The speech that rocked China's financial industry, from fmr Finance Minister Lou Jiwei
If your job involves China's finance, you should read it in full.
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China’s former Finance Minister Lou Jiwei made eight points in an explosive speech on China’s finance on Sunday, Dec. 20, 2020:
1. Significant financial chaos threatened China’s economy in a few years before 2016;
2. What Beijing did to resolve the chaos;
3. Beijing should continue to lower leverage and resolve financial chaos;
4. China should return to separate operation instead of continuing the journey of mixed operation in finance, namely limiting financial conglomerates;
5. Significant structural problems persist in China’s bond markets and China’s central bank shares at least partial responsibility;
6. Systemic risks exist with Alibaba-controlled Ant (Financial) Group growing exponentially; govt should intervene before it’s too big to fail; govt shall facilitate competition with Ant
7. China’s systemic flaw in identifying systemic financial risks calls for a Chinese version of the Financial Stability Oversight Council at the Treasury
8. China’s central bank failed in macro-prudential supervision; the state bailout of Baoshang and Hefeng banks is flawed in not sufficiently taking care of taxpayers’ interest.
Lou Jiwei, the former Chinese Minister of Finance and before that inaugural Chairman of the state sovereign wealth fund China Investment Corporation, ignited a fierce debate across the Chinese financial world with a public speech on Sunday.
Lou gave an extraordinarily candid reality check of China’s financial industry, from the early 2010s to now. Lou did not mince his words. In addition to criticizing what happened and still happens, he even called out China’s central bank and other regulators by name.
China’s economy and finance in itself already deserves big attention. Adding to that is Beijing’s recent opening up of finance to foreigners (ENG, Refinitiv). Wall Street, dubbed by as one powerful friend left in the U.S. of China (ENG, WSJ), rushed in taking majority/entire control (ENG, Bloomberg) of their once joint ventures.
Due to the explosiveness and depth of his speech, your Pekingnologist feels obligated to do a full translation. It’s a sharp, inside, and critical look at China’s finance industry from a high-level official. And English-language reports of this are meager. As far as your Pekingnologist is concerned, only three major media outlets - Bloomberg, Reuters, and South China Morning Post, and those were quite brief.
This is going to be a lengthy newsletter filled with jargon in finance. The subject here is highly technical and this one-man shop is certain to make mistakes. Suggestions for corrections are very welcomed.
Caixin, China’s leading financial news outlet published Lou’s speech (CHN) with a note that says 经本人审定 Lou himself reviewed the published version. That’s the Chinese source quoted below. All links, brackets (), and highlights are mine.
Notable pushback, including articles and experts apparently associated with the central bank, has also emerged. But this particular newsletter does NOT cover that - because this is already too lengthy.
One of the phrases Lou repeatedly used was 双循环 dual circulation and 内循环 domestic circulation. It will take pages to put that into perspective, but for the sake of simplification, just understand - in abstract - dual circulation as the entire Chinese economy, where there is one part that is externally linked, and the other part - domestic circulation - as the internal part of the Chinese economy that has few direct links with outside China.
On September 1 this year, General Secretary Xi Jinping presided over the 15th meeting of the central committee for deepening overall reform, proposing to "accelerating the establishment of a new development pattern featuring dual circulation, which takes the domestic market as the mainstay while letting domestic and foreign markets boost each other." The Fifth Plenary Session of the 19th Central Committee further listed the new development pattern characterized by dual circulation as one of the key elements of the 14th Five-Year Plan and 2035 Objectives. On April 9, the Central Committee and the State Council issued the guideline on improving the market-based allocation mechanism of production factors, a programmatic document to promote deeper reforms. Capital is among the five production factors, and on this I will share a few comments - or my experience.
The capital market here means a broad market, including not only stocks, bonds, bank credit/loans, but also regulation, financial infrastructure and the relationship between the treasury and finance.
NOTE: Throughout the following paragraphs, please remember the capital market is defined as a very broad one.
First, the danger of financial chaos to the domestic circulation.
In just a few years before 2016, serious chaos occurred in China's capital market. Large commercial banks all controlled insurance companies, opened stock brokerages, and, taking advantage of their advantages of (wide-spread) physical sites, sold insurance policies and wealth management products from affiliated and even other (unaffiliated) institutions, and stepped into PEs (private equity) and VCs (venture capital).
Insurance companies were keen to control commercial banks, and certain insurance companies with poor governance structures used this to facilitate their circular financing and Ponzi-scheme-like financing.
Banks bypassed the regulation of provision coverage ratio, risk provisioning, deposit-to-loan ratio and capital adequacy ratio, and moved a large amount of funds out of the balance sheet to carry out entrusted investment, creating shadow banking through "channels" and "pools of funds,” further raising the leverages of the relevant industries and accumulating risks.
