fix its broken balance sheets and avoid a financial crisis – but it may become a much less vibrant economy in the process.

As of March 31, 2022, the Seafarer Funds did not own shares in the securities referenced in this commentary.

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.

1. “State Council's Comprehensive Report on the Management of State-owned Assets for the Year 2020 (国务院关于2020年度国有资产管理情况的综合报告),” National People’s Congress of the People’s Republic of China, 21 October 2021.
2. Emilia Jurzyk, Cian Ruane, and Helge Berger, “Resource Misallocation Among Listed Firms in China: The Evolving Role of State-owned Enterprises,” International Monetary Fund, 12 March 2021.
3. “Global Financial Stability Report,” International Monetary Fund, April 2022.
4. “People’s Republic of China: 2021 Article IV Consultation,” International Monetary Fund, 28 January 2022.
5. “IMF Country Report: People’s Republic of China: Selected Issues – Local Government Financing Vehicles Revisited,” International Monetary Fund, 4 February 2022.
6. Source: CEIC. Data as of 1 March 2022.
7. Himino Ryozo, “Lessons from the Japanese Banking Crisis,” Financial Stability Institute of the Bank for International Settlements, 22 April 2021.
8. Mariko Fujii and Masahiro Kawai, “Lessons from Japan’s Banking Crisis, 1991-2005,” Asian Development Bank Institute, June 2010.
9. Sun Li, “The Japanese Experience in Dealing with Zombie Enterprises (处理僵尸企业的日本经验),” People’s Daily, 20 July 2017.
10. “The Orderly Liquidation of Lehman Brothers Holdings Inc. Under the Dodd-Frank Act,” FDIC Quarterly, Federal Deposit Insurance Corporation, 18 April 2011.
11. Yi Gang, “Reflections and Insights on the International Financial Crisis (关于国际金融危机的反思与启示),” National People’s Congress of the People’s Republic of China, 22 October 2010.
12. Nicholas Lardy, China’s Unfinished Economic Revolution (Brookings Institution Press, 1998).
13. Lamin Leigh and Richard Podpiera, “The Rise of Foreign Investment in China’s Banks—Taking Stock,” IMF Working Paper WP/06/292, International Monetary Fund.
14. Le Xia, “Lessons from China’s Past Banking Bailouts,” Bank of Finland Institute for Economies in Transition, 21 January 2020.
15. “Huarong Gets a State Bailout after One of China’s Largest Bad Debt Manager Posted a Record US$15.9 Billion Loss from Soured Loans,” South China Morning Post, 19 August 2021.
16. “Xi Jinping: Deepen Financial Reform and Promote Healthy Development of a Virtuous Circle of Economy and Finance (习近平: 深化金融改革 促进经济和金融良性循环健康发展),” Xinhua, 15 July 2017.
17. Data from the China Banking and Insurance Regulatory Commission and the People’s Bank of China, accessed via CEIC on 4 April 2022.
18. “The Three Red Lines Hang High, Line Stepping Real Estate Developers Are Quickly Selling Assets (“三道红线”高悬 “踩线”房企出售资产忙“瘦身),” China Securities Journal, 30 September 2020.
19. Scott Kennedy, “China’s Risky Drive into New-energy Vehicles,” Center for Strategic and International Studies, November 2018.
20. “Form 20-F,” Nio Inc., 6 April 2021.
21. Charlotte Gao, “Anbang Fully under State Ownership (at Least for Now),” The Diplomat, 26 June 2018.
22. Laura He, “Anbang Insurance Gets US$10 Billion Rescue Bailout from Beijing after Ex-chair Wu Xiaohui Admits Fraud,” South China Morning Post, 4 April 2018.
23. Wu Yujian and Guo Yingzhe, “Watchdog Hands Anbang Units to New Insurance Firm,” Caixin, 11 July 2019.
24. Wu Yujian and Guo Yingzhe, “Talk of Incentives Doesn’t Entice Investors to Bid on Anbang Assets,” Caixin, 13 October 2021.
25. “State-owned Asset Supervision and Administration Commission Speeds up Disposal of Zombie Enterprises, 700 Firms Have Exited the Market over the Past Three Years (国资委加快处置“僵尸企业” 3年间约700户企业实现市场出清),” Sohu, 29 December 2020.
26. Ji Siqi, “China’s Capital Concerns Prompt Calls to Prevent ‘Disorderly Expansion and Barbaric Growth’,” South China Morning Post, 20 December 2021.
27. Nicholas Borst, “SOE Reform in China – Implications for Policymakers and Investors,” Seafarer Capital Partners, March 2021.