Is China Really Too Big to Fail? (Part 2)

This is Part 2 of a two part series of posts by Shannon Brandao*, an international attorney and China expert and the editor of China Boss. Part 1 is here.

A 2019 Bank of Finland study revealed that in Western market economies, public confidence in a country’s banking sector is “highly sensitive to the industry-level financial stability indicators,” such as “cumulative number of failed banks, depositors affected by such failures and total bad debt in the sector.” In China’s financial system, however, nearly all the nation’s banks are owned and controlled by the state, and the Chinese Communist Party (“the Party”) can suppress data about failing banks and systemically important financial intermediaries by blocking information in its state-controlled media. China also has a Deposit Guarantee Scheme (DGS), which insures deposits in local and foreign currencies for businesses and individuals up to CNY500,000 ($78,000) per depositor per bank. That policy is intended to slow fear-triggered financial contagion, and, as Fitch Ratings has said, act as “the first line of defense for securitization deals against set-off risk in the event of a bank default or insolvency in China.”

But what if that first line of defense falters when systemically tested? What if China’s regulators are losing control of social media algorithms to young techies or foreign actors with other political or commercial agendas? What if hordes of Chinese netizens gather in secretive investor groups on Weibo, on foreign trading platforms or on the dark web where they are free to share financial information on Chinese banks and firms, as well as ways of getting money out of China? What if the authorities blunder in their attempts to calm fears during the debt crisis, as they blundered at preventing the panic during the initial coronavirus outbreak in Wuhan? What if the government’s own off-balance sheet liabilities are so great that it has no way to absorb the debts of systemically important firms and industries at risk of contagion without significant economic or political disruptions? What if all the above becomes apparent at the same time an overambitious and politically insecure former bureaucrat makes a series of policy missteps at home and abroad that cause investors to lose faith in his ability to govern?

In other words, China’s industry-level financial stability indicators are connected directly to the state and when the lights blink red, investors can only infer the degree of sovereign failure – the prospect of which is inherently more unsettling than the collapse of a single firm or industry. Consequently, investor panic and financial contagion in China’s economy is dicier and, potentially, more volatile than in market economies with independent banking sectors.  Furthermore, although the Chinese Communist Party has long sought to tightly control information so that it can govern without dissent, there is plenty of evidence of the use of circumventions, and it is naïve to think that methods of obtaining information relating to the financial interests of individuals and groups in China do not exist.

President Xi’s “common prosperity” crackdowns, alienation of trading partners and zero-Covid policy are already prompting investors to rethink China

Chinese leader Xi Jinping’s “common prosperity” campaign is a new twist on the old Communist-era social contract with the Chinese people. But one could just as easily describe it as a backflip on market reforms that were supposed to open China to competition. Xi has been moving quickly to reassert the state’s control over Chinese firms in pursuit of a “dual-circulation” state capitalist system that he says will boost domestic consumption and advance home-spun technologies for national rejuvenation.

But there are problems with Xi’s plan, and knowing when to stop draining the lifeblood out of the Chinese economy is chief among them. In September, China business and tech reporter Chang Che enumerated 18 “common prosperity” crackdowns in a Twitter thread to illustrate his point that “we’re way beyond ‘tech’ now.” Although cast as an effort to build a more equal society, few China watchers doubt Xi is gunning for China’s most successful private companies because he sees the entrepreneurs that run them as rivals. But investors have also begun to question Xi’s motives: At least “$1 trillion has been wiped off the valuation of Chinese firms since February,” and the country’s wealthiest are “running for cover,” Time magazine said.

