The Wall Street Journal once dubbed Charlene Chu the “rock star” of Chinese debt analysis. As an analyst at Fitch Ratings, her work was widely followed, particularly when she began warning about risks in China’s banking sector, even though the economy was booming.1Here is another Q&A she did some years ago with The Wall Street Journal. Chu, who earned an M.A. in international relations and an MBA at Yale, left Fitch to work on her cousin’s memoir about her life in rural China and then joined Autonomous Research, now a division of Sanford C. Bernstein & Company. Her research reports for Autonomous are must-reads for those tracking China’s economic development and its financial sector. What follows is an edited transcript of our discussion.
A decade ago, even as China’s economy was booming, you highlighted something few analysts talked about at the time: the massive accumulation of debt that corporations and local governments had taken on, creating risks for the nation’s banks and financial system. Since then, China has moved aggressively to deal with this problem. Can you update us on the situation with the banking sector today?
Well, this is the biggest expansion of a banking sector in recorded history. Chinese banks have gone from what was roughly $9 trillion dollars in assets in 2008 to just under $43 trillion today. That is remarkable, and it has happened in just over a decade. When you look at the size of other banking sectors around the world, you start to realize that the delta in China is bigger than the entire size of some of these banking sectors; even ones that took hundreds of years to build.
Historically, one of the best indicators of a financial crisis is the rapid expansion of a banking sector relative to the size of GDP. When that happens, there aren’t enough returns in the economy to repay that debt. Borrowers start having debt servicing problems, and banks start having liquidity issues, which ultimately lead to some sort of financial crisis. We’ve seen this numerous times around the world in different countries in the past, even in China. What’s unique to China, however, is the authorities have substantial control over banks, which are mainly state-owned, as well borrowers. In other countries, banking is done on a much more independent basis with independent actors. This means China’s authorities are able to manage default risk in a way that many other countries can’t. Still, we all know this can’t go on indefinitely. There is ultimately a constraint in terms of how much debt a certain level of GDP can absorb. I don’t think China has hit that limit yet — particularly if the authorities cut interest rates to lower the cost of servicing that debt — but we are closer to that limit than we were before.
China’s authorities finally got religion on this a few years ago and have been on a campaign to clean up the financial sector to avoid the types of issues we’ve seen elsewhere. They have made some important inroads, particularly with shadow banking, but there are still a lot of debt issues out there. Covid has exacerbated these problems, especially among smaller businesses and banks, and the government and banks are working to shore-up capital, write-off bad debt, etc. But we are still early in this process, and a lot of pain is ahead for many Chinese lenders.
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It seems that China has been able to do this partly because the country has an enormous pool of savings, giving the banks a large enough cushion to absorb this debt burden. Is that right?
There was a phenomenal amount of what we call “excess deposits” in the banking sector prior to the 2008 global financial crisis. What that means is deposits that had yet to be mobilized into credit. If we go back and look at China’s opening and reform period from the late 1970s to 2008, this was a very savings-oriented culture, with a very high accumulation of deposits. That’s why the stimulus in 2009 transmitted so rapidly — banks had a ton of excess funds on hand that could be lent out immediately.
It’s very different today, though. Most of those excess deposits have now been lent out. This means the authorities need to pair instructions for banks to lend with liquidity injections into the banking system to give banks the resources to extend new loans. Liquidity injections weren’t very strong in 2018–19, which is why credit extension was disappointing despite clear window guidance to increase lending. Earlier this year at the height of China’s Covid shock, the PBOC [China’s central bank] injected trillions of CNY [Renminbi] into the banking sector, and we saw credit rise quickly.
Banks, in other words, just don’t have the firepower they used to have, right?
Exactly. The natural rate of deposit growth has slowed. And on top of that, Chinese banks have depleted trillions of excess deposits. So to get credit going, and certainly to get it going at the rates of growth we are used to seeing when China is in stimulus mode, you’ve gotta have the PBOC actively injecting funds. As a central bank that can freely print money, there is no constraint on the ability of the PBOC to inject substantial amounts of money into the banking system, unless the country is experiencing significant inflation, which China currently isn’t. Nonetheless, this is an important sea change in China, and market participants need to understand that the past assumption that China is a high savings country with infinite deposits to fund infinite credit growth no longer holds.
If China’s banks don’t sit on the type of deposits they used to have, and were somewhat strained, why hasn’t Covid put them in great danger?
Because the PBOC did what central banks around the world did: injected a ton of money into the financial system. That gave banks the resources they needed to extend emergency loans and to smooth over liquidity issues arising from a decline in loan repayments. Liquidity is what tends to tip weak banks and weak banking systems over. A lot of problems can be pushed into the future when a central bank is willing to flood the system with money.
You’ve noted, in a recent report, a huge spike in consumer debt. I was under the impression that credit card debt was relatively low in China, as compared to the U.S., even non-existent. What happened?
