Financial Reform, With Chinese Characteristics

Forecast Highlights

  • China will prioritize streamlining and unifying the country’s financial regulatory framework, as well as cracking down on corruption in the sector, over liberalization.
  • The mounting risk posed by local government and corporate debt will require more ambitious relief programs.
  • Political sensitivities will delay implementation of certain regulatory reforms until after the pivotal 19th Party Congress, set for this October.

Financial sector reform in China is gaining steam. A number of recent developments point to a renewed push to clean up the country's financial system by chipping away at a disjointed and outdated regulatory system and clamping down on corruption in the banking, securities and insurance industries. Simultaneously, programs aimed at helping local governments and businesses metabolize their enormous debts have expanded rapidly. But while these initiatives hint at a more comprehensive approach to financial reform, with efforts to manage past debts running in tandem with those to tamp down the unsustainable credit growth of recent years, they do not portend substantial liberalization of China's financial system in the near future. More likely, these are early steps in what Chinese authorities see as an incremental, carefully managed program to restructure and improve (but not dismantle) the country's heavily state-influenced financial and economic systems.

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The Challenge of Reform in China

Financial reform has long been a stated priority of China's government. In practice, however, efforts to improve the sector's ability to assess risk and allocate capital efficiently – the crux of financial reform in a country where political imperatives weigh heavily on economic decision-making – have often taken a backseat to more pressing concerns such as maintaining stable employment. As a result, despite near continuous pledges by central authorities to rein in the worst excesses of China's post-2009 state-led investment boom, debt of all kinds – including local government, state-sector, private corporate and household – has continued to grow at an alarming pace.

For example, outstanding local government debt has risen from 12 trillion yuan (around $1.75 trillion) to over 17 trillion yuan since 2012, equal to roughly 23 percent of China's gross domestic product (GDP) today. The growth has defied attempts by central authorities to rein it in by tightening controls on poorly regulated private entities called local government financing vehicles.

The scale of local government liabilities pales in comparison to that of corporate debt, which accounts for around 60 percent of China's total outstanding public and private debt load. As of 2016, unresolved corporate debt was equal to more than 165 percent of GDP, while total commitments are now nearly three times the country's annual economic output. (These ratios are comparable to levels in South Korea and Japan, though China's debt has grown at a far faster pace.) Officially, nonperforming loans account for a low 1.74 percent of loans nationwide, while "special mention" loans, which are overdue but not yet considered non-performing, account for another 3.92 percent, according to official estimates. But many analysts believe China's real nonperforming loan ratio is closer to 10 or even 20 percent. (In Japan, this ratio is 1.5 percent.) Though Beijing has built in some safeguards for managing existing debts over the past year or two, it has done little to reform the incentive structure that generated China's explosive debt growth and capital misallocation in the first place.

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