China’s interventionist approach to financial risk management

The growing number of Chinese companies with distressed balance sheets poses a serious threat to China’s financial stability. Developers and private conglomerates are overwhelmed with debt and increasingly unable to access new financing. Many state-owned enterprises (SOEs) are extremely unprofitable and cannot service their debts without government support. Local governments are dependent on shell companies that finance costs through loans and land sales. Some smaller banks are poorly capitalized and heavily exposed to borrowers.

Faced with these threats to financial stability, China stepped up its regulatory intervention to mitigate the risks. This approach was not developed in a vacuum; Chinese politicians have learned from successes and failures financial purges in Japan, the West, and China’s recent past.

Chinese economists have long focused on the similarities between China’s current economic problems and those of Japan’s bubble economy, especially high levels of debt and an economy that is overly dependent on real estate. Japan’s inability to quickly resolve corporate bankruptcies and bad loans has exacerbated problems and stalled long-term economic growth.

Chinese economists have also compiled a long list of mistakes made by US regulators and politicians during the global financial crisis. Key among them was that allowing Lehman’s disorderly collapse unnecessarily exacerbated the severity of the financial crisis.

China also learned a lot from its own experience of restructuring its banking sector in the late 1990s. This financial cleansing came at a huge cost. According to some estimates, China had to contributes approximately 30 percent of its gross domestic product (GDP) to clean up the banking system. The failure to address the structural problems underlying the banking system means that many of the underlying problems have not been resolved and still remain.

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New textbook on cleaning up the financial sector

China’s current approach to financial risk management can be traced back to National Financial Performance Conference 2017. At that meeting, President Xi Jinping said that financial stability is an important national security risk and ordered China’s financial regulators to take the lead.

With their new marching orders, Chinese regulators have decided to bring order to the financial system. These efforts are shaped by China’s political priorities under Xi Jinping: stability, control, and self-sufficiency.

When significant financial risks arise in an industry or a particular company, Chinese policy makers apply one of three strategies:

Put the industry on a diet China’s first tactic to eliminate financial risk is to introduce macroprudential controls at the sectoral level. Regulators set new rules and requirements for the industry. Companies across the industry are being forced to limit risk-taking behavior and improve their financial position by increasing equity and reducing debt. The goal of this straightforward approach is to prevent hidden problems from metastasizing into larger financial risks.

Perhaps the most influential of these industry diets are “three red lines“Deployed for the real estate sector in 2020. The policy sets out the balance rules that developers must adhere to or face limits on their ability to borrow. Many major developers, most notably Evergrande, have run into financial difficulties since the rules were passed, proving that emergency diets can create more problems than they solve.

Arranged marriage with the state When diet is not enough to prevent financial hardship, regulators must take more drastic action. In such situations, the government intervenes to arrange for the acquisition or injection of capital by state-owned firms or state-affiliated private enterprises. The goal is to prevent destabilizing bankruptcies that could have broader repercussions for a key sector or the economy as a whole.

These bankruptcies also provide an opportunity to reassert state control over strategic or sensitive industries. Private enterprises or partially privatized state-owned enterprises are subject to tighter state control.

Funding for a troubled company usually comes from state-owned enterprises, state-owned investment funds, or state-owned asset management companies that act as fiduciaries of the Chinese government in carrying out the restructuring. Sometimes funding comes from private companies linked to the government. These companies are persuaded to provide funding at the official or unofficial direction of the government, often referred to as “national service”.

Admission to custodyIn cases where arranged marriages are not enough, even stronger action must be taken. In the most dire cases, where bankruptcy would have far-reaching financial, economic, and sometimes political consequences, Chinese regulators place the company under “state tutelage.”

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Under this mechanism, the government oversees the formation of a committee of creditors made up of the company’s largest creditors. Sometimes a separate risk committee is formed with direct participation from the government and important stakeholders. These organizations directly control the bankruptcy process, directing it in a way that minimizes wider financial and economic shocks.

Companies under state protection are in a state of suspended animation. Payments on debts and other obligations are suspended. These companies often continue to run their day-to-day business for years, even if they are insolvent, as a result of government pressure to minimize disruptions.

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

Upon completion of this process, the company may be restructured, sold wholly or partly to other entities (usually government-related buyers), or reorganized into an entirely new entity.

Control is the goal

While the Communist Party trumpets its efforts to strengthen the rule of law and enable the market to play a “critical” role in the economy, these goals often give way to preventing financial instability.

Now, regulators have little hesitation in trying to fundamentally change troubled industries, including by passing new rules that are forcing many existing players out of business. Life support is disconnected from troubled companies and banks. Private conglomerates face visits from government risk committees. Weak companies, both public and private, face strong pressure to merge with stronger structures.

Intervention has recently expanded beyond the simple elimination of financial risks. Chinese politicians are now open about the government’s role in containment “Random and barbaric expansion” of capital. Areas of the economy not under government control are seen as unstable, sources of risk, and potential challenges to CCP influence.

China’s new approach to financial stability is likely to lead to a more state-led economy. For example, after the crackdown on the real estate sector, public developers used their privileged access to finance to make large acquisitions of assets from private developers. As a result, the real estate sector is undergoing slow nationalization.

Through early intervention, often draconian in nature, policymakers prevented financial risks from turning into a full-blown financial crisis. However, China’s enthusiasm to eradicate financial risks is also hurting the economy’s dynamism. While Beijing has learned from the mistakes of past financial purges, its current approach risks committing new ones.