There are a couple of caveats to that. China has four times the population of the U.S. So, in theory, they should have a substantially larger amount of consumer credit than here [in the U.S]. The second issue is the timing of that increase was consistent with a move to more fintech payment systems [like Alipay and Tencent’s WeChat Pay]. These days, almost everything in China has to be settled through a mobile phone app and that means you need a credit or debit card. Suddenly, hundreds of millions of people who didn’t previously use credit cards had to get them just so they could continue to engage in normal economic activity.
Before Covid hit, the authorities were trying to get banks to rein in credit card lending because some institutions had been too aggressive on that front, especially mid-sized banks with licenses to operate nationwide. However, post-Covid, the government has backed off from that pressure to reduce credit card growth in order to encourage consumption.
If China’s economy is affected by high corporate debt, rising consumer debt and a slowdown caused by Covid-19, the economy should be under unusual stress. Do you have a sense of whether this makes Beijing more eager to attract foreign capital?
They are increasingly eager for global capital. It’s one of the reasons we’ve seen a significant push toward getting Chinese stock and bonds included into various global equity and bond indices. Foreign direct investment isn’t what it used to be, and more and more companies and countries are talking about diversifying supply chains away from China, which means the marginal new dollar of foreign direct investment is less likely to go to China now than in the past. That ultimately means a loss of FDI [or foreign direct investment], which must be offset with portfolio inflows or else the balance of payments will turn negative. Flows into equities are often the first thing that come to mind, but it’s fixed-income flows that could really move the needle for China. China has the second largest bond market in the world with limited representation in global investment portfolios. There is enormous opportunity here for China’s bond market to attract inflows, given the country’s higher interest rates, well-managed economy, and an exchange rate that fluctuates less than other emerging markets’.
For a time, it seemed like they had huge foreign exchange reserves and were less dependent on foreign capital. Have we seen a reversal? Do they need this to help bolster the economy?
With a massive banking sector that’s more than three times that size of GDP, the amount of foreign inflows is still quite small. So it’s not a huge driver of growth and economic activity. But where foreign inflows do matter is in relation to the balance of payments. One of the striking things you’ll see, if you go back to the Global Financial Crisis, is that China was a massive balance of payments surplus country driven by a huge trade surplus. Today, that BOP [Balance of Payments] surplus is essentially gone. When a country moves into a BOP deficit, it is hemorrhaging foreign reserves. That in turn makes financial markets nervous about the value of the exchange rate, which is what was behind the volatility we saw in the second half of 2015 and early 2016.
Can you say something about the amount of money China raises offshore? How big is it, and how significant?
There is a lot more offshore debt in China than people realize. Our figures show about $2.6 trillion, while the official data is around $2.1 trillion due to a narrower definition of what constitutes a Chinese company. These are small numbers compared to a domestic banking sector with total assets of $43 trillion. However, it is a vulnerability for China’s balance of payments with net FX [foreign exchange] reserves now just around $500 billion.2Foreign reserves minus total external debt. That figure hasn’t been this low since 2005.
Foreign exchange reserves are what countries with managed exchange rates use to influence the value of their currency. Large reserves imply ample firepower to keep an exchange rate at a certain level, while low reserves can make market participants nervous about exchange rate instability. China has less firepower today to manage the CNY than many people realize due in part to this build-up of debt. Admittedly, it may be overly harsh to net the entire balance of offshore debt from a country’s foreign reserves since a lot of it doesn’t need to be repaid for years. However, there are instances when it makes sense, and I would argue that one of them is right now as Chinese financial institutions face potential sanctions from the U.S. for doing business with individuals and entities deemed to be undermining Hong Kong’s autonomy. If the U.S. were to impose stiff sanctions on Chinese banks that impacted their ability to access USD or roll their offshore USD debt, then it is very possible China’s FX reserves would be drawn on to fill this gap.
There’s been a lot of talk about the U.S. and China “decoupling,” and yet what you’re saying is that China very much needs to stay connected to the American and global grid and take advantage of the international markets, to raise money or finance its corporations. And so, the government very much needs to see those international channels open, right?
Just from a balance of payments perspective, they certainly do need to be open, just so they can stay in a position of U.S. dollar accretion, or at least flat. The biggest threat to that right now, of course, is the deteriorating relationship with the U.S. and with other countries as well. If you start looking at scenarios where you have sanctions or entity lists coming up in other countries and China needs to retaliate, some of that retaliation might mean closing themselves off to certain entities or certain types of investment flows. That would obviously be contradictory to what they want for their balance of payments. I think this is one reason China has been restrained in its retaliation against recent U.S. actions. They still need foreign investment — FDI and portfolio inflows — and escalating the conflict could disrupt these flows even more.
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Does this influence Beijing’s thinking on whether or not to further open up its financial sector to foreign institutions, like global banks, insurers and brokerage firms?
I think it does. The government has been lowering investment barriers to foreign financial institutions, but whether that will continue is a question given the looming threat of the U.S. imposing sanctions on Chinese financial institutions for conducting business with people deemed to be undermining Hong Kong’s autonomy. If this happens, China will have to retaliate in some way, and halting the opening of their financial sector to foreign investment is one option.
