China started to stabilise its macro leverage ratio in 2017 in the wake of excessive credit growth. To skirt the regulatory requirements, banks previously relied on shadow banking such as wealth management products and trust loans to channel credit to local government financing vehicles (LGFV), the property sector, and other highly indebted and unprofitable industries.

The ballooning credit brought shadow banking attracted the attention of financial regulators, who set their minds to crack it down to rein in the looming financial risk associated with over-leverage and the central bank’s lack of control of credit supply. In a recent article published by researchers affiliated with the China Banking and Insurance Regulatory Commission (CBIRC), broad shadow banking had scaled down from RMB 100.4tn at its peak in early 2017 to RMB 84.8tn by the end of 2019. The ratio of shadow banking to GDP also declined to 86% in 2019 from 123% in 2016. As a consequence, the macro leverage growth gradually slowed down before the pandemic had the trend reversed.

In 2020, in a bid to counter the economic fallout caused by COVID-19, China’s central bank, the People’s Bank of China (PBOC), announced for the first time that it would keep the growth of M2 and social financing in line with and slightly higher than the nominal GDP growth as written in the first quarter Monetary Policy Implementation report in 2020. The PBOC initiated injecting an elevated level of liquidity into the market via traditional open market operations and targeted policy tools such as relending and refinancing to small- and medium-sized banks. As of December 2020, the M2 growth reached 10.1% y/y after peaking at 11.1% in the second quarter of the year. The social financing growth also rose to 13.3% y/y, the highest in three years. Meanwhile, the annual nominal GDP growth picked up quickly to 2.99% y/y after a slump in the first quarter in 2020. In contrast, M2 and social financing growth in 2019 was 8.7% and 10.7% y/y, respectively, with full-year nominal GDP growth at 7.31% y/y. The government also took a proactive fiscal policy with a deficit-to-GDP ratio projected to be 0.8 pp higher than in 2019. A total RMB 100bn of special off-budget treasury bonds were issued for the third time since their introduction in 1998. The mix of monetary and fiscal support had a far-reaching impact on China's non-financial corporates, local governments, and banks. The financial risks ensuing from the elevated macro leverage, however, are quite differentiated among regions and sectors.

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The Corporate Sector

According to the Centre for National Balance Sheets (CNBS), as of Q3 2020, the non-financial sector leverage ratio in China surged to 270.1%, up 24.7 pp from the end of 2019. Within the non-financial sector, non-financial corporations saw the largest increase in leverage, due to the increasing supply of credit and abated interest rates benchmarked by the loan prime rate (LPR), which is linked to the medium lending facility (MLF) rate set by the PBOC. In fact, the supply-side reform aimed at phasing out excessive capacity in conjunction with the deleverage campaign in previous years has steadily driven down the leverage of non-financial corporations, notably for the property sector. Under the principle that housing is for living in, not for speculation and that the property sector should not be used as a short-term stimulus to prop up the economy, the liability asset ratio of the real estate sector has gradually inched down. The share of newly increased bank loans to the real estate sector has also seen a steady drop from nearly 50% at the peak in 2016 to around 20% in 2020 while the sector still accounts for almost one-third of outstanding bank loans. In August 2020, China further instituted new rules in real estate financing in a bid to limit debt levels, outlining caps for debt-to-cash, debt-to-assets, and debt-to-equity ratios for property developers. Specifically, the ratios of liability to asset and net debt to equity are not allowed to surpass 70% and 100%, respectively. The developers’ cash reserves should also match their short-term liabilities. On the other hand, the PBOC and CBIRC jointly launched a new regulation in December 2020 to curb the concentration of real estate financing in the banking sector and capped the share of real estate loans and personal mortgages in individual bank’s total lending. Looking ahead, the property sector is likely to remain the focus of macro prudential regulations.

In contrast, the state-owned enterprises, especially local ones that have indulged with implicit government guarantees, pose another financial risk. A series of corporate bond defaults in November 2020 rattled the credit market with their impact rippling through the end of 2020, resulting in a noticeable contraction of bond financing and a massive PBOC liquidity injection to calm down the market. The defaults and the absence of government support belied the assumption that state-owned enterprises always have government backup, especially against the backdrop of weak fiscal positions in 2020. In addition, tolerance of these defaults is also necessary in order to stabilize the surging leverage for non-financial enterprises as long as they do not incur financial risks on a larger scale. The year 2020 witnessed a great effort of the PBOC to support the small and micro-sized enterprises via various traditional and targeted monetary tools in a bid to boost economic recovery and employment, including deferral of the debt payment. At an executive meeting of the State Council in December 2020, an extension of this preferential policy was announced to continue to shore up the brisk recovery for micro-, small and medium sized enterprises as evidenced by a dip down into the contraction territory of PMI for small enterprises. Looking ahead, the financial risks stemming from MSMEs hinge on the pace of economic recovery. A below-expectation growth would lead to more defaults once targeted monetary tools are phased out.2021-03-03_16h16_44

Local Governments

The government leverage also jumped in 2020 thanks to accommodative fiscal policies. During the annual “two sessions”, a mix of fiscal support measures were announced including incremental fiscal funding worth RMB 2tn, which was made available by raising the budget deficit and issuing special treasury bonds to make up for the fiscal shortfalls of local governments. The 2020 deficit-to-GDP ratio was projected at more than 3.6%, up 0.8 pp compared to 2019. The special local government bond quota also went up to RMB 3.75tn, RMB 1.6tn more than a year earlier. By the end of the third quarter of 2020, the leverage ratio for the central government ticked up to 19.1% in contrast to 16.8% at the end of 2019 while that for the local governments jumped by 4.1 pp y/y to 25.6%. The local government debt outstanding by November 2020 reached RMB 2.56tn, up 19.81% y/y. Meanwhile, the growth rate of the broad local government fiscal revenue decelerated from 26.75% y/y in 2011 all the way down to 4.69% y/y in 2019. As such, the pressure of debt payment is mounting for local governments. That said, it does not mean a looming fiscal crisis for all of them wherein the deeply indebted central and western provinces relying heavily on fiscal transfer from the central government are the most precarious. It should be noted that we do not account for implicit local debt from the LGFVs here subject to data availability. The central problem arising from LGFVs is their asset quality. With the endorsement of local governments, LGFVs can have easy access to bank credit without concerning project returns. Based on an analysis published by the Paulson Institute, LGFV debt has not been invested wisely, leading to waste and returns of below 2% that is far lower than the cost of borrowing. The health of regional banks and the local economy are seriously put into question.

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