Walter Molano | China: A tricky manoeuvre

An air of trepidation runs thick through Asia. The process of Chinese deleveraging is at the forefront of the collective thought.

Since the onset of the US financial crisis in 2008, China has been the main driver of global economic activity. Part of this has been recycled through the One Belt, One Road initiative, which has poured billions of dollars into Latin America, Africa and other parts of Asia. As a result, it buoyed commodity markets and investment.

However, this was done by expanding the national balance sheet. During the past decade, China's total debt has grown to more than 250 per cent of GDP, from an initial level of 141 per cent of GDP.

State-owned enterprises, or SOEs, have been the main conduits for this expansion, in the process transforming hundreds of well-connected individuals into billionaires and hundreds of thousands of households into millionaires. According to a report by Bain, there were almost 900 billionaires in China in 2018, up fourfold in 10 years. Meanwhile, the number of Chinese millionaires spiked eightfold to 1.6 million during the same time period.

Realising that the credit expansion bloated the nation's balance sheet and grossly distorted the country's distribution of income, the government ordered the deleveraging process to begin. The intent is to manage an orderly deleveraging that can avoid the chaos associated with a classical economic downturn. However, this is a feat that is fraught with danger.

At the end of last year, central bank governor Zhou Xiaochuan warned that the Chinese financial system had become vulnerable to "sudden, contagious and hazardous risks" due to high levels of leverage. In a paper published on the People's Bank of China website, he called for reform and tougher regulation.

The so-called shadow banking system is one of the problems facing the economy, where a myriad of retail products fly below the regulatory radar. Most of these products are nothing more than Ponzi schemes, and they send powerful reverberations through the region's financial system when they collapse.

Too many to keep track of

Another problem is the huge universe of SOEs. These state-owned entities have always been a headache for government regulators. They are too many to keep track of. Hence, they became cesspools of abuse, cronyism and nepotism. They have also become vehicles to move capital offshore.

At the end of July, Beijing announced that it would hold responsible senior corporate officers for losses at state-owned companies that sold assets cheaply or invested in overpriced overseas projects. Yet, with 51,000 SOEs fully owned by the central government and multiple times more owned by various provincial and municipal governments, the public sector's ability to fully monitor these institutions is almost impossible. This does not even address the number of mixed-ownership companies, where the state is a partial shareholder.

In order to start the deleveraging process, Chinese banks were ordered to curtail their lending. Interbank lending declined by 1.3 trillion yuan in 2017. However, this was offset by a 1.5 trillion yuan increase in negotiable certificates of deposit, which are short-term facilities. Therefore, the financial sector's balance sheet continued to expand in 2017, albeit at a relatively slower pace. The same process was seen in 2018.

Unfortunately, the small amount of stress produced casualties along the way, with more than a dozen local bond defaults this year. The interesting thing is that almost all of them were private companies. These were the weakest links in the chain, and the most vulnerable.

This is the reason Asians are so worried. This is just the tip of the iceberg. To make matters worse, Washington suddenly decided to raise tariffs on Chinese exports, at the very moment when systemic financial risks abound.

Many Chinese SOEs are focused on the export market, and they would be badly damaged by a trade war with the United States. An uncontrolled unwinding of the Chinese balance sheet would be chaotic and it would send powerful shock waves through the global economy.

Some people argue that this is the reason the National People's Congress, the NPC, decided this year to remove the two-term limit on the presidency. President Xi Jinping's second term was coming to a close, but now he can remain in power for the rest of his life. Of course, he still needs to be reappointed every five years by the NPC, and the legislature can always replace him.

Nevertheless, Chinese commentators note that with the enormous concentration of economic power in the hands of a few individuals and the potential financial risks that lie close on the horizon, the NPC did not want to complicate the situation with a change in the presidency. Therefore, Xi Jinping was left at the helm as China negotiated its tricky manoeuvre.

- Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.

wmolano@bcpsecurities.com