Is China too big to fail? Evaluating financial contagion and systemic risk in China’s current debt crisis (Part 1)

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

Much media attention has been given to the plight of China Evergrande Group – a behemoth property developer with over $300 billion in debt obligations that defaulted on $1.2 billion in foreign bonds last December. But Evergrande’s debt, as eyewatering as it is, belies the severity of China’s current debt crisis. According to Bloomberg, Chinese authorities have been “stepping up efforts to ring fence Evergrande, not save it,” believing “[a] run on property firms in the wake of an Evergrande failure” would be far more dangerous to the overall economy, nearly a third of which depends on China’s property market.

Beijing’s rush to contain the fallout from Evergrande’s insolvency shows that state control over the banking system and news media does not eliminate systemic risk in the Chinese economy. Rather, the urgency to diminish the ripple effects from a failing developer that, according to Reuters, only “accounts for 4% of Chinese real estate high-yields” in the dollar bond market suggests systemic risk is high and that how investors learn about and relate to the country’s economic failures may be different than in systems with independent banks and a free press. I’ll talk more about that later, but first – to evaluate systemic risk and financial contagion in China’s current debt crisis – we’ll need to look at the country’s astronomical levels of indebtedness.

China’s domestic debt has been growing nearly four times faster than its economy

While China’s economic growth from 2010-2019 averaged 7.7%, it also began trending downward, falling in recent years to 4-5%. Domestic debt for the same period, however, skyrocketed to an average annual rate of around 20%, surging even higher in 2020 after the initial Covid-19 outbreak. By 2021, China’s debt had reached “nearly four times” GDP, according to CNBC news analysts.

China’s dangerous levels of domestic debt can be traced to a $600 billion stimulus package – considerably larger than that offered by the U.S. ($152 billion) and Japan ($100 billion) at the time – released in 2008 to ease pressures on national economic growth stemming from the global financial crisis. Although China was somewhat insulated from the downturn in U.S. and European markets, it “still suffered from a sharp decline in exports and a major stock market correction that wiped out an estimated two-thirds of its market value,” according to the Center for Strategic and International Studies. Experts believe that easy access to credit after the stimulus, which was mostly funded by loans from state-owned banks, as well as the government’s infrastructure investment policies, motivated too many Chinese firms to take excessive leverage risks.

China’s corporate debt dwarfs the global average. Most of it, however, is held by state-owned firms (SOEs) in a wide range of industries outside the property sector

When S&P Global Ratings surveyed over 25,000 global entities in October 2021, it found that Chinese firms had a debt-to-GDP ratio of 159% – almost twice that of U.S. firms – and that 91% of China’s construction and engineering firms were dangerously over-leveraged. S&P defines high indebtedness “as a ratio of funds from operations to total debt, or debt to EBITDA as more than four times.”

More unexpected, however, was the finding that high levels of indebtedness could also be seen in Chinese firms in 7 additional industries – transportation (86%), retail (79%), leisure/media/entertainment (67%), business and consumer services (64%), consumer goods (59%), pharmaceuticals (58%), and real estate (57%). Although S&P didn’t analyze firms by ownership structure, a 2019 OECD report found that state-owned enterprise (SOE) debt accounted for over three-quarters of China’s non-financial corporate debt. But the key takeaway is that China’s property sector – although a current news media focus – is not extraordinary for having many over-leveraged firms. More fundamentally, the commonplaceness of over-leveraging across so many industries in China should draw more concern for its increased potential to transmit financial contagion via runs on failing firms.

Chinese banks hold hundreds of billions in bad-debts and non-performing loans, and President Xi is stripping them of their independence

Most commercial banks in China are state-owned or state-controlled and lending decisions are still firmly connected to local and central government prerogatives, rather than market considerations. In July 2021, Liu Zhongrui, an official at China Banking and Regulatory Commission (CBIRC) told reporters that “[o]utstanding non-performing loans in the banking sector stood at 3.5 trillion yuan ($540 billion) by end of June,” and that “Chinese banks are facing the threat of rising bad loans in the future as the current economic recovery is unbalanced and lacks a solid foundation,” Reuters reported.