Adding to the list of uncertainties, President’s Xi’s chest-thumping abroad has increased geopolitical tensions and pummeled China’s soft power. In June, the Pew Research Center found that China’s “international image across 17 advanced economies remains broadly negative” and that “[c]onfidence in Chinese President Xi Jinping remains at or near historic lows in most places surveyed.” Reasons given by those polled were the government’s lack of respect for personal freedoms and its poor handling of the initial Wuhan outbreak. But it’s just as likely that Xi’s “wolf warrior diplomats” are co-piloting the downward spiral in global perceptions. Two of Ministry of Foreign Affairs spokesman Zhao Lijian’s 2020 twitter bombs, in which “he repeatedly promoted an unsubstantiated—and absurd—theory” about the U.S. as the origin of Covid and shared an “illustration of an Australian soldier holding a knife to the throat of an Afghan child”, seem to have done the most damage, Bloomberg’s Peter Martin says.

But MOFA’s international grandstanding is costing China a lot more than just soft power. In January, The Wall Street Journal reported an uptick in China’s stockpiling of essentials and domestic production planning. WSJ’s analyst also noted that the National Development and Reform Commission had introduced a “security-oriented economic agenda” that “is trying to fortify the Chinese economy against a prolonged period of tension” with the U.S. and its allies.

If that isn’t enough to make investors reconsider their China exposure, there’s Xi’s zero-Covid policy, which Goldman Sachs analysts predicted could keep China closed to international travel for all 2022 and possibly part of 2023. Hard lockdowns imposed by local governments to manage sporadic outbreaks of the Omicron and Delta variants are not only causing massive disruptions for millions of Chinese citizens and businesses, but also for global supply chains, and experts say that if quarantine and testing backlogs at the country’s ports – which are among the world’s busiest – continue, companies will seek ways to avoid China as much as possible.

Asymmetry of information: Revelations of hidden debt in firms or industries once thought financially solid can destroy public confidence overnight, and China’s $3 trillion in FX reserves may not be enough to restore it

Recent news that China’s 13th largest developer, Shimao Group, is also struggling sent shockwaves across the property industry. Shimao had not been designated by the PBOC or the Ministry of Housing and Urban-Rural Development – the two supervisors responsible for curbing over-leveraging in China’s real estate market – among firms in danger of crossing any of Beijing’s “three red lines” – rules that restrict new borrowings of heavily indebted developers annually. The sudden default of Shimao’s Shanghai unit on a US$101m project in early January alerted analysts to serious problems with transparency and oversight, leading some to “fear Shimao’s difficulties could be more destabilizing for the Chinese property market than the Evergrande and Kaisa crisis,” according to Aljazeera.

Aljazeera’s reporters also described “a general sense of unease over the company’s lack of visibility” that had emerged after investors learned “that homebuyers who recently purchased 96 Shimao properties in Shanghai were not able to register for the transfer of ownership titles, as the properties had already been pledged to one of Shimao’s lenders,” and that “[f]or many months, Shimao’s onshore bonds were also traded at more heavily discounted prices than their offshore bonds.” The speed of credit down ratings and a sharp plunge of “more than 50 percent” in Shimao’s share prices since November had also “caught investors off-guard.”

The Shimao example also highlights how word of insolvencies, hidden debts and sell-offs in China either spreads too quickly for Chinese censors to effectively block on social media or is passed around in other ways. Experts say Beijing is cracking down on social media algorithms because central propaganda agencies worry about losing control of online content. Consequently, authorities have proposed the “world’s first government regulation dedicated to ‘algorithm-empowered recommendations’ to curb the use of technology, and to hold owners of these algorithms accountable for any content that run contrary to state policies,” The South China Morning Post reported. Nevertheless, a spate of runs on small banks propelled by social media rumors hints that regulators also struggle to prevent liquidity risks that can occur this way.

Finally, that China has the world’s largest foreign currency reserves would be of little comfort in a true financial crisis. As the last guarantee on foreign debt, China’s $3.128 trillion in FX reserves are plenty and then some. But even though Beijing needs to keep amounts high to maintain confidence in the economy, it has a history of burning through reserves fast. In a January 2016 Bloomberg interview, Michael Shaoul of Marketfield Asset Management said China had been using its FX reserves at an alarming rate that he believed was big enough to have an impact on domestic liquidity. Shaoul thought China’s FX reserves were then being used to drive economic growth with additional infrastructure investment and to compensate for “very substantial capital flight.”

