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Opinion: Beware of Risky Financial Innovation

China’s policymakers must guard against risky financial innovation while achieving balanced deleveraging, said Huang Qifan, vice chairman of the National People’s Congress Financial and Economic Affairs Committee and former mayor of Chongqing, at a national governance forum Saturday.

The following is an abridged version of Huang’s remarks, translated from Chinese:

On macroeconomic deleveraging

China’s macroeconomic leverage ratio is currently very high, as the following indicators show.

China’s M2 measure of money supply reached 170 trillion yuan ($26.0 trillion) in 2017, 2.1 times the size of its gross domestic product (GDP), indicating excessive leverage. Compare this with the U.S.’ M2 measure, which was around $18 trillion, or 0.9 times its GDP last year.

Another indicator is the rise of the financial sector as a percentage of China’s GDP. In 2005, finance accounted for only 4% of China’s GDP. That figure grew to 7.9% by the end of last year, and has hovered around 7.8% in the first five months of 2018. The global figure is around 4%. The higher a proportion of GDP accounted for by the financial sector, the more likely an economic crisis will be, as other countries’ experience shows. For example, the financial sector’s share of Japan’s GDP reached a high of 6.9% in 1990 before the Japanese economy was hit by a crisis and entered its two “lost decades.” The figure in the U.S. reached a high of 7.7% in 2001, right before the internet bubble burst, and climbed again to 7.6% 2006, before the subprime mortgage crisis.

Additionally, China’s macroeconomic leverage ratio is currently very high. Last year, debt in China, including government, residents’ and nonfinancial enterprises’ debt, added up to almost 250% of the country’s GDP, putting it among the world’s most leveraged economies. At present, debt in the United States is equivalent to 250% of GDP, while it is 350% in Japan.

The last indicator is the liability ratio of increases to China’s total social financing. Last year’s increase in total social financing was 18 trillion yuan, compared to the average annual increase of 5 trillion to 6 trillion yuan a decade ago. Equity accounts for only 10% of total new financing today, with debt accounting for 90%. If this ratio persists, we can imagine that China’s debt will not shrink over the next 10 years, but instead grow higher and higher.

Based on these indicators, China’s central government has pushed for macroeconomic deleveraging and risk prevention.

There are three main ways to deleverage, based on other major economies’ experience in the past 100 years.

One path is overly austere deleveraging. This is a very bad form of deleveraging. Deleveraging, of course, will bring about financial contraction, but improper measures and overly tight financial policies will cause serious economic depression or even economic collapse.

The second path is deleveraging through serious inflation. By injecting money, bad debts are diluted through inflation. But this transfers the burden of bad debts onto residents, potentially causing a violent economic crisis and social upheaval.

The third path is benign deleveraging. Although the economy has been restrained, it remains healthy, and industrial structure and enterprise structure are adjusted for the better. Not only does this form of deleveraging reduce macroeconomic leverage, it also avoids economic depression. In order to achieve benign macroeconomic deleveraging, China should form a system of targets. If China sets a target of a 50-point fall in macroeconomic leverage, the leverage ratio will remain at around 200%, which is more reasonable.

On financial innovation and risk

Generally speaking, the innovation of financial enterprises can be divided into three types. The first type is business-model innovation, to meet the needs of economic development and to solve problems, For example, the business models of third-party payment, consumer finance, and so on have appeared in recent years due to the development of the internet. The second type is innovation in service models, such as the innovative payment methods offered by Alipay and WeChat on smartphones. The third form of innovation is innovation in financial products for the purposes of profit and leveraging. Financial supervisors must be most on guard when it comes to the third kind.

Usually, commercial banks’ financial management business and shadow banks’ capital management businesses engage in a lot of this kind of innovation. Shadow banks’ modus operandi involves obtaining financing from the short-term, lower-interest-rate capital market, to invest in longer-term financial products with higher interest rates and higher risks.

Commercial banks’ funds are transferred to shadow banks through off-balance-sheet transactions or the interbank lending market, becoming the basis of these financial products. Shadow banks’ high leverage, opacity, and close connection with commercial banks hugely magnify financial risk.

China has already created licenses for over a dozen categories of financial products, spanning banking, bonds, insurance, small loans, and other areas. Most of the time, financial innovations use high interest rates, guaranteed repayment, capital pools, maturity mismatches, multiple stacked and nested channels when absorbing and placing funds. These methods increase leverage while decreasing transparency. During procyclical periods, product efficiency increases. But during countercyclical periods, losses grow sharply.

In practice, there are a number of combinations of methods that regulators and policymakers should guard against.

The first is the combination of guaranteed repayment and high interest rates in financial management with banks’ desire to attract deposits. For example, universal insurance usually offers around 50% higher interest rates for a particular term than deposits over the same period. Because of the higher interest rate and higher returns, people are attracted to invest in it. But high interest rates and high returns are not enough to attract deposits without guaranteed repayment. What if, in the future, the financial institution is unable to pay back even the principal? So, the promise of guaranteed repayment is the driver of all actions to attract people’s funds. People dare to buy universal insurance, despite the risks, because of a mistaken belief that the bank will not default on its debts. If China wishes to do away with the concept of guaranteed repayment, investors will have to start considering the risks of their investments.

The second dangerous combination is that of stacking and nesting multiple financing channels. In order to further expand leverage and continue borrowing, many financial institutions shift their liability into private funds, disguising it as a form of equity, covering up the leverage of this part of its capital. Over the years, many of China’s cases of “snakes swallowing elephants” — small and midsize insurance companies acquiring larger listed companies — have essentially been achieved through using universal insurance to increase leverage. Overlaps between various segments further exacerbate the risk.

The third dangerous combination is that of maturity mismatch with the pooling of capital. When the capital in a particular pool comes from a variety of sources, some of it must be returned in a year or two years, even though the loans extended by the pool itself often mature in three to five years, or even 10 years. With excessive use of capital pools, making maturity mismatch widespread, liquidity risks will emerge.

Financial regulators must set a clear red line that financial innovations must not cross. For example, shadow banks can be allowed to pool capital, but the ratio of maturity mismatch must not exceed 30%. If it exceeds 30% or even reaches 100%, it must clearly be recognized as a Ponzi scheme.

Last but not least, China must prevent the risks that arise when loans are circulated multiple times, causing the leverage of each cycle to be superimposed on the others. Stock exchanges should set limits to the number of cycles, and the capital adequacy ratio of total financing should be capped at 1:10 in order to control risk while enlivening the market.

Translated by Teng Jing Xuan (jingxuanteng@caixin.com)

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