Modern economies rely on complex financial systems to support growth and prosperity. At an earlier stage of development, China achieved economic growth despite an immature financial system, as state-led investments in areas such as infrastructure were high return. Today’s requirements are more complicated and risks are apparent. China’s financial reform goals include improving efficiency (return on investment) and reducing systemic risk while attempting to preserve state influence. China has made strides, but long-standing tasks remain unfinished even while new ones emerge and the cost of retiring old liabilities swells.

To gauge the state of financial system reform, we construct a quarterly incremental capital output ratio (QuICOR) as an acid test for efficiency; then we discuss the policies giving rise to this picture. The indicator tells us how much investment occurs relative to one unit of output growth: a lower ratio is better, with 3.5 being best practice internationally according to IMF guidance. To supplement this analysis, we look at other indicators, including total credit growth rates, the ratio of stock and bond financing to less direct channels, interbank lending rates, return of household savings, and the foreign bond holdings.

Quarterly Assessment and Outlook

China demonstrated some positive movement in financial system reform this quarter, as reflected in policy developments and outcome indicators. However, improvements were very modest. Challenges remain elevated and important parts of the system remain cordoned off from market forces.

The outlook for further progress is reasonably good. In the short term, monetary policy continues to support more efficient risk pricing for credit (higher rates) and enhanced enforcement, while the new Financial Stability and Development Commission (FSDC) augers well for more coherent regulation in the longer term. The main risk to this outlook is that leaders shift back to worrying about growth rates (which will fall due to financial reform) instead of long-term financial health, and dilute the policy mix that now supports progress. As for other reform clusters, the October 2017 Party Congress was watched closely for signals on financial reform. The China Banking Regulatory Commission (CBRC), China Insurance Regulatory Commission (CIRC), and People’s Bank of China (PBOC) are all likely to have new leaders in the near future, which could impact the pace and direction of financial reforms. If successful, foreign inflows through new programs such as Bond Connect should soon be evident in our indicators.

This Quarter’s Numbers

Our capital output ratio (QuICOR) continued a slight moderating trend from 2016 highs, ticking down to 7.0. This remains highly elevated – double international best practice and well above recent Chinese levels. China needed less than 5 RMB of capital investment to generate 1 RMB of output growth seven years ago; today it takes 7 RMB. Capital stock investments (everything from new factories to truck fleets to business computers) that generate less GDP growth indicate financial inefficiency. This results from the overall state of financial affairs, not some discreet issue. And the chart shows a persistently high ratio over the five-year period, not a short-term anomaly.

The slight moderation this year is good news, and the first in four years. It flows from action by the PBOC over the past year to slow investment growth and let borrowing rates rise. But our QuICOR indicator remains high despite the bank’s success at holding growth rates of aggregate new financing and bank loans flat through 2Q2017 (see Growth in Credit). Too large a share of new credit is still going to fund or restructure financial transactions rather than generate new output in the real economy.

The main risk…is that leaders shift back to worrying about growth rates…instead of long-term financial health, and dilute the policy mix that now support progress.

At the current rate of moderation from very high levels (0.1 decrease per quarter), it will take until 2024 for China to return to 2010 investment efficiency levels. Such a gradual deceleration would avoid a sharp growth slowdown but would result in a lot more bad debt in the future. If the pace of investment rationalization quickens, fewer bad loans would be made, but a more painful GDP deceleration would occur. This is the essence of the financial system reform challenge Beijing faces.

Direct Financing Ratio looks at the share of bond and equity financing (“direct” financing, which is generally more effective at generating sustainable output growth) relative to bank lending (“indirect” financing). The traditional dominance of banks in China gives government a tool for steering investment flows but leads to inefficiency and bad debt, and Beijing pledged to change this in the 2013 Third Plenum reform manifesto. Yet in 2Q2017, bond and equity markets continued to subside as a share of credit growth, representing just 15.9% of the total versus a 2015–16 average of 26% (this is on a four-quarter moving average basis: looking at 2Q2017 the share was 0.6% – essentially zero). Both a lack of new equity listings and higher borrowing costs in the bond markets contributed to this.

Higher bond financing costs make sense, given the high QuICOR ratio and current risks to growth in China: savers should expect more return for putting their assets in jeopardy. But not all credit channels respond to these fluctuating financial risk conditions in the same way, because government influences the outcomes. Banks are considered safer borrowers, on the assumption that Beijing will bail them out if needed. Through 2Q2017, bank funding rates were up about half a percent over 2016 levels, from 2.4% to 2.9%. For riskier nonbank financial institutions (NBFIs), including those referred to as “shadow banks,” short-term borrowing costs have risen more, from 2016 levels comparable to bank rates (2.5%, suggesting risk was not being properly priced in) to a 2Q2017 average of 3.34%. Interbank Lending Rates shows these trends. The rise in short-term rates for both banks and nonbanks and widening of credit spreads between them are encouraging from a reform perspective: risk is better priced in. At the same time, this rise in rates means a greater risk of financing stress – and defaults – for borrowers in the near term, if this rationalization continues (which it has so far in 3Q2017). This is the rub: only the introduction of real financing risk today can lower systemic risk in the future.

