China’s Global Integration
Last year, China’s capital outflows of almost $500 billion and its stock market volatility were top of mind. Now, after years of rapid credit expansion amid declining return on investment, signs of stress have surfaced in China’s financial system in the form of banks’ balance sheets. An underlying factor common to these events is China’s continued financial liberalization, a process that market participants will need to understand and adjust to.
To that end, the Milken Institute has just released “China’s Global Integration and Capital Flows,” the first in a series of reports whose goal is to summarize and present the most pertinent information on Chinese capital flows to investors and policymakers.
Driven by public investment, nonfinancial corporations have amassed debt totaling 170 percent of GDP. (See Figure 1.) This has led to concern among analysts and regulators alike about vulnerable corporations having to juggle declining earnings and increased debt repayment.
Figure 1. China non-financial corporate credit outstanding as a share of GDP
Source: Bank of International Settlement
It therefore wasn’t surprising that the China Banking Regulatory Commission issued a notice September 9 directing banks to establish creditor committees to ensure smooth debt restructuring and continued access to credit. This is in line with other initiatives to lighten the burden on banks, such as debt-to-equity swaps, sales to asset-management companies and securitization. These tools are aimed at both cleaning up banks’ balance sheet and restructuring corporate debt that has been weighing on companies’ performance. But at the same time, these measures allow failed companies to keep going, thereby distorting the natural life cycle of markets. And while providing corporations with the needed financing is paramount to economic growth, it is becoming increasingly difficult to distinguish between providing short-term remedies for a company with long-term prospects and merely keeping a failed company afloat.
In the near future, China will have to tackle the difficult task of balancing continued growth driven by public investment with sending a clear signal that so-called zombie companies will not be kept alive in the absence of sensible economic prospects.
Free Trade and Economic Zones
The process of opening Chinese financial markets, while rather jagged at times, has been consistent in recent years. A key component has been the development of the Shanghai Free Trade Zone and Shenzhen’s Qianhai Special Economic Zone (Guangdong Province), which are considered prototypes for the broader economy on relaxing controls on international capital flows. Meanwhile, the government’s timetable for full currency convertibility will facilitate foreign portfolio investment in China.
On August 31, the commerce minister announced approval of seven additional free-trade zones (see Figure 2), more than doubling the number and expanding them toward the west. This can be seen as part of the “One Belt, One Road” initiative as well as an extension of the country’s opening process beyond the existing zones along the east coast. However, the goal of these new zones will be geared toward regional growth and ties rather than serving as testing grounds for new reforms. The goal is to create regional industry hubs that will further innovation-driven development and invigorate foreign direct investment into heavy-industry regions that have been struggling with the new model of economic growth reliant on consumption, services and innovation. This ride will no doubt be a long and bumpy one, but the message toward broader and strategic opening has been clear for a while now.
Figure 2. China’s provinces with free-trade zones
Source: Milken Institute, 2016.
For an in-depth analysis, see our most recent report, “China’s Global Integration and Capital Flows.”