The growing number of Chinese companies with distressed balance sheets poses a major threat to China’s financial stability. Property developers and private conglomerates are overburdened with debt and increasingly unable to access new financing. Many state-owned enterprises (SOEs) are not profitable and cannot pay their debts without government support. Local governments rely on shell companies to finance expenses through loans and land sales. Some small banks are poorly capitalized and highly exposed to risky borrowers.
Faced with these threats to financial stability, China has stepped up regulatory intervention to defuse the risks. This approach was not crafted in a vacuum; Chinese politicians have drawn lessons from the successes and failures of Financial Cleanups 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 relies too heavily on real estate. Japan’s failure to quickly resolve corporate bankruptcies and bad loans exacerbated the problems and held back long-term economic growth.
Chinese economists have also cataloged a long list of mistakes made by US regulators and policymakers during the global financial crisis. Key among them was that allowing Lehman to collapse unnecessarily worsened the severity of the financial crisis.
China also learned a lot from its own experience in restructuring its banking sector in the late 1990s. That financial cleanup involved huge costs. According to some estimates, China had to commit approximately 30 percent of its gross domestic product (GDP) to cleaning up the banking system. The failure to address the structural problems at the heart of the banking system means that many of the underlying problems were not resolved and remain today.
A new playbook to clean up the financial sector
China’s current approach to dealing with financial risks dates back to the National Financial Work Conference in 2017. At that meeting, President Xi Jinping declared financial stability a major national security risk and ordered China’s financial regulators to take the lead.
With their new marching orders, Chinese regulators set out to clean up the financial system. These efforts are shaped by China’s political priorities under Xi: stability, control, and self-reliance.
When significant financial risks arise in a specific industry or company, Chinese policymakers adopt one of three strategies:
Put industries on a diet – China’s first tactic to clean up financial risks is to impose macroprudential controls at the sectoral level. Regulators set new rules and requirements for an industry. Companies across the industry are being forced to curb risky behaviors and improve their financial health by increasing capital and reducing debt. The goal of this aggressive approach is to prevent latent problems from morphing into more serious financial risks.
Perhaps the most influential of these industry-specific diets are the “three red lines” implemented for the real estate sector in 2020. The policy establishes balance rules that real estate developers must comply with or face restrictions on their borrowing capacity. Many big developers, notably Evergrande, have run into financial trouble after the rules were adopted, showing that crash diets can create more problems than they solve.
“Arranged marriage” with the State – When going on a diet is not enough to avoid financial problems, regulators must take more drastic measures. In these situations, the government steps in to organize a takeover or injection of capital by state-owned companies or state-related private companies. The goal is to avoid a destabilizing bankruptcy that could have broader implications for a key sector or the economy as a whole.
These bankruptcies also offer an opportunity for the reassertion of state control in strategic or sensitive industries. Private companies or partially privatized state companies become subject to tighter state control.
Financing for the troubled company usually comes from state-owned companies, state-owned investment funds, or state-owned asset management companies, which act as proxies for the Chinese government to carry out the restructuring. Sometimes the funding comes from private companies connected to the state. These companies are persuaded to provide financing through formal or informal government guidance, often referred to as “national service”.
Entering State Custody – In cases where an arranged marriage is insufficient, even more drastic measures must be taken. In the most serious cases, where a bankruptcy would have far-reaching financial, economic, and sometimes political consequences, Chinese regulators will place a company under “state custody.”
Under this mechanism, the government oversees the formation of a creditors’ committee made up of the company’s main lenders. Sometimes a separate risk committee is formed with direct representation from the government and important stakeholders. These entities directly oversee the bankruptcy process, guiding it to minimize broader financial and economic disruption.
Companies in state custody enter a form of suspended animation. Payments of debts and other liabilities are suspended. These companies often continue to operate 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 bankruptcy. The Chinese government prioritizes loss allocation 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 in whole or in part to other entities (typically state-related purchasers), or reorganized as an entirely new entity.
control is the goal
Although the Communist Party has touted 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.
Regulators now show little hesitation in trying to fundamentally reshape troubled industries, including by issuing new rules that force many existing players out of business. Life support is being withdrawn from struggling businesses and banks. Private conglomerates face visits from government-run risk committees. Weak companies, both state-owned and private, face strong pressure to merge with stronger entities.
The scope of intervention has recently expanded beyond simply addressing financial risks. Chinese lawmakers are now outspoken about the government’s role in restricting “disorderly and barbaric expansion” of capital. Areas of the economy that are not subject to government control are seen as volatile, sources of risk, and potential challenges to CCP influence.
China’s new approach to financial stability is likely to result in a more state-centric economy. For example, following the crackdown on the real estate sector, state property developers have used their privileged access to finance to make large asset acquisitions from private developers. As a result, the real estate sector is undergoing slow-motion nationalization.
Through early interventions, often draconian in nature, policymakers have prevented financial risks from morphing into a full-blown financial crisis. However, China’s enthusiasm for ending financial risks is also hurting the economy’s dynamism. While Beijing has studied the mistakes of previous financial cleanups, its current approach risks making new ones.