Return on Savings shows the changes in financial conditions from the other side of the market: rates household depositors get for their savings. In a market-driven system, higher borrowing costs for banks and nonbanks usually show up in the rates offered to citizens for savings account deposits. But in China, the state controls those rates and continues (through 2Q2017) to keep them low and fixed at 1.5% (the one-year deposit interest rate) to reduce defaults. Various financial institutions – banks and nonbanks – meanwhile offer households “wealth management products” (WMPs) at more flexible rates that are not guaranteed to the same degree as savings deposits (though households are sometimes misled to believe they are riskless). As the chart shows, WMP rates have diverged sharply from the savings deposit benchmark rate, with a five-year high in the spread this quarter. Again, from a reform perspective, this rise in returns is healthy, though this raises funding costs for borrowers and thus should slow growth. The divergence between these market-influenced rates and state-controlled benchmark savings rates illustrates the opposing forces at work: political desire to keep growth stable and market signals that rising risk necessitates higher returns and lower growth.

This is the rub: only the introduction of real financing risk today can lower systemic risk in the future.

Finally, foreign participation in China’s financial system can bolster sustainability. International players bring additional capital, more advanced risk management skills, and other assets. Greater foreign participation in bond markets is a Chinese goal. During 2015 and 2016, Beijing took many steps to open China’s bond markets wider to foreign participation, to enhance domestic liquidity and balance outflows and to create reasons for foreigners to hold Chinese currency. These factors are critical for balance of payments and exchange rate dynamics. But to date, foreign bond holding remains minimal, with only 1.4% of all bonds in the market in 2Q2017 being foreign held – a mild increasing trend since the start of 2016 in both value and share, though the share was higher in 3Q2014 (see Foreign Held Bonds). Foreign bond holdings were on the rise previously in anticipation of solid returns, low default risk, and the prospect of exchange rate gains. Foreign expectations moderated in 2015 partly due to financial challenges in China such as the equity market crash and partly due to global conditions. Meanwhile the total value of Chinese bonds more than doubled from RMB 27 trillion (approximately USD $4 trillion) to RMB 62 trillion (USD $9.3 trillion) over the past three years. This explains the chart. As China allows rational risk pricing and creates confidence in its bond markets, opportunity will be created in China and we should see the indicator of foreign bond holdings rise.

Policy Analysis: 2Q2017

During this quarter, the financial policy balance between maintaining growth and addressing systemic risk continued to show a rebalance that began late last year, as reflected in our data indicators. The 2Q2017 monetary statement posture was to “continue to implement a prudent and neutral policy, keeping liquidity in the financial system basically stable.” In practical terms, this has meant more tightening than neutrality – hence, the rise in borrowing rates described earlier, although the bank made liquidity more ample at times in the quarter to reduce tensions. Regulators coordinated their messages and actions more carefully, and loopholes for financing were closed. Three policy developments were notable: anti-corruption investigations at the China Insurance Regulatory Commission (CIRC) and the China Banking Regulatory Commission (CBRC), a “regulatory storm” aiming at risk-management and cracking down on companies involved in investment overseas, and establishment of a new Financial Stability and Development Commission (FSDC) shortly after the quarter.

Foreign participation in China’s financial system can bolster sustainability.

The Communist Party placed Xiang Junbo, chairman of the CIRC, under investigation for “serious violations of regulations” in April, and Yang Jiacai, assistant chairman of the CBRC, under investigation in May. Both Xiang and Yang were veteran financial regulators who spent their careers working in state-controlled banks and regulatory agencies. Former China Securities Regulatory Commission (CSRC) vice-chairman Yao Gang was placed under investigation by the Party earlier, as well. Thus, three of China’s four financial regulatory institutions have at least one former vice-chairman under investigation and in various stages of incarceration (PBOC being the exception). The purge of high-level financial officials signals top leader exasperation with the ongoing challenges of stabilizing and reforming the financial system.

Perhaps spurred by those arrests, CBRC issued seven policy documents within 12 days in April, calling for regulatory scrutiny and warning against rule violations in the banking industry. On the list were “regulatory arbitrage” and “improper financial innovation.” Later in June, in a document leaked online, CBRC cracked down on a number of private companies for creating “potential financial risks” for the country and instructed banks to review their exposures. These companies were all involved in high-profile overseas acquisitions, and irregularities in those deals appeared to be Beijing’s concern. The move sent a strong message and these firms’ equities, as well as Chinese outbound investment in general, took a hit. Largely as a result of these heavy-handed interventions in cross-border capital flows, by mid-year net outflows in China’s balance of payments had stabilized, though at some cost to policymaker credibility.

In July (shortly after our 2Q2017 period), President Xi Jinping chaired a once-in-five-years National Financial Work Conference (NFWC). The most important outcome was establishment of a Financial Stability and Development Commission (FSDC) to be staffed by PBOC personnel. The nascent unit is to serve as a coordinating body to streamline the work of financial regulators. This appears to be instead of previously rumored plans to merge CBRC, CIRC, CSRC, and the PBOC into a single agency. In terms of the new commission’s mission, President Xi said that SOE and local government debt levels were to be aggressively reduced.

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