Is Beijing Opening Its Financial Markets to Save Its Economy?

A Chinese bank employee counts 100-yuan notes and US dollar bills at a bank counter in Nantong in China's eastern Jiangsu Province on Aug. 6, 2019. (STR/AFP/Getty Images)

Commentary

As China continues to see its economy decline and foreign exchange reserves shrink, the Chinese Communist Party (CCP) has announced plans to open up the Chinese financial markets to foreign countries as a way to alleviate an immediate economic crisis and address long term concerns. 

However, the Western financial firms represented by the Wall Street may not actively respond, because they worry that their investments could go insolvent. The harder the CCP tries to cover up its economic truths, the stronger the trepidation of foreign investors.

Opening Up the Financial Industry During Market Stress

The Chinese economy’s decline is so obvious now that it marks the end of the economic stimulus era. China has tried to increase money supply using a variety of ways, but with increasingly lower returns. Chinese official media even admitted recently that “the tens of billions of RMB that China has spent on initiatives to boost the economy since the second half of 2018 have failed to stimulate economic vitality. They served as cardiac shots that only slowed down the pace of economic decline.”

This approach is like when a patient is beyond the power of any medication, the doctor simply gives him shots after shots of cardiacs. While the patient stays alive for now, the cardiacs’ effectiveness will inevitably dwindle over time because they can’t resolve the underlying issue. 

In a previous article on the Epoch Times, I explained that “The decline in the Chinese economy is a natural consequence of the Chinese Communist Party (CCP)’s blind and relentless pursuit of high growth.”

In normal situations, authorities would be extra cautious when navigating through economic hardship and avoid overly aggressive treatment that may worsen the current state. But the CCP has been going against common sense lately and made the bold decision to open up its financial industry to foreign institutions, which obviously will be a blow on China’s already fragile financial system. In mid-October Chinese Premier Li Keqiang signed a State Council decree to loosen restrictions on foreign ownership of Chinese financial firms. State media admitted that “this is another adventure for the Chinese economy.”

Opening up the financial markets was one of the many promises China made in 2001 when joining the World Trade Organization but has long refused to fulfil. Why did the CCP reject the idea of opening up during its economic stimulus period in the years before, but chose to take the risk now during much tougher times? Let’s review the reasons why the CCP refused to deliver the promise, as well as what’s driving Beijing to take that step today.

Twenty Years’ Rollercoaster Ride to Openness

China promised the world it would open up the financial market in “a few years” after joining the WTO. The “a few years” turned out to be two decades. 

Why? The fundamental reason is that the Chinese banking industry has been the authorities’ cash bag for too long in a planned economy system, that it can’t operate like a regular commercial banking operation. Commercial banks invest people’s deposits so risk management is a critical part of their lending process, as well as having collateral in place to protect its depositors. But Chinese banks, being owned and operated by the state, are under their jurisdiction and must lend to whomever the CCP wishes, therefore unable to function within the rules of regular commercial banks.

In the Mao era China adopted a planned economy model in which all funds in the country were controlled by the finance department and allocated by orders of the state planning committee. The banks during that time only had a small amount of personal deposits and business working capital to fund its loans, and lending was limited to only state enterprises’ short-term liquidity needs. Since the economic reforms of the 1980s, the proportion of state-managed funds declined significantly. In the meantime, personal deposits quickly grew to become the major source of funding as middle-class salaries rose and demand for goods soared.

But the banks’ risk management processes did not change with the fund source, because the planning committee holds on to some planned-economy era beliefs and view private deposits as unreliable and at risk of overdraft. The banks view private deposits as a tiger that needs to be kept in the cage. In the meantime the state planning committee insists on fully controlling usage of the funds. In the 1990s, the top four Chinese banks were ordered to provide “stability and unity” loans to state-run enterprises hemorrhaging cash. This resulted in soaring bad debts from the impotent state enterprises which pulled the financial system to the edge of bankruptcy. 

Later, when foreign companies flocked into China after it joined the WTO, the Chinese banks were struggling to survive. The CCP kept the foreign banks out in order to protect state banks. Fast forward to 2005, a cash crisis forced China to open up, and lowered the barriers to enter the financial market in 2006. HSBC, JPMorgan Chase, Woori, Deutsche Bank are among the first entrants, and some of them even opened multiple branches. Unfortunately, the spout was turned off in 2008 when China closed its doors again to keep out the global economic crisis.

