The growing number of Chinese companies with distressed balance sheets represents a significant threat to China’s financial stability. Real estate developers and private conglomerates are overloaded with debt and increasingly unable to access new financing. Many state-owned enterprises (SOEs) are deeply unprofitable and cannot service their debts without government support. Local governments depend on shell companies to fund spending through borrowing and land sales. Some small banks are poorly capitalized and heavily exposed to risky borrowers.
Faced with these threats to financial stability, China has ramped up regulatory intervention in order to defuse risks. This approach was not crafted in a vacuum; Chinese policymakers 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 similarities between China’s current economic problems and those of the Japanese bubble economy, especially high debt levels and an economy that is overly dependent on real estate. Japan’s failure to expeditiously resolve corporate bankruptcies and bad loans exacerbated problems, and dragged down long-term economic growth.
Chinese economists have also catalogued a long list of mistakes made by U.S. regulators and policymakers during the Global Financial Crisis. Key among them was that allowing the disorderly collapse of Lehman unnecessarily worsened the severity of the financial crisis.
China also learned much from its own experience restructuring its banking sector in the late 1990s. That financial cleanup involved enormous costs. By some estimates, China had to commit roughly 30 percent of its gross domestic product (GDP) to cleaning up the banking system. Failure to deal with structural issues at the heart of the banking system means that many of the underlying problems were not resolved and remain today.
A New Playbook for Cleaning up the Financial Sector
China’s current approach to tackling financial risks can be traced to the National Financial Work Conference in 2017. At that meeting, President Xi Jinping declared that financial stability was an important national security risk and ordered China’s financial regulators to take the initiative.
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-sufficiency.
When significant financial risks emerge in an industry or specific company, Chinese policymakers adopt one of three strategies:
Putting Industries on a Diet – China’s first tactic for cleaning up financial risks is to impose macroprudential controls at the sectoral level. Regulators lay down new rules and requirements for an industry. Companies across the industry are forced to curb risky behaviors and improve their financial health by increasing equity and reducing debt. The goal of this blunt approach is to prevent latent problems from metastasizing into more serious financial risks.
Perhaps the most influential of these sector-specific diets are the “three red lines” rolled out for the real estate sector in 2020. The policy sets out balance sheet rules that real estate developers must adhere to or face restrictions on their ability to borrow. Many large developers, most notably Evergrande, have fallen into financial distress after the rules were adopted, proving that crash diets can create more problems than they solve.
“Arranged Marriage” with the State – When going on a diet isn’t enough to stave off financial distress, regulators must take more drastic action. In these situations, the government steps in to arrange an acquisition or capital injection by state firms or state-connected private enterprises. The goal is to avert a destabilizing bankruptcy that could have broader implications for a key sector or the wider economy.
These bankruptcies also offer an opportunity for a reassertion of control by the state in strategic or sensitive industries. Private enterprises or partially privatized SOEs become subject to firmer state control.
Funding for the distressed company usually comes from SOEs, state-owned investment funds, or state-owned asset management companies, which act as proxies for the Chinese government in carrying out the restructuring. Sometimes funding comes from state-connected private companies. These companies are persuaded to provide funding by 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 action must be taken. In the most severe cases – in which a bankruptcy would have far-reaching financial, economic, and sometimes political consequences – Chinese regulators will put a company into “state custody.”
Under this mechanism, the government oversees the formation of a creditor committee made up of the company’s biggest lenders. Sometimes a separate risk committee is formed with direct representation by the government and important stakeholders. These entities directly supervise the bankruptcy process, guiding it to minimize broader financial and economic disruption.
Companies in state custody go into a form of suspended animation. Payments on debts and other liabilities are halted. These companies often continue operating 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 the bankruptcy. The Chinese government prioritizes the allocation of losses 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 off in whole or in part to other entities (usually state-connected buyers), or reorganized as a completely new entity.
Control Is the Goal
Although the Communist Party has trumpeted 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 problem industries, including by issuing new rules that force many existing players out of business. Life support is being pulled from distressed companies and banks. Private conglomerates face visits from government-led risk committees. Weak companies, both state-owned and private, face heavy pressure to merge with stronger entities.
The scope for intervention has recently broadened beyond simply addressing financial risks. Chinese policymakers now openly talk about the government’s role in restraining the “disorderly and barbaric expansion” of capital. Areas of the economy that are not subject to government control are viewed 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, in the wake of the crackdown on the property sector, state-owned property developers have used their privileged access to financing to make large acquisitions of assets from private developers. As a result, the property sector is undergoing a 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 stamping out financial risks is also damaging the dynamism of the economy. While Beijing has studied the mistakes of past financial cleanups, its current approach risks making new ones.