So global financial institutions, hoping to finally get a bigger foothold in China’s highly regulated and restricted financial services market could face new hurdles. Is that what you’re saying?
Yes. There definitely could be new hurdles if we get into a serious sanctions situation where the U.S. is imposing sanctions on prominent Chinese banks. If sanctions stay limited to just a handful of individuals and companies, then the spillover effects will be pretty narrow. But if we get into a situation where Chinese financial institutions are getting sanctioned, then yes, I suspect Beijing will be looking at ways to make life very difficult for U.S. financial institutions that want to be doing more business in China.
On the question of Hong Kong, there’s a new national security law, and China has acted with considerable power. The U.S. has already responded with sanctions, and the threat of more. Is Hong Kong’s status as a global financial center at risk?
It could be, but it ultimately comes down to how companies in Hong Kong choose to respond. In a more benign scenario, companies might say that they want to diversify their presence in Asia and start directing new investment into places like Singapore or Tokyo. That would mean marginal new growth and investment occurring outside Hong Kong, but no exodus of companies and capital. In a more detrimental scenario, companies will simply exit, partially or fully. That would be detrimental because it could lead to substantial capital outflows.
Hong Kong has a massive banking sector — 934 percent of GDP at the end of July — and a pegged exchange rate. Normally, in a free floating exchange rate environment, the exchange rate would adjust to reflect those outflows. But that can’t happen here. So there is a real concern about significant outflows putting stress on the peg. The authorities do have a lot of money backing the peg, but the mechanics of how all of that works is highly technical. This is one of the biggest macro imbalances in the global economy, and it’s present in a key global financial center. So the real question for Hong Kong is does the new national security law — and Hong Kong’s changing relationship with China — ultimately result in companies and people leaving Hong Kong to a point where it starts being very substantial in terms of capital outflows and stresses the peg.
If it stressed the peg, or if somehow it burdens the peg, what would be the result? What would happen?
We would start seeing the assets backing the peg get depleted. If it was fairly small, the market would brush it off, but if backing assets started falling significantly, market participants would get concerned that the authorities don’t have the resources to uphold the peg. At that point, capital outflows and conversions of HKD deposits into USD would start to spike, putting more pressure on backing assets. A lot of market participants take confidence in China’s large foreign reserves and assume that Beijing would step in to help. I’m sure China would intervene, but what resources they would have at that moment isn’t clear. As I noted before, China’s own foreign reserve adequacy is weaker than perceived, and if they started spending down a lot of their reserves to help Hong Kong, then market participants could start getting nervous about the CNY. China will help, but it won’t risk confidence in the CNY to help support the HKD.
On a simple level, would it mean that my holdings of Hong Kong stocks and other assets in Hong Kong could be devalued?
The value of the Hong Kong dollar — which fluctuates between a very narrow band of 7.75–7.85/USD — would have to fall for your holdings of Hong Kong stocks or other assets to lose value. For that to happen, the peg would have to break or be reset at a different value. There is certainly a risk that could happen in such a scenario, but it’s not a certainty. In a currency board, the relief valve in response to large capital outflows is interest rates, not the exchange rate. So as more money left Hong Kong, interest rates would rise, but the value of the currency would stay the same. If authorities were willing to tolerate very high interest rates for a prolonged period, then the peg wouldn’t necessarily have to break. Very high interest rates can be extremely costly though, so it is possible authorities would choose to abandon the peg or reset the value. The other way the value of your assets could be undermined is if financial markets started crashing. I would expect the stock market would be under severe pressure in such a scenario, so you would also take a hit from that.
There are small signs that the U.S. could limit or restrict U.S. government and military pension money from flowing into funds that invest in Chinese companies. Is there any risk that the U.S. government could put greater restrictions on American firms investing in Chinese companies listed here, or overseas, in Hong Kong or Shanghai?
There is a question over the next few years, particularly if Trump wins re-election, about whether U.S. authorities try to make China into an ESG [environment, social and governance] issue with the focus on the G [governance]. In such a climate, funds would have to assess whether they can or even want to be taking on China exposure, which would definitely be something that could offset China’s efforts at attracting inflows. Wall Street is such a huge lobbying constituency in D.C. that I find it hard to believe that the administration would go down this route aggressively, but a lot of surprising things are going on at the moment.
If you could offer some advice to the Chinese authorities, what’s the single biggest challenge they face, in terms of the banks or the economy?
China’s biggest challenges at the moment are (1) it is facing a world that is much less welcoming of its development than decades ago, and (2) its rapidly aging population. These have implications for its role as manufacturing center of the world, its potential growth rate, and, by extension, its ability to keep the debt issues we discussed earlier at bay. I will leave the international relationship advice for others to opine on, but I would suggest much more focus on demographic issues given their importance to the country’s long-term growth and development. I question how this new shift to a focus on internal versus external demand — what Xi Jinping has dubbed the Dual Circulation strategy — can be successful in a climate where the domestic working age population is declining.
David Barboza is the co-founder and a staff writer at The Wire. Previously, he was a longtime business reporter and foreign correspondent at The New York Times. @DavidBarboza2