The Chinese Financial System - The Importance of crisis management and resolution frameworks in a post COVID world
By Eamonn White & Daniel Trinder, lecturers on the Chinese Financial System for the School of Economics & Finance at Queen Mary University of London
At a glance
After two decades of impressive growth, the Chinese financial system has become globally significant. While China historically only opened up its financial system to international capital markets gradually, the pace of liberalisation is now beginning to quicken as China’s GDP slows, which may allow greater utilisation of international markets to manage the transition to a more consumer-based economy.
February’s US-China trade deal helps support the development of Chinese distressed debt markets. At a time of rising non-performing loans (NPLs) in China, this will facilitate their more efficient management and help limit the erosion of both the profitability and solvency of banks which crowd out new lending opportunities.
This may indicate that China is moving beyond ensuring complete strategic autonomy when it comes to NPLs management as it moves towards opening up distressed debt markets to international investors which presents an opportunity to better manage current and pending problems with bank NPLs in a post-COVID world.
Over the last 2 years, NPLs have also caused a number of mid-sized banks in China to fail. The shifting approach to bank failure in China reinforces the need for a clear crisis management and resolution framework to build market understanding of how crises should, and will be, managed as they materialise.
Chinese Financial System - Becoming Globally Significant
Over the last 20 years, China has seen massive development in the size and complexity of the financial system. This can be seen in the increased diversity of sources and expansion of the total amount of credit provided by the Chinese financial system to the economy in recent years in nominal terms, and as a percentage of GDP (Gross Domestic Product).
Over the past few years, China has also gradually opened up its financial system to foreign investors. The Peterson Institute estimates that foreign ownership of Chinese stocks and bonds has risen from less than RMB1 trillion in 2014 to RMB4.2 trillion (US$594 billion) by the end of the first quarter of 2020. Chinese shareholding limits on foreign ownership of securities, insurance and fund management firms have recently been removed. While foreign ownership continues to remain very low in absolute terms, these changes could facilitate greater participation of foreign firms in the Chinese financial system over time.
While these changes grab all the headlines, ironically it might be another opening of the door that has more immediate implications for the Chinese economy and financial system. Article 4.5 of Phase 1 of the US-China trade deal signed in February allows US financial service suppliers to apply for asset management company (AMC) licenses that would permit them to acquire NPLs directly from Chinese banks. When additional national licenses are granted, China has agreed to allow such US AMCs to operate on a non-discriminatory basis alongside other Chinese suppliers. Such opportunities for foreign firms in China have existed previously, however, they were generally restricted to acquiring limited debt portfolios from Chinese AMCs, rather than acquiring individual loans from the original lenders. Pilot programs allowing for direct acquisition were enacted by some AMCs but were extremely narrow in scope.
Chinese Banking Sector and Rising NPLs
After three decades of impressive growth, Chinese GDP continues to slow, now further compounded by the impacts of COVID-19. In June, the International Monetary Fund (IMF) forecast that China’s economic growth in 2020 will fall to 1% from last year’s 6.1%. The COVID related economic slowdown will exacerbate existing NPL problems in the banking sector. For example, more than 100 real estate firms filed for bankruptcy in China in the first two months of this year alone. More broadly, COVID driven de-globalisation, and/or changes to global supply chain models will likely impact exports and increase bank NPLs.
Consistent with this, the Chinese Banking and Insurance Regulatory Commission (CBIRC) reported in July that across the banking system as a whole NPL ratios rose to 2.1% at the end of June 2020 up from 1.86% at the end of 2019. Although the trend is only edging up slowly and the magnitude remains relatively low for now, especially when viewed alongside European Union (EU) banking sector NPLs, the CBIRC noted that financial sector NPLs related to COVID will likely take a long time to materialise.