The People’s Bank of China (PBOC), China’s central bank, had been pushing to move special mention loans – which are those at risk of becoming nonperforming, the number of which is also sharply rising – off balance-sheet in order to lower lending rates and reduce the appeal of shadow-banking in corporate finance. The plan might have worked had Beijing not begun to strip away the financial supervisor’s independent discretion. In October 2021, Wall Street Journal’s Lingling Wei reported that China’s top anticorruption agency was spearheading a “sweeping round of inspections” of “25 financial institutions at the heart of the Chinese economy,” for their ties to “big private-sector players.” PBOC and the Shanghai office of the China Banking and Insurance Regulatory Commission were both targeted in December. The “[i]nspections aim to ensure full Communist Party control over what is seen as the lifeblood of the economy,” Wei said. But Cornell University professor Eswar Prasad, a former China expert for the IMF, told the WSJ: “That notion of operational autonomy is now coming into conflict with a more intrusive role of the government in the economy. The PBOC is losing.”

Local governments’ balance sheets are so debt-ridden, Beijing calls them a gray rhino, but their hidden liabilities are causing greater concern among investors and analysts  

During a State Council Information Office (SCIO) briefing in 2017, Wang Zhijun, one of the directors of the Central Leading Group on Financial and Economic Affairs, referred to China’s “shadow banking system, property bubbles, inflated local debt levels and illegal fund raising,” as the nation’s gray rhinos, or serious financial risks that have not been given enough attention. By the end of fiscal year 2020, according to official data, China’s local government debt had ballooned to 25.7 trillion yuan ($3.97 trillion), but that is only the amount reported on their balance sheets.

Local government financing vehicles (LGFVs) – which are investment companies created by local authorities to sell development bonds that are subsequently repackaged as wealth management products for individuals – have accumulated much more than that in debt. Those liabilities, however, have been transferred to the LGFVs’ books even though local governments themselves are obligated. Although estimates of local government debt, including that of LGFVs, vary widely due to irregular bookkeeping standards in China, Nomura analysts have estimated LGFV debt at nearly double the amount on government books, and Goldman Sachs said it is equivalent to half of China’s GDP with 60% of current bonds issued “used to repay maturing debt … rather than [for] new investment.”

Private firms turn to shadow-banking, and ordinary families cannot pay down debt  

In a 2018 article, The Hidden Risks of China’s Private Sector Debt Crisis, The Wall Street Journal’s Nathan Taplin argued that China’s “SOEs [had] improved their health partly at the expense of more efficient private companies,” and that, “[i]f this persists, it will mean structurally lower income growth—and precipitate a financial crisis anyway if private firms and households can’t get rich quickly enough to keep subsidizing their state cousins.” Because government-backed SOEs are still heavily favored over private companies in formal corporate lending, up to “80% of [private] firms’ financing goes through informal channels,” most often in China’s unregulated shadow banking industry. Although some analysts think that the trend might boost innovation, others who have examined firm financing patterns in China more closely found that “firms with access to formal bank loans tend to grow faster.” This is probably due to more onerous credit terms for private borrowers – who’ve traditionally been considered high risk in China – like high interest rates and harsh repayment schedules.

Sadly, China’s rising household debt suggests that even ordinary families have fewer funds to cover daily needs and emergencies. While Chinese citizens are typically thought to be thrifty and avid savers, He Huifeng at The South China Morning Post says that over-leveraging is the trend “among upper middle class households who are borrowing to the hilt to invest in China’s economic recovery from the coronavirus pandemic, either by snapping up property or investing in the stock market.” She also talked to “families from across the socio-economic divide” who acknowledged “their cash flow has reached a critical threshold,” but said they were unable to “reduce their debt exposure.”

Is China really too big to fail?

A 2019 Bank of Finland study showed 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.

Stay tuned for Part 2 tomorrow.

*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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