The Embarrassing Aftermath of an Economic Bubble

Since 2008 the CCP has embarked on a journey of boosting its economy with land sales and money printing. In 2009 China’s broad money supply (M2) was 170 percent of its GDP. Today the ratio has maintained above 200 percent for five consecutive years. With China’s surface prosperity, it has hoarded a gigantic amount of foreign exchange reserves that reached close to $4 trillion in mid-2014, thanks to hundreds of billions of dollars’ annual trade deficit to the United States for many years. Sitting on an oversupply of RMB and sufficient foreign exchange reserves, the CCP had no reason to open up the financial industry.

But the “prosperity” was short-lived, and it did not take long for financial crises to reemerge. The excessive funds the Chinese banks injected into the real estate industry have formed a large bubble that is now on the verge of bursting. The economy is declining, and the currency overissuance has been maxed out. 

Since 2017, this downward economic trend has cast ominous shadows on the prospects of China’s real economy and left businesses deep in debt. The banks can’t find many credible enterprises that are willing to expand production, so they continue to lend to the real estate industry. 

Chinese financial insiders summarize this situation as “too much money but no liquidity.” “Too much money” refers to the central bank’s continuous over issuance of funds. “No liquidity” means the banks are starved of high-quality loans. Many businesses went bankrupt in 2018 due to debt default, excessive capacity, and overborrowing, while the more conservative small/medium enterprises struggle with a deteriorating economic environment. 

The result is an extreme reluctance to borrow by companies. Government infrastructure used to be an interesting project for banks, but today most of them are high risk with low return or even no return. As the central bank continues to inject funds, businesses unwilling to borrow, and banks reluctant to lend, a great amount of capital has silted up in the financial sector.

In the past two and a half years, the banking industry’s growth rate of loan revenue dropped from 15 percent to 8 percent. The loans by the central bank to commercial banks declined by 4.2 percent in September 2019. With excessive capital and declining economy, does China really need funds from foreign financial institutions? Obviously not. What this means is that the CCP is shooting for something else.

Open Up the Financial Industry to Save Foreign Exchange Reserves?

Foreign financial firms could do one or both of two things when entering China. First, exchange foreign currency to RMB in order to operate in China. Second, make investments in RMB. As discussed earlier, China has ample RMB liquidity. The CCP is targeting foreign exchange reserves: they don’t have enough now.

China’s foreign exchange reserves have shrunk from the peak $4 trillion in 2014 to today’s $3 trillion, a 25 percent drop which is still declining. Though $3 trillion sounds like a lot, it’s actually a shortage. China needs to take care of almost $2 trillion short term debts. At the same time foreign businesses have invested almost $600 billion, and they have been leaving China as a result of the trade war. 

Their exit is accompanied by the leakage of large amounts of foreign exchange in the form of capital withdrawal and profit transfer. The Chinese authorities would not dare to withhold the money, so the disposable foreign exchange reserves are in fact only several hundreds of billion dollars. The import of critical products like oil, food, and electronic parts will soon exhaust what’s left of the reserves. So it is obvious that the CCP is in need of more foreign currency.

That’s exactly why the CCP decided to open up the financial industry to draw in the much-needed foreign currency. But the financial world favors winners only. Once businesses operate well, banks would want to finance for them. But things are still gloomy today.

In September the CCP announced the removal of restrictions on foreign investment on Chinese equity and debt markets, but it failed to gain traction. The Washington Post said in a Sept. 12 article that the Chinese market is no longer a field of Dreams, but a Hotel California that “you can check out any time you like, but you can never leave.” Obviously Wall Street has noticed that it is pure luck that foreign investors can safely exit from the jungle with the cash-craving CCP lurking around.

All signs today point to an even more severe foreign exchange shortage in China. Western banking community will thus continue to avoid the Hotel California trap. As enticing as it sounds, China’s financial industry has lost its glamour. Capital always looks for the economic truths, while the CCP fears disclosure and wraps many layers of foil over the truth. But the more the packaging, the more the doubt.

Can CCP save its foreign exchange reserves by opening up the financial market? I’m afraid Beijing will be disappointed again.

Dr. Cheng Xiaonong is a scholar of China’s politics and economy based in New Jersey. He is a graduate of Renmin University, where he obtained his master’s degree in economics, and Princeton University, where he obtained his doctorate in sociology. In China, Cheng was a policy researcher and aide to the former Party leader Zhao Ziyang, when Zhao was premier. Cheng has been a visiting scholar at the University of Gottingen and Princeton, and he served as chief editor of the journal Modern China Studies. His commentary and columns regularly appear in overseas Chinese media.

Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.