Beijing is hurtling from one economic reform attempt to the next, but it’s creating ever more problems in its wake. At the plenary meeting of China’s rubber-stamp legislature, Beijing rolled out yet another slate of adjustments to its economic reforms. The steps taken at the National People’s Congress are the latest in China’s ambitious plans to micromanage its way through its slowdown without sparking a financial crisis. This round is aimed primarily at the private sector, which is suffering from a major credit crunch. The quick fix: some 2 trillion yuan (nearly $300 billion) worth of cuts to corporate taxes, fees and pension contributions – which combined are worth as much as 2 percent of China’s gross domestic product – plus pledges to get lending to those who need it. The reality is that the problems Beijing is trying to address now are the direct result of prior attempts to fix other problems. The current credit crunch was spawned by a crackdown on shadow banking. Shadow lending proliferated because of Beijing’s attempts to stave off inflation. The risk of inflation arose only after Beijing opened the stimulus floodgates during the 2008 global financial crisis.

Beijing is evidently desperate to find calmer waters, so it’s also rolling out major plans for “financial supply-side structural reform.” Details are vague at this point, but it heralds Beijing’s most ambitious attempt to stabilize the Chinese financial system. It’s worth a shot. But the sector’s appetite for risk is perpetuated by slowing growth and the Communist Party’s intolerance for a socio-economic crisis; Beijing won’t find much smoother sailing from here.

Putting Out Fires, Starting New Ones

Trade-offs and unintended consequences are inherent in any major reform push. Beijing, facing a staggering number of social and economic challenges, is pushing reform across the board. But it seems that each time it tries to put out one fire, it starts another – illustrated most vividly in the Chinese banking sector.

Throughout the 1990s and early 2000s, China’s unusually high household savings rates gave banks a stable deposit base, and breakneck growth among state-owned enterprises and property developers made it easy for Chinese banks to paper over inefficiencies. The state-centric financial system was rigid and unresponsive but relatively stable. But when the 2008 global financial crisis struck, exports and profitability plummeted, throwing the entire Chinese economy, including the financial sector, into turmoil. In response, Beijing took decisive action to spur lending and unleashed a fire hose of fiscal stimulus packages worth nearly $600 billion. Most important, Beijing lifted effectively all constraints on spending by and lending to local governments, and over the next two years, the economy was flooded with some $2.8 trillion in new lending. Within three years, the value of assets held by the Chinese banking system had soared by 77 percent.

These measures managed to contain the immediate crisis; official GDP growth rebounded to 10.6 percent within two years. But they caused other problems. The economy had become overdependent on cheap credit, and local governments maneuvered to make it nearly impossible for anyone to turn off the spigot. By 2011, Beijing began to fear inflation. In response, the People’s Bank of China took measures like raising interest rates and forcing banks to hold greater capital reserves to curb lending.

The central bank’s moves allayed inflation concerns, but they caused an array of new problems – most consequentially, the dramatic rise of “shadow banking.” In China, companies rely on bank lending to an unusually high degree; just 18 percent of total financing in the country last year came from channels like equity and bond sales, according to Caixin. Stricter monetary policies meant less bank capital to go around. And with state-owned enterprises (whose debts were implicitly guaranteed by the government) and property developers (who could offer greater collateral than most private firms) eating up the overwhelming share of bank lending, private firms were increasingly forced to seek more expensive loans through informal channels or overseas banks, exposing them to costly currency fluctuations.

Banks, under pressures of their own, also retreated into the shadows. Beginning in late 2011, the financial crisis in Europe had reduced flows of foreign currency to Chinese banks to a trickle and, by weakening the yuan, raised borrowing costs. Banks faced a drop in available funding, but Beijing demanded that they keep doling out credit to often deadbeat local governments – somehow without violating strict capital requirements. To reconcile these conflicting pressures, banks embraced increasingly risky financial instruments, including convoluted interbank lending schemes and off-balance sheet vehicles such as wealth management products, or WMPs. And they got very good at hiding them – and the nonperforming loans they often carried – from regulators.

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As competition for depositors and investors intensified, banks had to offer ever higher rates on their WMPs or take on ever riskier assets. Their margins shrunk, increasing the risk of cascading defaults. But since Beijing had always backstopped the financial sector, and since the Communist Party couldn’t stomach the political fallout of a cleansing financial crisis, the banks assumed the state had implicitly guaranteed unregulated assets as well. The shadow lending raged on. Beijing had created a moral hazard epidemic.

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But after a technical default between two small banks sent interbank lending rates soaring in early June 2013, Beijing refused to inject liquidity into the market, attempting to smash its implicit guarantee. This caused an almost cataclysmic new problem. Within days, interbank lending ground to a halt, sparking a liquidity crisis that began to spread into the rest of the economy. Beijing capitulated by the end of the month, intervening more forcefully to keep interbank lending rates stable.

