The Chinese government has been engaged in a decade-long campaign to stave off a financial crisis triggered by excessive debt growth, an effort that has critically damaged its $10.7 trillion real-estate debt market and set the stage for a political showdown between local and central governments as the country attempts to navigate sharply slowing economic growth and new geopolitical headwinds.
At the heart of Beijing’s debt problems has been the growth of the so-called shadow banking sector, made up of firms that act like banks by issuing loans but that are not subject to the same regulations and supervision as traditional banks, according to a report issued Monday by the Center for Strategic and International Studies, a nonpartisan think tank.
“China is currently facing a long-term, structural economic showdown and rising risks of a financial crisis,” wrote Logan Wright, a China expert at Rhodium Group and the author of the report.
He noted that a shrinking working-age population, rising wages, high debt levels and a stagnating property sector mean that the supercharged growth China has experienced over the past 30 years will not be repeated.
“Local governments laden with debt are increasingly unable to implement Beijing’s policy initiatives,” he wrote. “A economic rebound after lifting Covid-related controls on citizens’ movements and activity is already underway … but all of the structural headwinds to China’s growth will persist.”
Massive stimulus
The role of shadow banks in China’s current debt crisis carries ironic echoes from the 2008 financial crisis in the West, when lightly regulated nonbank financial institutions in the U.S. were a major source of the lending that inflated the residential real-estate bubble, which eventually burst, with calamitous effects.
It was China’s attempt to insulate itself from the subsequent global recession that led to its own love affair with debt, according to Wright. China’s stimulus package was officially tallied at $588 billion, or 13% of the country’s GDP at the time, but the real effect was much larger because the government leaned on the banking system to make loans in addition to making direct fiscal outlays.
“Banks were encouraged to lend aggressively, and did so, to all types of borrowers, but particularly those that were state-owned,” Wright wrote, noting that by the end of 2012, the size of China’s banking system had doubled in terms of assets in just four years.
China’s political class ignored the financial risks that accompanied such headlong growth because of the benefits of rising output and employment.
Moral hazard
Meanwhile, the state’s ultimate control over the economy’s financial system led market participants to believe that the government would step in to prevent serious losses that might result from ever-riskier lending.
These conditions were conducive to a wave of financial speculation, indirectly encouraged by the [People’s Bank of China],” Wright wrote. “By intervening regularly to keep money market rates low and stable, the central bank encouraged shadow banks not only to borrow aggressively in the money markets at low rates but also to add leverage to their positions in order to generate yield.”
The explosion of shadow-bank lending, initially a tool to help China survive the 2008-2009 global recession, transformed its financial system into one more reminiscent of that in the U.S. before the financial crisis, when off-balance-sheet structures hid the magnitude of private-debt levels and generated significant, if hidden, risks.
“One of the strangest responses, with hindsight, to the global financial crisis — which was caused in some sense by shadow finance in the U.S. and Europe — was the creation of a shadow financial system inside China,” said Brad Setser, former senior adviser to U.S. Trade Representative Katherine Tai, at an event held Monday to introduce the report.
Shadow boxing
By 2016, Chinese regulators realized that the unregulated growth of the shadow banking system threatened to create financial instability while robbing the state of its control over the allocation of credit.
Chinese Communist Party leaders were therefore “forced to contemplate difficult choices about how to slow the growth of overall debt and shrink the shadow banking system without affecting the broad economy too seriously, which could trigger unemployment and social discontent,” according to Wright.
Regulators devised a series of policies aimed at limiting debt growth, with a particular focus on local governments, which had for years financed infrastructure projects by borrowing from investors who assumed the central government in Beijing would bail them out if such projects failed to produce the necessary revenue to repay the debts.
The campaign largely succeeded in stabilizing debt levels across the Chinese economy, but it led to a sharp drop in economic activity starting in 2018 and to a scramble among property developers to replace shadow-bank funding.
Chinese housing developers began funding their operations through preconstruction sales of homes, shifting their borrowing from shadow banks to prospective homeowners.
“This process also introduced some Ponzi-type elements of financing into China’s property sector, as the rush to raise money from presales was likely necessary because shadow banking loans were being called in,” Wright wrote.
By 2021, home buyers were funding construction of new homes to the tune of $1 trillion per year, with prospective homeowners encouraged by ever-rising real-estate prices and the belief that the Chinese government wouldn’t allow developers to fail to deliver promised housing.
The introduction of Ponzi-like financing systems into an industry that over the previous two decades had been one of the most important drivers of China’s
economic growth had disastrous effects when property construction and sales began plummeting in the wake of the default of property giant Evergrande Group in December 2021, according to the report.
The U.S. response
As China seeks to stabilize its real-estate market and contain its shadow banking system, the question of how U.S. policymakers and businesses should relate to the Chinese financial system looms large.
Wright commends recent efforts by Congress and U.S. financial regulators to use laws like the Holding Foreign Companies Accountable Act to increase scrutiny of Chinese companies’
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efforts to raise money in U.S. financial markets, but he sees little advantage to the U.S. in attempting to sabotage the Chinese economy by forcibly decoupling from it.
“Influencing investors’ perceptions of China’s financial markets or patterns of participation within those markets is not [in America’s interest],” he wrote. “Beijing has its own challenges in attracting foreign inflows given its slowing economy, declining interest rates, opaque policymaking, and stagnant reforms.”
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