Internet-based peer-to-peer lending was proliferating and risk events were frequent.
Interbank lending was not about smoothing through temporary liquidity shortages, and the scope of lending was beyond the banks.
The real economy did not have enough revenue, funds were pumped into the financial sector. It was a high leverage, high risk, high profit operation. The profits of the financial sector exceeded the combined profits of all other sectors of the economy, driving the real economy interest rates up significantly, leading to difficult and expensive corporate financing, , seriously affecting the development of the dual circulation, especially the domestic circulation.
1) The insurance company Lou referred to is of course Anbang headed by now-imprisoned Wu Xiaohui.
2) Like many in China, Lou uses the term “real economy” which is overwhelmingly considered in Chinese mainstream view as the most important part of the economy.
Second, the return of finance to its origin - serve the real economy.
At the end of 2015, the Central Economic Work Conference proposed "deleveraging." In the Central Financial Work Conference of 2017, General Secretary Xi Jinping further proposed that "finance should return to its origin and serve the real economy." After this, the financial chaos began to be tackled.
The first is to strengthen risk segregation, clean up the securities brokerages’ "pool of funds" . Bank-based asset management, which dominated China's asset management market, entered the era of independent subsidiary operation (ENG, Deloitte), and funds from banks were no longer allowed to go to equity investment.
Insurance companies "returned to insurance businesses", and their universal life insurance businesses were cracked down on.
Cleaning-up work on insurance companies’ circular financing through control of banks began. Securities brokerages were asked to focus on stockbroking and investment banking as the main business, and they were asked to isolate themselves from the “pool of funds” they used to run; securities investment fund companies were asked to strictly separate the different types of funds they ran and build a firewall in between, promises to bail out high-interest credit assets were forbidden.
Funds set up by PE and VC began to register, and they were ordered to be isolate from the “pool of funds”, to stop cross-fund manipulation for profits. Based on these moves, investors can better identify the risks associated with the funds.
Peer to peer lending has all been phased out. Macro leverage has stabilized at a high level, and market interest rates have stabilized with declines. The changes are welcome.
NOTE: Too technical for your Pekingnologist, who can barely get the translation correct.
Third, we can not waver in the direction of deleveraging and resolving (financial) chaos.
Since this year, the macro leverage ratio has increased again, about 20 percentage points higher than the end of last year, reaching more than 260%, which is a special change in a special period. The sudden outbreak of the coronavirus, unseen in a century, plunged both our country and the world economy into a deep recession. As a response, both China and the world adopted expansionary fiscal and monetary policies, leading to high leverages in the period. Now that China has made impressive achievements in controlling the pandemic and relaunching the economy, becoming the only major economy in the world to achieve positive economic growth. An orderly exit from the extraordinary fiscal and monetary policies is being considered. The macro leverage ratio should be stabilized and made to decline gradually.
First, although significant accomplishment has been achieved in the fight against financial chaos, it is far from successful. The cleanup of "pools of funds", the regulatory requirement that management of trust assets on the basis of their net value, so that the value of the trust product directly reflects the value of its underlying assets , the elimination of the presumption that local governments will always bail out state-linked borrowers, identification and cleanup of high-risk institutions, and disruption of financial infrastructure needs to be continued.
Second, macro policy spillover from the United States, Europe and other major countries is obvious, increasing the risk of global financial market volatility; while China is increasing financial openness, we need to "maintain strategic stability, do their own business".
1) Despite the world-wide recession where stimulus is the go-to option for China and other governments, Lou insists Beijing should continue deleveraging and an orderly exit from the extraordinary fiscal and monetary policies is being considered.
2) Resolving China’s financial chaos is far from over, in his opinion.
Fourth, the mixed operation of the financial industry should NOT be our direction, (we need) to change to separate operation (in finance).
Compared with the separate operation in finance, mixed operation appears to save operating costs, but it also more easily harbors and transfers risks, resulting in intensifying financial risks, bringing greater systemic risk to the national economy.
Meanwhile, for regulators to really control the risks associated with mixed operations, it requires the regulatory regime to go from separate supervision of separate financial licenses to fine-tuned grid supervision and engage in more stringent supervision.
This is not only difficult, but also (requires regulators) to go deep into the operations of the financial industry, and significantly increases the compliance costs of financial institutions. Looking at the issue comprehensively, if mixed operation really goes fully compliant, the financial institutions’ compliance cost may not be low from their own micro-level perspective.
From the measures (we’ve) taken to resolve the chaos, (we have in fact) weakened the model of mixed operation, and have been transitioning to separate operation. From the perspective of the national economy as a whole, the separate operation of the financial industry can better serve the development of the real economy.
