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VULNERABILITIES IN CHINA’S FINANCES; RISKS FOR U.S.

The U.S.-China Economic and Security Review Commission has issued its annual report to Congress. The New York Analysis of Policy and Government will periodically present summaries of their work.

In 2020, the Chinese government leaned on state control to contain the  economic fallout of the COVID-19 pandemic, instructing banks to lend  to companies hard hit by the virus and deploying the country’s financial  system to absorb the pandemic’s shocks. While Beijing’s response has  enabled a rapid recovery in China’s economy, it has done so by fortifying the role of the state in managing economic activity and promoting policies.

The Chinese government is beginning to experiment with breaking  this implicit guarantee and to defuse risks in China’s financial system  as regulators embark on a cleanup of the banking sector and assess  systemic problems caused by a decade of rapidly accumulated debt  (see Figure 6). Confronting the scale of these problems, the Chinese  government increasingly views foreign capital as part of the solution.  Beijing’s financial opening in recent years thus reflects a calculated  strategy to secure foreign investment inflows and use them to shore up  the domestic economy and strengthen its companies. As this opening  continues, exposure to unique risks in China’s financial system rises  for foreign investors, and their financial wellbeing becomes increasingly  staked on Beijing’s management of the Chinese economy. China’s  financial opening is also deepening U.S.-China financial integration just  as the U.S. government takes more concerted steps to confront China’s  unfair economic policies and threats to U.S. interests. Of particular  concern is the rising inclusion of Chinese securities in global investment  indices. These inclusions are funneling hundreds of billions of U.S.  investment dollars toward a financial system that lacks transparency,  adequate pricing of risks, and regulatory oversight (see Figure 7).  They are also financing companies whose operations are otherwise  antithetical to U.S. national security and foreign policy objectives.

There is every indication that China’s quest for foreign capital will  continue. Local governments shoulder crushing debt levels, banks  remain undercapitalized, and increased public expenditure on caring for  an aging population will erode national savings. U.S. portfolio investment  inflows to China are also poised to grow significantly, especially if  China recovers from the pandemic ahead of other economies, making  Chinese financial markets more attractive. As these trends converge  and U.S. exposure to risks in China’s financial system rises, doubts  about whether deepening U.S.-China financial integration is desirable  are coming into sharper relief. 

Key Findings 

China’s formal financial system is dominated by state-owned banks,  whose position has been strengthened in the wake of the COVID-19  pandemic in 2020 (see Figure 8). These banks favor state-owned  enterprises (SOEs) and privileged companies, leaving other Chinese  companies starved for capital. Between 2008 and 2016, a large and  unwieldy shadow banking sector emerged to fill this gap, leading to  a proliferation of risky financial products and rising leverage across  China’s financial sector. 

▶ In 2016, Beijing launched a financial de-risking campaign to rein  in shadow banking activity and clean up the financial sector. This campaign choked off small private companies’ access to financing.  The COVID-19 pandemic has further deteriorated the financial health  of these companies, forcing the government to ease its regulatory  tightening and prioritize economic stability over financial de-risking.  With such vulnerabilities remaining unaddressed, investors in China’s  capital markets are increasingly exposed to structural problems in  China’s financial system.  

▶ As Beijing strategically opens its financial sector to secure foreign  capital and global investment indices shift asset allocations toward  Chinese securities, U.S. investors’ exposure to the unique and  significant risks accumulated in China’s capital markets rises (see  Figure 9). These risks center around the opacity of China’s financial  system and Beijing’s interference in market activity to advance its  political objectives. 

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▶ Increased financial exposure to China threatens to undermine U.S.  efforts to defend against China’s unfair economic practices and  protect U.S. policy interests. Several Chinese companies included in  global investment indices are subject to U.S. export controls but not  investment restrictions. This mismatch enables problematic Chinese  companies to continue raising U.S. capital and reduces the strength  with which the United States can defend against companies that  threaten national security. 

▶ While China’s leadership speaks of developing more dynamic capital  markets, liberalizing interest rates, and imposing market discipline  on the banking sector, these ambitions are tempered by a low  tolerance for market instability and a strong bias in favor of state 

owned companies to maintain economic growth and safeguard  employment. 

▶ After years of unbridled lending, China’s financial system is facing  

▶ Beijing continues to deny U.S. audit regulators full visibility into  the financials of U.S.-listed Chinese companies in line with U.S.  accounting standards. These evasions from effective regulation and  oversight, together with U.S.-listed Chinese companies’ complex  ownership structures, deprive U.S. investors of both full transparency  and the opportunity for legal redress in cases of accounting fraud,  eroding the integrity of U.S. capital markets. 

▶ The COVID-19 pandemic has exacerbated key risks in China’s  already strained financial system. Although a full accounting  of economic damage is still underway, China’s first economic  contraction in four decades will make it more difficult to tackle  the country’s debt burden, resolve nonperforming loans, and  efficiently allocate capital. 

▶ Beijing’s imposition of the national security law in Hong Kong  has accelerated the territory’s assimilation into China’s national  governance system, which could erode its status as a global financial  hub. As the Chinese government calibrates financial opening, it may  lean more on Hong Kong to raise foreign capital and serve Chinese  companies and continue to rely on the territory as an extension of  mainland capital markets. 

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