The Chinese Financial System and Global Economic Stability

I - The Basics

Considerable attention is being paid at the moment to stock exchange and exchange rate developments in the Chinese economy. This is not surprising, given that China has the world’s second largest economy and that rapid Chinese growth has underpinned the global economy in recent years when the United States and the European Union economies have been faltering.

Interpretation of these developments is complex for two reasons. First, China is unique in that its economy has market aspects while the country remains under the political control of the Communist Party. Secondly, the economy is not fully transparent, certainly to outsiders and even, in some respects, to the Chinese themselves.

The result is divergent assessments. David Stockman, formerly economic adviser to President Reagan has recently written:

China is the greatest construction boom and credit bubble in recorded history. An entire nation of 1.3 billion has gone mad building, borrowing, speculating, scheming, cheating, lying and stealing…In two short decades, China has erected a monumental Ponzi[1] economy that is economically rotten to the core…Once asset values start falling, its pyramids of debt will stand exposed to withering performance failures and melt-downs. 

More politely and technically, the IMF April 2015 World Economic Outlook said:

In China, rebalancing toward domestic demand has so far been driven primarily by rapid growth in investment and credit, an unsustainable pattern of growth that has led to rising vulnerabilities in the corporate, financial, and government sectors. To avoid a further build up of attendant risks, policies need to be carefully calibrated to simultaneously contain vulnerabilities, manage the corresponding slowdown, and unleash sustainable sources of growth.

Charlene Chu, head of Asia at Autonomous Research has written:

Not surprisingly, the most common question I get is ‘Are we going to have a financial crisis in China?’ and that kind of thing is impossible to predict. There is certainly a scenario where you start to go down that path, but there are unique features in China. There’s no over reliance on foreign funding, a closed capital account, and heavy state influence over lenders and borrowers. That contributes to a more stable situation than in other emerging markets. 

How do we get our bearings? Let’s step back and deal with a few of the basics.

1. The terms ‘renminbi’ and ‘yuan’ are both used when talking about China’s currency. Why are there two terms?

The way this is usually explained is that ‘renmimbi’ (‘the people’c currency’) refers to the currency as a whole (like ‘sterling’ in the UK) and that ‘yuan’ is the unit of account within it (like ‘pound’ in the UK). On this basis, CNY is used as the international abbreviation for amounts of Chinese currency, just like GBP for British pounds and USD for United States dollars. Not everyone, observes this convention and sometimes you see RMB used in reports of Chinese currency amounts.

2. What is the difference between onshore yuan (CNY) and offshore yuan (CNH)?

Hong Kong was the initial key. In 2004, renminbi deposits were allowed in Hong Kong, with the Bank of China (Hong Kong) designated as the sole offshore renminbi clearing bank. Things have developed rapidly since then, with the establishment of a bond market in 2007, a trade settlement scheme in 2009 and the growth of offshore centres in other countries.

In the offshore market, the yuan floats freely, whereas in the onshore market, it is subject to a managed float. The value of the offshore yuan can therefore diverge from the value of the onshore yuan. There are channels through which arbitrage[2] pressures the CNY and CNH to converge, but this does not happen instantaneously, since the channels themselves are managed, and there are limits to the speed at which the CNY can change.

The consequence is that the use of the (offshore) renminbi is increasing rapidly, especially in Asia.

3. How do foreign investors enter mainland China?

Direct investment. On 10 March 2015, the Ministry of Commerce released the Catalogue for the Guidance of Foreign Investment which became effective on 10 April 2015. In it, industries are classified as follows:

• encouraged industries, for which the Chinese government is actively seeking foreign investments and for which investors are able to enjoy certain benefits such as tax incentives, cheaper land cost, simplified approval procedures or other favourable investment terms;
• restricted industries, for which the Chinese government intends to impose restrictions such as foreign shareholding ratio’s, limits on the operation of the company and special approvals; 
• prohibited industries, in which no foreign investment is allowed;
• permitted industries, a residual category.

