In the Margin

The Op-Ed was drafted around August 2022, for a graduate course.

The views expressed on this blog are my own and do not reflect those of any institution I am or have been affiliated with.

Seemingly over one night, more than $5.8 billion in cash disappeared from five Chinese rural banks. Millions of customers were informed that their life savings had been frozen, and they would not be able to withdraw their money. Furious customers staged protests in Henan, one of the most populated provinces in China. Hundreds of protestors were arrested by the authorities.

Why the crisis? How come that $5.8 billion, roughly equal to Montenegro’s annual GDP, just disappeared? The ripple stems from the real estate industry. Relying heavily on borrowings to finance projects, the real estate sector accounts for a quarter of the Chinese GDP. Worrying about the high leverage, the Chinese government introduced the “three red lines” policy to deleverage the property sector in August 2020. The policy put limits on real estate developers’ liability-to-asset ratios, debt-to-equity ratios, and cash to short-term-borrowing ratios. Those who violate the policy face strict financing constraints, and are asked to slow down or stop borrowing altogether. Nearly 70% of listed real estate developers violate at least one of the three red lines, facing a liquidity crisis. Evergrande, the second largest property developer in China, defaulted its interest payments. On average, every day, there is one property developer declaring bankruptcy.

Now, the ripple expands into the financial system. Chinese banks face a bigger exposure to the property sector than any other industry – loans to property developers stood at $1.8 trillion, growing at an annual speed of over 6% before the three red lines policy. Developers’ defaults quickly put the Chinese financial system under liquidity stress. Furthermore, focused as it is on large state-owned banks and enterprises, the Chinese government has little regulation on small rural banks. Poor management and non-transparent shareholder disclosure lead to substantial stakes. In the Henan crisis, the major shareholders of five rural banks are also shareholders of a group called Xincaifu Group (meaning New Wealth), and these key personnel are accused of transferring money from those banks to Xincaifu through illegal loans.

Suffering from property-sector risk and subject to weak regulations, rural banks have become a time bomb for China’s financial system. The nonperforming debt, the debt that is not being serviced and will likely not be repaid, is a great concern – the average bad debt rate of rural banks is above 4%. The bad debt rate of the overall Chinese banking sector is 1.8%, while that in the United States was 5% before the 2008 financial crisis.

What did the government do? The Chinese government does not sit back amid protests. Local authorities have arranged partial repayments and compensation to customers with less than $74,000 deposits. However, this only serves as a temporary band-aid to appease public outrage. For Chinese financial regulators, the real question is: to bail out or not to bail out?

Maintaining the political stability is the major reason for Chinese government to bail out rural banks. Public trust and social stability in the central government and the Chinese economy are crucial for the legitimacy of Chinese Community Party and President Xi. From big property developers to financial institutions, China has a long-standing history of rescuing distressed state-owned businesses. However, the contingent liability may put too much pressure on the government’s budget. Under China’s unique state-market system, the state has an unambiguous liability for state-owned banks’ debts. There is no legal reference concerning whether, when, or how the state should bail out small banks. In 2020, regional bank Baoshang Bank declared bankruptcy, becoming the first bankrupt commercial bank in nearly two decades. Similar to Henan’s banks, Baoshang Bank’s major shareholders engaged in transferring money to their own companies. After the scandal broke out in May 2019, financial regulators from the China Banking and Insurance Regulatory Commission (CBIRC) and the Chinese central bank (People’s Bank of China, PBC) took over Baoshang bank and transferred its services to the second-largest national bank – the China Construction Bank. Backed by the PBC’s liquidity support, all retail customers received full repayment and institutional customers received 90% of repayment on average. Later in November 2020, Baoshang Bank was closed down. Under a restructuring agreement, the local government, local state-owned enterprises, and local state-owned banks purchased its assets and liabilities. Nevertheless, PBC and CBIRC sent a clear warning to bankers counting on the unlimited contingent liability. The PBC governor Yi Gang said that the central bank would no longer bankroll government spending or bail out troubled companies backed by local authorities.

What will the government do now? In the Henan banking crisis, the government may use the Baoshang strategy. With limited support from the PBC, local authorities will intervene to protect customers (especially retail customers) but not necessarily bail banks out.

Nevertheless, as the Chinese economy is slowing down, it is harder for central and local governments to clean up small banks’ messes with a shrunken balance sheet. Struggling between political and economic choices, Chinese financial regulators are pursuing a third way out. To defuse the rural bank bomb, CBIRC encourages market-oriented methods to reform the rural banking system by restructuring and merging small and midsize financial institutions. However, considering the prevalence of nontransparent interest groups, it is questionable whether the market by itself is willing or capable of reforming the rural banking system. The Chinese government may need to provide policy incentives for larger state-owned banks to participate in the reform. Moreover, as a precautionary measure, in May 2022 CBIRC set up a bailout fund to migrate systematic risks, namely the Financial Stability Guarantee Fund. With start-up liquidity of $898 million, the final size of the fund remains unclear.

The mysteriously evaporated $5.8 billion is only the tip of the iceberg. Behind the Henan banking crisis, the Chinese financial system faces more existential risks – real estate distress, an economic downturn, and political dilemmas. Standing at the crossroad of state intervention and the market economy, global investors are waiting for Xi’s next move.

© Yuhua Cai, 2022. All rights reserved.
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