Rising NPLs will be more challenging for those banks entering this crisis with low capital adequacy and liquidity positions. City commercial and mid-sized banks are forecast to be more affected when compared to their larger peers, which are state-owned lenders and joint-stock banks. According to a report published in July by Fitch’s Chinese subsidiary, Fitch Bohua, if GDP in 2020 is 1% as forecast by the IMF, NPL ratios among city commercial banks would increase by 3.44 percentage points to nearly 6% and joint-stock banks and state-owned lenders could also see their NPL ratios increase by 2.62% and 1.92% respectively is shown in the chart below.
Chinese bank failures and approach to Crisis Management
As NPLs rise, so does the risk of financial instability in the Chinese financial system. In 2019, three Chinese banks failed. Baoshang Bank was taken over in May by The People’s Bank of China (PBOC) and CBIRC. This was China’s most high-profile bank failure in two decades. Bank of Jinzhou and Heng Feng Bank were bailed-out by state-owned bank, ICBC, and the Central Huijin sovereign wealth fund in July and August last year. In July this year, the CBIRC approved a bailout plan for Bank of Gansu which involved the purchase of new shares by the Gansu provincial government to restore the bank’s core tier 1 capital.
Interestingly on Baoshang Bank, the authorities did not guarantee corporate depositors and interbank liabilities above RMB 50m (US$ 7.16m) and these liabilities were renegotiated with creditors i.e. haircuts applied akin to a bail-in. However, the application of a quasi “bail-in” to Baoshang creditors resulted in an interbank liquidity squeeze across the entire banking system which was halted only by PBOC support. Such creditor haircuts represented a major departure from precedent where the market assumes an implicit government guarantee of bank liabilities. However, the subsequent state recuses of Bank of Jinzhou, Heng Feng Bank and Gansu Bank shied away from a similar attempt to impose losses on large bank creditors and have focused largely on wholesale creditor bail-outs.
Previously Chinese authorities relied heavily on AMCs to manage NPLs in the banking sector and in 1999 created Cinda, Huarong, Orient and Great Wall, and ordered that quartet of AMCs to purchase, manage and dispose of NPLs held by its big state banks and allowed foreign participation. However, worried about seeing state assets sold on the cheap to foreign institutions, China opted to bail out and list its big banks instead.
Roll forward to 2020 and the Chinese authorities seem to be looking to rely on AMC again to manage COVID related NPLs, which the US-China trade deal helps facilitate. Once an asset management license is granted, U.S. institutions can directly buy NPLs and bypass the Chinese companies currently acting as middlemen. US distressed debt managers have already begun to explore such opportunities. Oaktree Capital Management, the largest distressed securities investor in the world, set up a subsidiary Oaktree (Beijing) Investment Management Co immediately after the signing of the Phase I US-China trade deal.
Conclusion
While the Baoshang Bank case demonstrates the Chinese authorities attempt to avoid unnecessary transfers of public resources to private actors by relying on consensual/negotiated bail-in, the shifting approach to bank failure reinforces the need for a clear crisis management and resolution framework to build market understanding of how crises should, and will be, managed as they materialise. Establishing such a regime is essential to successful management of financial crises which are all the more important in the wider context of slowing economic growth where the fiscal capacity to fund bail-outs of such a large financial sector may be more constrained in the future.
It is too early to assess the full extent of implications from rising NPLs on the Chinese banking sector and wider implications for the stability of its financial system. However, it reinforces the need for the development of distressed debt markets to facilitate efficient management of NPLs regardless of policy towards crisis management and resolution framework. The opening up of the Chinese financial system and recent US-China trade deal will allow greater leverage of international expertise in distress debt management and greater tapping of foreign investor appetite.
China seems to be casting aside concerns concerning strategic autonomy as they realise that opening up distressed debt markets to international investors is an important part of any strategy for managing current and pending problems with bank NPLs. Elsewhere other countries and regions will face similar policy choices, in particular the EU which has a much larger structural problem with bank NPLs. The EU is unlikely to go down a similar path as China but must find a way to kick-start the distressed debt and to enhance investor-appetite as quickly as possible to support the banking union’s recovery post COVID.
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