The 2015 Catalogue lists 349 “encouraged”, 38 “restricted” and 36 “prohibited” industries.

The Catalogue also contains rules on foreign ownership restrictions and corporate forms through which an investment must in certain cases be made (typically, an obligation to form an equity or cooperative joint venture). 

Portfolio investment. Shares in Chinese companies take the form of H shares in Hong Kong and A shares in mainland China. The Qualified Foreign Institutional Investor programme, started in 2003, allocated individual foreign institutional investors a quota up to which they could invest in H shares. The Renminbi Qualified Foreign Institutional Investor programme, started in 2011, allowed access to A shares as well. The trend is towards global rather than individual quotas.

As a case in point, the Hong Kong-Shanghai Stock Connect programme was instituted in 2014. This allows investors to buy a limited number of mainland stocks through their accounts in Hong Kong which are not subject to the mainland’s capital controls. The QFII and RQFII programmes are allowing more foreign institutional investors to trade on the Chinese interbank market.

4. What are China’s objectives in relation to the international use of the renminbi?

One clear objective is to get the renminbi included in the basket of currencies underpinning Special Drawing Rights. This basket is reviewed by the International Monetary Fund every five years. Currently, four currencies are in the basket: the US dollar, the Euro, the Japanese yen and the British pound.

There are two criteria for inclusion: the size of exports and the ‘freely usable’ status of the currency. A freely usable currency is one that the IMF determines (i) is, in fact, widely used to make payments for international transactions and (ii) is widely traded in the principal exchange markets. Both elements under this definition, “widely used” and “widely traded,” have to be satisfied.

At the last review in 2011, China clearly met the export criterion, but was judged not to have met the freely used criterion. Whether that situation has changed is being considered by the IMF. Technical analysis alone will not determine the outcome. It ultimately requires judgement by the IMF’s Executive Board, which means that political considerations will play a part.

Expect searches for leverage and smoke-filled rooms. Special Drawing Rights do not play a very large role in the international finance system, but inclusion of the renminbi in the basket will serve as a wider stamp of approval for the currency as well as help confirm China’s emerging superpower status.

More generally, however, it is likely that China will retain more restrictions on capital flows than other major economies for many years and will not have full capital account convertibility. Bear in mind, too, that:

• China’s interest in foreign direct investment has been technological transfer, access to international markets and new start-ups. However, as more than one foreign investor has found to their cost, contractual issues do not play out the same way in China as in, say, the United States.
• China may well also need greater access to international capital markets for fiscal reasons.

The second brief will consider the problems in all of this, and their implications for the global economy.

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Part II - Problems and Global Implications

The first brief in this pair described some basic features of the Chinese financial system, especially in its links to the global economy. This brief outlines some of the problems and their wider implications.

1. The Chinese financial system has large marshy areas, the full extent of which is unknown to the Chinese authorities. A guide to the Chinese financial system published by the China Centre at the Brookings Institution put the matter this way:

China has a large and diverse informal lending sector that helps fill the gap left by a formal sector excessively focused on funding state owned enterprises and politically favoured businesses. Lenders in this sector include loan sharks, pawn brokers, formal or informal cooperatives of locals lending to each other, state owned enterprises lending out excess cash, and many other privately, and sometimes secretly, raised funds that invest in start-ups.

Moreover, there has been government specification of rates of interest which can be offered on bank deposits. These have been low historically, so that there have been workarounds for high net worth individuals, including participation in loans made by the banks.

There is reliance by individuals on implicit guarantees by the bank, and so banks may have more credit risk than is shown on their balance sheets. Not knowing where risk is located in the system makes it difficult to regulate. It will amplify any financial crisis, as the global experience since 2007 has indicated. Moreover, the Chinese system is vulnerable to accounting fraud. There is a hedge fund called Muddy Waters which finds frauds and publicises them after selling short the stock of the firms.