Markets stabilized for the next two years, but the measures exacerbated other problems. By capitulating, Beijing erased any doubts about its implicit guarantee of off-balance sheet assets. And by reducing volatility in money markets, it only increased incentives for yield-seeking banks to further expand the shadow banking bonanza. By 2016, according to the rating agency Fitch, total shadow banking assets had surpassed 70 percent of GDP. Beijing’s attempts to crack down with new regulations mostly just pushed banking activities further into the shadows. Finally, in 2016, President Xi Jinping declared financial risk a priority on par with national security, and Beijing moved more decisively to bring the party to a close. Greater short-term volatility was allowed in money markets, making speculative lending less lucrative. China’s outdated regulatory apparatus was overhauled to close loopholes and eliminate arbitrage. Stringent new rules were announced, and Xi’s feared anti-graft drive was expanded to ensure compliance.

By most metrics, Xi’s measures appear to have worked, at least in terms of pushing lending back onto balance sheets. In 2018, according to Moody’s, the shadow banking sector, which had peaked at 87 percent of GDP, contracted for the first time in a decade, dropping back below 70 percent. Outstanding loans in the sector dropped 6.5 percent. New loans in the formal banking sector, meanwhile, increased 13 percent year on year. Yet, once again, the reforms have spawned new issues – ones that can’t be fixed painlessly.

Treating the Symptoms

For all the risks it spawned, shadow lending has helped keep credit flowing to areas where formal lending channels were falling short. Without it, China is once again grappling with a credit crunch. Total social financing, a broad measure of credit and liquidity, contracted for most of 2018, until Beijing started boosting monetary stimulus toward the end of the year. According to Financial Times data, Chinese banks will need to raise some $260 billion in fresh capital over the next three years as they start to put informal loans on their balance sheets. Private firms, in particular, have been hit hard, accounting for 16 billion yuan of the 20 billion yuan in onshore bond defaults in China last year, according to Natixis.

The private sector now accounts for more than 60 percent of GDP, and it’s creating 90 percent of new jobs in China. But firms in the all-important coastal provinces are the most vulnerable to the trade war with the U.S. The problem is that newly risk-averse Chinese banks are simply ill-suited and poorly incentivized to meet the sector’s needs. It’s easier, less risky and often politically advantageous to prioritize state-owned enterprises – which banks can be sure won’t be allowed to collapse – rather than gearing up to make prudent assessments of scads of private firms in dubious financial standing.

Beijing has to find a way out of the credit crunch, but it’s trying to avoid another overcorrection. The measures announced at the NPC, particularly the tax cuts, are a relatively low-risk way to keep money in private sector accounts. Beijing also continues to pledge that it’s not about to flood the economy with stimulus on the scale of 2008. Senior regulators, meanwhile, are hinting they might be willing to allow the return of some “good shadow banking activities” – that is, anything that prudently channels money into the real economy. Whether they can really monitor activities that were designed to be hidden closely enough to distinguish between good and bad off-book lending (when even banks have struggled to do so) is another question.

Regardless, some fallout from these measures is inevitable, particularly as growth slows. At minimum, forcing banks to lend more to private firms will undermine the government’s parallel goal of limiting overall credit growth. More important, the underlying structural and political problems locking Beijing in this high-stakes game of financial whack-a-mole haven’t gone away. The new emphasis on financial supply-side structural reform suggests that Beijing may be gearing up for major surgery. The government today is certainly better equipped than previous administrations to spur reform among the entrenched interests opposed to painful restructuring.

But at this point, the proposed reforms are more an acknowledgment of China’s problems than a detailed plan for fixing them. Meanwhile, Xi has only deepened the role of state-owned firms in the economy and party influence over private firms. Similarly, keeping firms reliant on banks for financing rather than channels like investors and stock markets is another lever of the party’s power. When the choice is economic efficiency or control, Xi chooses control; state dominance of the economy is indispensable. There’s nothing to suggest China has any real intent or ability to build a liberalized, dynamic formal financial sector capable of meeting a dizzying mix of oft-conflicting political and economic aims.

To address moral hazard, meanwhile, Beijing has been desperately trying to persuade banks and investors that off-balance sheet instruments like WMPs are not government guaranteed, and the government refused to intervene during a spike in peer-to-peer defaults last year or amid the recent surge of private sector bond defaults. But neither of these posed systemic risks. What’s clear to the financial sector is Beijing cannot stomach the collapse in growth that would come with a widespread credit crunch. Neither can it stomach the political fallout of a cleansing financial crisis. Beijing can yell about prudence and moral hazard until it’s blue in the face; it’ll still be stuck searching for a way to let the economy drive itself – without letting it drive over the precipice.

Editor’s note: An earlier version of this analysis referred to a report from the American Economic Association, which was originally cited by another news agency. Since we have been unable to verify the report in question, we have removed the reference from the site. We regret the oversight.

Phillip Orchard
Phillip Orchard is an analyst at Geopolitical Futures. Prior to joining the company, Mr. Orchard spent nearly six years at Stratfor, working as an editor and writing about East Asian geopolitics. He’s spent more than six years abroad, primarily in Southeast Asia and Latin America, where he’s had formative, immersive experiences with the problems arising from mass political upheaval, civil conflict and human migration. Mr. Orchard holds a master’s degree in Security, Law and Diplomacy from the Lyndon B. Johnson School of Public Affairs, where he focused on energy and national security, Chinese foreign policy, intelligence analysis, and institutional pathologies. He also earned a bachelor’s degree in journalism from the University of Texas. He speaks Spanish and some Thai and Lao.