NOTES: To put Lou’s words into a context that may be more familiar with English speakers, think along the lines of Glass–Steagall Act of the 1933 Banking Act and more recently Dodd-Frank.
At the risk of oversimplification, Lou champions a financial industry where banks be just banks (mainly just taking deposits and lending), securities brokerage be just securities brokerage, insurance companies be insurance companies, etc., and that regulators should NOT give too many various licenses to one financial conglomerate.
The significance of Lou’s words is that for years China’s finance industry has been effectively gearing toward mixed operation, but he thinks this direction is WRONG.
Fifth, the bond market now has more defects compared to the stock market.
China’s stock market experienced a major crash in 2015, after which the reform of the stock market was accelerated. There have been measures such as the introduction of registration-based (compared with administrative approvals) IPO system in the Shanghai Stock Exchange STAR Board, the introduction of net value-based securities investment funds, the simplification of delisting stocks, regulation of margin trade and short selling, and increasing the punishment for stock fraud, but of course there are many more reforms needed.
In comparison, bond market reform has lagged behind. Since the beginning of this year, bond defaults have occurred frequently, especially defaults of large state-owned enterprises, which have affected the credibility of state-owned enterprises and governments in the relevant regions.
The problems are, first of all, market fragmentation and lack of uniformity in issuance and regulation. There are three regualtors that can greenlight bond issuance: China Securities Regulatory Commission (CSRC), the People’s Bank and the National Development, and Reform Commission. In particular, the inter-bank market has evolved to one that’s no longer a place for inter-bank financing. Non-bank financial institutions and non-financial enterprises have been able to issue and list bonds, including medium-term notes, in the inter-bank market.
Second, the Exchange Bond Market and the inter-bank market, are divided in trading, leading to different pricing for the same bonds. In July, the central bank and the China Securities Regulatory Commission decided to agree to cooperate on undertaking interlinked and interconnected cooperation between the two markets, which is a good change and is recommended (by me) to be implemented as soon as possible.
In addition, most of the inter-bank market bonds are held by banks in large quantities. Banks underwrite and hold bonds, and market liquidity is poor. Once the debt defaults, commercial banks suffer.
There are still many problems in the bond market, and the basic condition is to have an unification of issuance standards, transaction circulation, and regulatory mechanisms
According to China’s Securities Law, the market (for bonds) should be the Exchange Bond Market, and the regulator should be the China Securities Regulatory Commission. The inter-bank market should return to its roots as the interbank lending market, corporate bonds should all withdraw (from the inter-bank market). Interest rate bonds (goverment bonds and policy bank bonds) can be traded in both markets at the same time, but the settlement should be interlinked to facilitate financing between banks, but also to enable the two markets to have same pricing for same bonds.
After the fundamental problems are solved, there are still big space for bond market reforms. We have to speed up in the problem-oriented and goal-oriented fashions, otherwise it will be the next place of big eruption of financial risks.
1) This is the part that has since caused the biggest pushback. Media outlets and experts apparently associated with China’s central bank have pointedly say Lou’s view is incorrect here. That pushback is NOT included in this newsletter because this is already too lengthy.
2) A number of high-profile defaults have shocked the Chinese bond market this year.
Sixth, we need to prevent data-based financial platform from becoming too big to fail.
Data-based financial platforms are developing rapidly in China and have a considerable positive role, mainly in collecting data and analyzing the risk profiles/characteristics of borrowers and providing them to lenders, to help lenders acquire customers and make risk assessments. This is conducive to complementing the capabilities of banks, especially small and medium-sized banks, to serve micro and small enterprises. However, the platform also have the potential to create systemic risk.
Some experts have already pointed out the platform(s) is(are) leveraged; the fintech platforms are so leveraged that, in lending, their own capital actually made up only a small percentage of the loans, resulting in insufficient "risk retention" which is in fact no skin in the game; their lending to corporate customers and to individual customers are disproportionate; there is also the issue of the the ownership of data in possession of the platforms.
Another important risk is that if a single platform has too large a market share, the authenticity of the data it "crawls" and the bias of the risk assessment model could be in question, potentially leading to a large number of bad loans.
For example, one platform has partnered with dozens of banks in just a few years, resulting in trillions of yuan in loans. We can limit the number of banks cooperating with a single platform, for example, to no more than 10-15. Also, enable multiple platforms to do similar business to create competition.
It is also easier to regulate if there are more than one platform, where it’s easier to compare and supervise, and to strike a balance between efficiency and risk, to prevent the winner-takes-all, too-big-to-fail situation, and prevent the potential for systemic risk. As the just-concluded Central Economic Work Conference called for, financial innovation must be carried out under the premise of prudential supervision.
NOTE: The whole text appears squarely aimed at Alibaba-controlled Ant (Financial) Group, to which China's anti-trust authority just opened a case on Thursday morning.
