I wanted to write a brief follow up to my BloombergView piece on reforming financial and wealth management products in China. As usual, start there and come here.
There is fundamental problem with all the talk about financial reform and risk management that you may have seen recently and over the weekend with the NPC that you might have seen in China: it is all predestined to fail. I know that sounds cynical but follow me here through a couple of points to remember.
First, absent true deleveraging, any attempt at risk focused financial risk management will fail. Assume for one minute that Beijing is serious about reigning in the wealth management sector (broadly defined) but that they let leverage go up by 15% in 2017. If leverage grows by 1.5-2 times nominal GDP growth, as the government has forecast and seems very likely, there will be little to no change in the risk profile of Chinese finances. Absent true deleveraging in China, any attempt at risk focused risk management will fail, it will merely reallocate where the risk lies.
Second, China simply cannot make any significant change to the wealth management industry, it has become to integral to the growth system to seriously reign in. There is an old saying in finance “if you owe the bank $1 million and can’t pay you have a problem, if you owe the bank $100 million and can’t pay they have a problem.” Same problem here. Shadow banking in China is simply too integrated now to move with any speed.
Assume for a minute that Beijing decided to prioritize wealth management risk reduction reducing the size, structure, and products offered by the industry. This would imply enormous changes to both the regular mainline banking system and corporate ability to meet growth targets. If China meets its 15% growth in financing, which includes bond swaps, that would mean no growth in shadow banking and an explosion in bank lending straining balance sheets already straining.
Additionally, non-SOE’s are almost entirely dependent on shadow banking channels to finance growth. If shadow banking is removed as a financing option, virtually the only companies that will have access to capital in China are SOE’s. Then given the extremely short term nature of shadow banking products, typically under 6 months, any real crack down will make this change necessary in a very short time frame. To avoid major liquidity crunches in client firms or shadow banks themselves, mainline banks would have to ramp up activity extremely fast.
Third, and potentially most importantly, despite the talk of a super regulator or risk focus, they need to actually enforce these rules. The halls of Beijing are filled with nearly comical stories of lending irregularities, stories of regulators of banks helping banks avoid regulation, and regulators looking the other way. Beijing has all the tools they need right now to crack down on irregularities but they simply choose not to. That would force banks not to make loans to zombie firms, which would force zombie firms to go out of business, which would mean that 6.5% would be nothing but a pipe dream.
Shadow banking may raise specific risks given product design and liquidity, but as long as leverage continues to rise rapidly and Beijing chooses to look the other way to prop up ailing firms and hit the growth target, there will be no change to the overall risk profile.