Authorities in China have dueled with capital flight for years, using a variety of legal weapons from huge fines on banks and other merchants that help customers move money overseas to bans on cryptocurrencies. But, Bloomberg analysts say, the “battle is more intense than ever,” and the scale of foreign funds that have been flooding into China’s borders post-Covid creates more risk for asset bubbles that “would burst were that money to start pouring out.” On the flip side, permitting increased outflows may reduce the bubble risk, but “increases the potential for money to flood out too quickly — as the country witnessed in the wake of the 2015 currency devaluation,” Bloomberg said.


Decades of over-leveraging, combined with President Xi’s various domestic and foreign policies, now threaten to upend China’s state capitalist system and cause a collapse of investor confidence in China, Inc.

In closing, according to Bloomberg, authorities’ strategy to ring-fence Evergrande and other failing developers rests on plans for the state to absorb the shock by “mak[ing] it easier for state-backed property developers to buy up distressed assets of debt-laden private firms by not counting such loans as debt under rules that cap borrowing.” Beijing has also directed state-owned banks “to issue debt to fund real estate acquisitions,” Reuters said. But for the reasons described above (and as I argue in the January 24th issue of the China Boss newsletter), moves to expand state control over failing private developers are also fraught with risk because SOEs, like China’s state-owned banks and local governments, are brimming with their own bad debts.

But the state has been absorbing debt like this for decades.

While mayor of Beijing in the mid-2000s, Chinese vice president Wang Qishan is said to have compared the constant shuffling of China’s financial and non-financial corporate debt this way to a game of musical chairs that at some point would overwhelm the entire financial system and force Beijing to relinquish control of state entities that comprise 40% of the economy through privatization. See Desmond Shum, Red Roulette: An Insider’s Story of Wealth, Power, Corruption, and Vengeance in Today’s China (London, Simon & Schuster, 2021), p.174, which I strongly urge you to read.

The latter is also what JPMorgan Chase CEO Jamie Dimon probably meant when he joked late last year that his firm would outlast the Chinese Communist Party. No doubt other global investment firms figure the same, though whether they can outcompete powerful locals – who, Wang suggested, were “get[ting] the bullets ready” for that day – is less certain.

In the end, President Xi’s crackdowns on the private sector – the primary source of jobs and driving force behind China’s economy  – combined with his zero-Covid approach at home and foreign policy failures abroad may turn out to be catastrophic in the coming weeks and months – especially if economic growth crumbles under the weight of closed borders and hard lockdowns or Chinese trade is ensnarled in blockades as punishment by the West for a two-pronged military campaign against Ukraine and Taiwan. Moreover, that China’s domestic debt is growing at nearly four times the rate of its economy means that Chinese families, themselves strapped with loan payments, are unlikely to spend enough to bailout their government from its own financial mismanagement. But of all the uncertainties in determining if China can prevent system overload in the current debt crisis – whether its trillions in FX reserves would be enough to reassure investors that it can guarantee foreign debt, band-aid over lagging consumption with more investment in infrastructure (which helped to create the current property debt crisis in the first place), and cover the state’s own liabilities while compensating for increases in capital flight when the lights blink bright red on President Xi’s state-led industry-level financial stability indicators is perhaps the most uncertain of all.


*Shannon Brandao is an international lawyer and the founder of China Boss News on Substack and the China Boss Newsfeed with over 20k followers on LinkedIn. A graduate of UCLA (BA Politics with a China focus), and the University of Miami School of Law, she also holds an LLM in International Business Law from the Katholieke University of Leuven in Belgium where she now resides with her husband, two cats, and a bossy terrier that keeps everyone in line.

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