The Covid-19 crisis has put pressure on China’s economic development, and, by extension, on its financial sector. In a series of short analytical pieces, MERICS Visiting Academic Fellow Michiel Haasbroek discusses the impact on different levels. This third and last part will discuss what immediate changes and new trends are likely to emerge from the current situation. This article builds on part 1 and part 2 of the series.
While consistently plagued by inefficiencies and pockets of emerging financial risk, China’s financial system, or at least its banks, has been shored up, with banks enjoying almost-guaranteed profitability through financial repression. Indeed, banks account for over 35 percent of China’s profit generation. These profits have been partially distributed as dividends, filling the pockets of their many stakeholders. Profitability will come under pressure, but will be helped along by creative accounting for loan losses.
As asset quality is set to deteriorate and banks have been asked to make concessions, liquidity will come under pressure, too. The regulator has therefore kept an eye on banks not distributing dividends; for instance, Bank of Xinjiang which recently announced it would scrap its dividend payment. Finally, the expanding balance sheets of banks means there is an ongoing need to strengthen capital buffers. This precarious situation is likely to last, as reforms towards greater financial stability have been sidelined by the coronavirus crisis.
China’s financial sector is challenged by inequality and de-globalization
China’s financial sector has a pivotal role in two of the country’s most pressing issues: inequality and de-globalization. Inequality has reached such an extent that there are vast differences between regions (underlining the limited success of past campaigns to “open up the West”). It is likely that there will be another push for development, likely relying on regional lenders to provide credit support. Investments in technological upgrading are likely to widen regional gaps, but benefit the overall economy. Any innovative industrial policy ought to embrace underdeveloped regions, but since they lack the necessary concentrations of industry, skilled labor and supporting institutions, success will remain elusive.
Solving inequality through economic growth consistently stumbles on the epic scale of the changes needed for the party-state to manage transitions relating to China’s low skilled workers, including over 290 million migrant workers Labor costs have increased to such an extent that China’s lower-skilled manufacturing sectors are no longer internationally competitive, yet a vast army of people lack skills to work at higher levels, and the social safety net remains underdeveloped.
The need for further development of the social safety net was clearly recognized in the government work report presented to the National People’s Congress (NPC) in May 2020. It is also a theme that we can expect to re-surface in the next Five-Year Plan, which is being developed for the 2021 - 2025 time period. Note that the question of social security provision is closely tied to financial market development, as insurance premia need to be invested in financial products (and the domestic market has opened up for insurers recently). Markets, and their institutional infrastructure, need further development to meet the needs of both investors and borrowers. Equally, control over the free flow and veracity of information may hamper the functioning of the market and test the appetite of foreign investors. A recent accounting fraud with coffeehouse chain Luckin Coffee underlined this risk again. Yet foreign purchases of Chinese bonds doubled to USD 19.6 bln in May.
Southeast Asia trade reduces China’s dependence on developed export markets
Although de-globalization is likely to be a turbulent and challenging process, it may turn out to be surprisingly positive for China if it manages to carve out its own sphere of influence. Already, trade relations with Southeast Asia have become the most important for China, lessening its dependence on developed export markets. Trade friction, domestic problems, changes to the role and function of Hong Kong and China’s Belt and Road (BRI) policies all add up to a picture in which the world moves towards various spheres of influence.
China has used its financial sector in this diplomatic game. Chinese banks have followed Chinese enterprises in “Going Global”, by means of BRI project funding, and Renminbi internationalization. In fact, the Turkish Central Bank recently became the first user under an RMB swap agreement between the two central banks.
However, this process will remain fraught with risk and friction and requires more mature diplomacy than we have seen so far. The new “Wolf Warrior” style among China’s diplomats, i.e., a trend towards increasingly assertive and aggressive conduct, does not bode well. Difficult debt rescheduling is required around the BRI, the process of de-dollarization needs a further impetus from Renminbi internationalization, and China needs to assuage the fears around its power plays that exist within Asia.
Conclusion: Strict information control hampers China’s financial services development
So far, the discussion has examined how structural issues remain relevant and what challenges the future will hold, and it follows that we can see some core developments relating to the financial services sector. In sum, we can expect:
- there will be no large interest rate cuts but, rather, targeted cuts in reserve requirement ratios (RRRs) and attention paid to sufficient liquidity in the system.
- there will be more bond financing in order to lower funding costs, and it will increasingly meet the investment demands of foreign investors. This market has opened up further in recent years and accounts for increasing inflows of foreign capital, with foreign entities holding USD 139 billion in onshore debt as of end March 2020.
- global tensions will impact securities markets, as a retrenchment of Chinese listings to the Hong Kong market is likely to follow from US regulatory actions and from attempts to bolster the Hong Kong market. The market will be helped by policy fine-tuning and by allowing in more institutional investors.
- control over information and self-censoring by analysts will continue to hinder informed investment decisions and increase risk.
Overall, the bifurcation whereby strong corporates have access to market-based funding and SMEs are increasingly serviced by smaller lenders will cement the two-speed economy, juxtaposing affluent and innovative urban centers to underdeveloped regions, especially in China’s west.
Eventually, the debt mountain will need to be addressed and loan delinquencies will no longer be able to be postponed. Loose credit conditions have helped to support high asset prices, especially in real estate. This is a pivotal node in China’s economy and should be closely watched. Securing the stability of the real estate market will be a major challenge. As defaults remain relatively rare and new, restructuring is also in its infancy. The real estate sector promises to be a rocky ride for bondholders or international lenders. However, the market for distressed debt investors will likely prosper.
Opportunities in this new financial landscape can be expected to emerge for foreign financial institutions as players in the development of the financial market (as brokers, or ancillary services, including ratings), (re-)insurance, RMB clearing, and payments (accepting Alipay/ Wechat pay at European vendors).