Seventh, macro-prudential supervision should be oriented to prior and interim supervision.
The recent interview and suspension of IPO of a data-based financial platform is to prevent systemic risk in a prior and interim fashion, which is the point. If systemic risk has already broken out and the government has to make a bailout, I’m afraid taxpayers are left to lose. In this aspect, there is international experience to learn.
The U.S. macro-prudential management is performed by the Financial Stability Oversight Council, chaired by the Secretary of the Treasury with members from various regulatory agencies. The Council meets regularly to analyze the potential risks in various financial areas. After a decision is made, the regulator in this specific area goes to “demine”/clear the land mine, and then reports to the Council.
A dedicated team in the U.S. Treasury Deparmtent compiles market changes and information from regulators, and and uses models as assistance in analyzing potential systemic risks, which are then presented to the Council. In this way, systemic risk is identified and put to a stop in the prior and interim stages.
The reason for the Treasury Secretary to chair the Council is that he or she is better suited to represent the interests of taxpayers - it’s his or her job to protect taxpayers. Our country lacks a mechanism to centralize the risk analysis from multiple areas, and address them in the prior and interim stages.
NOTE: Again, the platform Lou talked about is still Ant (Financial) Group.
Eighth, systemic risks should be handled in the interest of taxpayers.
According to the current institutional arrangement, the PBOC is responsible for macro-prudential supervision, but apparently it failed to prevent risks from happening in the prior or interim stages.
For example, according to press reports on the bankruptcy of Baoshang Bank (ENG, Pekingnology), a total of 170 billion yuan was put into the bailout by refinancing and China’s deposit insurance fund. In fact, that amount of money was the seigniorage that should have gone to the Chinese central treasury.
A popular narrative is that issuing money creates seigniorage. That is actually inaccurate. A proper financial analysis is that, seignoirage always exists: it increases when the balance sheet of the central bank expands, and decreases when the balance sheet of the central bank shrinks.
After deductions from the central bank's budget expenditures, the next seigniorage should be paid to the central Treasury and incorporated into the national budget that will have to be approved by the National People’s Congress (China’s national legistlature). And the entire budget should be made public.
The 170 billion, from (central bank’s) refinancing, if suffers losses, then the loss will offset gains in the asset-side of the central bank’s balance sheet, and (in fact) taxpayers will suffer the loss. Therefore, the central bank is the lender of last resort, but not the last bearer of the final loss.
We have to put taxpayers' interests as the top, choose a bankruptcy and restructuring plan which recovers losses from the embezzlement, misappropriation and bad debt (from Baoshang Bank), and hold (lawbreakers at Baoshang Bank) accountable, to minimize the current losses of taxpayers.
State equity should be remain in the bailouted financial institution, and the state equity can be converted into preferred shares, so as to make an exit when the institution goes above water.
However, in any case, it may be difficult to fully recover the principal and interest of the refinancing (the loan from the central bank used in the bailout), and taxpayers’ interest are damaged; revenue of the central Treasury is reduced, and the fiscal deficit is increased.
Baoshang Bank has long had serious problems with its governance structure, asset quality, capital adequacy and other core issues, which were ignored; regulators saw it but didn’t intervene; it finally erupted.
Therefore, it is most important to stop the problem in the prior and interim stages. I am unambiguously opposed to the 赤字货币化 monetization of deficits, which is the practice of making up for the fiscal deficit by overdrafting the central bank or issuing bonds directly to the central bank. However, I am even more opposed to the use of (central bank’s) refinancing to rescue (consequences from) systemic risks, resulting in losses offsetting the profits that should be handed over to the central treasury, resulting in the expansion of the fiscal deficit, which has become 货币赤字化 running deficit because of monetization (probably a bad translation).
This is not transparent, lacks supervision by the National People's Congress and the society, and implies moral hazard. In fact, the bankruptcy and reorganization of Hengfeng Bank is similar, taxpayers are burdened with current losses, and the only hope is that the entry of state-owned equity resulting in better returns in the future. In the process of continuing deleveraging and dealing with potential risks, similar situations may still occur and this has to be brought up for your attention.
NOTES: Lou called out the People’s Bank of China by name, saying it failed in its duty. Lou also has issues with the state intervention in Baoshang Bank and Hefeng Bank, apparently believing taxpayers suffered big current losses.
Pekingnology actually ran a detailed translation on how Baoshang Bank failed in August.
The above is a reflection on eight aspects of the capital market, to raise questions and offer solutions, for your reference, especially government departments, to help solve problems and make the development of the capital market more healthy and efficient, and contibute to the new development pattern of dual circulation.
Hope you find the long read worth your time. Happy Holidays!
The newsletter is penned by Zichen Wang, founder of Pekingnology. Feedback is welcomed at email@example.com.