2. There is a marked tendency to believe in political solutions to every economic policy problem. One source relates, in the wake of the recent stock market crash, that party propaganda officials told students at Tsinghua University School of Economics and Management to loudly chant at the start of their graduation ceremony: “Revive the A-shares! Benefit the people!”. The message has changed, but the style has echoes of the China of fifty years ago. The Chinese reaction to the stock market crash shows an unwillingness to accept adjustments accepted as normal in market economies.

3. The regulatory system is not always coherent and is always subject to political intervention. The World Bank’s China Economic Update Report in June contained the following warning:

Instead of promoting the conditions for sound financial development, the state has interfered extensively and directly in allocating resources through administrative and price controls, credit guidelines, pervasive ownership of financial institutions and regulatory policies.

Adverse Chinese reactions forced a redaction of the report, the World Bank claiming that the original had not gone through the necessary clearance processes.

It may well have been the case that the Chinese authorities had welcomed the rapid run-up in share prices as creating a chance to sell equity stakes in dangerously debt-burdened enterprises, especially in a stock market as heavily speculative as the Chinese is widely acknowledged to be. The political backlash has put a temporary end to that project.

4. The Chinese have been adept in making incremental reforms, but unwilling to come to terms with the cumulative consequences.

China, as Francis Fukuyama has observed, delivers high quality authoritarianism. As opposed to Russia which exemplifies low quality authoritarianism. There has undoubtedly been skill in a succession of moves the Chinese government has made. Deng Xiaoping, in folksy fashion, referred to the country as ‘crossing the river by feeling its way over the stones’. And in recent decades, state management has avoided economic dislocation.

But together, the reforms have put China in an uncomfortable halfway house. Capital flows have become much larger. A recent Financial Times blog put it thus:

With some channels quite open but others still closed, there is much illicit use of the open channels to disguise capital flows…The debate is not about whether or not to open the capital account, because it is in fact already partially open. The question is where to go from here.

What China will want to do is attract longer term investors, and insulate itself as far as possible from destabilizing short term movements. It will also want to retain, indeed augment, administrative measures which may not be applied routinely, but which can be invoked in an emergency. Which is how it has responded to the stock market crash. Firstly, it lowered interest rates.

Then it went on to place a moratorium on all new public offerings, a six month prohibition on share sales by company directors or any shareholder with a more than 5% stake. State owned enterprises were instructed not to sell shares, a market stabilization fund was created and the China Securities Regulatory Commission started to purchase shares through its own proprietary accounts.

The problems here are that in response to domestic political pressures, policies may be adopted which are counter-productive, that in bigger crises (after all, shares are a small part of total financial assets) the government may run out of fingers to put in leaking dykes, and that to the extent that the renminbi does become a reserve currency, other countries may resist China’s discretion to solve its problems by extraordinary measures at their expense.

5. At the end of the day, there is no separation between external and internal economic relations when it comes to the strength of a reserve currency. A reserve currency needs a deep and well functioning set of financial markets across the board.

6. China is attempting to reorient its economy from exporting with an undervalued yuan to one where personal consumption is allowed to rise faster than national output.

Whereas the yuan has been undervalued in foreign exchange terms as recently as a few years ago, the IMF believes that it is no longer undervalued. In that sense, one condition for the transition has been met. On the other hand, this transition has to be accomplished with a rapidly aging population, an unintended consequence of the one child policy designed to reduce the population growth rate. Japan has confronted both a credit bubble and an aging population over the last thirty years.

The result has been chronic deflation and low growth. While foreign institutional investors in China would certainly be harmed by a financial crisis, the potential for systemic international contagion remains limited for now. The internal result might be more akin to the path that Japan has already trodden.

7. There are two channels through which a Chinese financial crisis can affect the global economy: one which works through international financial asset markets and the other which works through slowing Chinese economic growth. The Chinese have an interest in not roiling international financial markets more than they have to. The impact of slowing economic growth on global growth and domestic social and political stability is where the serious repercussions are likely to occur.

Charles Simkins is Senior Researcher, Helen Suzman Foundation.

These article first appeared as HSF Briefs.