A bail out threatens market discipline
Huarong was one of the four entities created by the government in 1999 to clean up distressed debt after the Asian financial crisis. The institution went on to push into asset management and investment banking. Its assets grew sixfold between 2011 and 2017, with bad-debt management contributing less than a third. But in 2018, the company’s leadership was suddenly replaced by executives from state-owned banks and regulators. Beijing seemed in control, if also gruesomely so – ex-CEO Liao Xiaoming was executed in January after he was found guilty of bribery, corruption and bigamy.
When Huarong’s failure to publish financial data rocked the market in April, regulators had had three years to deal with the problem. The fact that authorities were taken aback by the crisis shines a light on a policy contradiction. Beijing’s desire to enforce market discipline implies the cost of bankruptcy will be borne by investors and not socialized through bailouts. But regulators fear that allowing a systemically important company to fail will badly shake China’s financial system – and that they might end up accountable for any ensuing crisis (a worry not assuaged by the opacity of the Chinese financial and political system).
Faced with this contradiction, the Chinese state developed an opaque mixed strategy. To ensure that Huarong did not trigger a damaging chain reaction, state banks were reportedly asked to provide emergency lending – and there is even talk that the PBOC used its own balance sheet to absorb assets. At the same time, the government will probably use behind-closed-doors restructuring negotiations to shift some of the cost of this silent bail out onto investors, as happened when Baoshang Bank defaulted in 2020. The bail out element will reinforce investors’ tendency to favor politically important companies, while the bail in will weaken their trust in the once iron-clad guarantee that some companies are too big to fail.
Beijing’s mixed strategy is a shift towards market discipline, but it is unclear exactly by how much. This suggests there is more trouble on the horizon. The credit-ratings firm S&P recently published research indicating that only 6.3 percent of the property developers it tracks comply with the central banks’ limits on indebtedness. This shows how the lack of a clear and transparent approach to dealing with struggling high-profile companies has allowed entrenched old habits to live on. The mixed strategy is limiting improvements to the efficiency of the capital allocation and feeding investors’ fears about rising junk assets.
The leadership in Beijing seems to be aware that the efficiency of the financial system must improve to continue catching up with advanced economies. Four years of reform and the explicit support of Xi indicate this is a priority. Despite successes in tempering credit growth, Huarong is a reminder that Beijing still has to deal with many of the effects of old habits and poor investments. The real test of its resolve to institute market discipline still lies ahead.