A government push to upgrade key manufacturing will need financing that the inefficient, largely state-owned lenders are best positioned to provide—for better or worse.
(Bloomberg Markets) — Optimism was everywhere in China’s finance circles back in 2014. E-commerce giant Alibaba Group Holding Ltd. wowed the world by raising $25 billion in New York. A new cross-border trading link let Chinese investors buy Hong Kong-listed stocks and foreigners trade mainland shares. Global index providers raced to include Chinese bonds and stocks in their benchmarks.
International asset managers’ China holdings exploded, from $753 billion in 2014 to $8 trillion at their peak in 2021. The thinking was clear: With the entry of Wall Street banks and a few more policy reforms, China’s financial markets would mature and allocate capital more efficiently.
That optimism is proving misplaced. President Xi Jinping’s policy pivot toward upgrading the industrial sector has placed capital-market developments on the back burner. For the inefficient, largely state-owned banking industry, however, things are looking up.
It’s a zero-sum game. The boom in asset management and the growing diversity of channels for raising capital posed a structural threat to banks, which to this day finance more than 60% of China’s economy. Since 2015 the People’s Bank of China has maintained its benchmark deposit rate at an artificially low 1.5%, allowing the country’s famously frugal households to be lured away by wealth products that offered higher rates. In 2017 a repository for leftover cash from online spending set up by Alibaba’s fintech affiliate, Ant Group Co., became the world’s biggest money-market fund, with assets hitting $270 billion. It offered a yield of more than 4%.
Banks were also seen as ineffective financiers, unwilling to lend without collateral and failing to pass lower policy rates on to borrowers. Unlike in the US, where key bank lending rates track Treasury yields, loan officers and bond traders in China live worlds apart. In 2019 the government set a new reference rate for bank loans, just so the PBOC could strengthen the transmission of its monetary measures to the real economy.
Fast-forward to the next decade: Despite their inefficiencies and inadequacies, banks will probably thrive, if only because they’re best positioned to fund the government’s industrial development ambitions. Since the US-China trade war began in 2018, Xi has steadily pushed for the country to become technologically self-reliant, building its capabilities in areas such as semiconductors, smart manufacturing, artificial intelligence and biotech.
Financing high-end manufacturing takes a lot of patience. Take Contemporary Amperex Technology Co., which dominates the global supply chain for electric vehicles, making its long-term future seem bright. But it’s still in a highly cyclical business. After two years of meteoric gains, shares of Chinese EV and battery makers have lost about 50% of their market value from their late 2021 peak. This is in part because battery inventory is at an all-time high, equivalent to 200 days of demand in China, according to Bernstein Research. As such, the current supply glut will take some time to absorb, and battery stocks are only trading at 10 to 20 times earnings despite a strong long-term outlook.
This explains why banks are a natural fit to finance such high-end manufacturing. Unlike fund managers, who have to worry about day-to-day market returns and client redemptions, banks can take a more long-term perspective.
Diminished appetite for risk, such as early-stage equity financing, is also a factor in China. While venture capital has expanded its holdings in the industrial sector since 2018—manufacturing as a percentage of VC investments grew from about 33% in 2017 to 72% last year—the checks that venture capitalists are willing to write are much smaller. Whereas the average investment size for, say, real estate was over $600 million, it’s about $100 million for semiconductors, machinery and biotech, according to data provided by the Centre for Asia Private Equity Research Ltd.
After all, some of these funds are still recuperating from hefty losses. They witnessed firsthand how billion-dollar investments in online education startups were wiped out overnight. Beijing has a track record of making sudden policy U-turns, so it’s better not to place too many eggs in the same basket and be caught overextended again.
The picture is even less rosy in the corporate debt markets. Bond traders are simply unwilling to fund China’s manufacturing ambition. The government’s deleveraging campaign, which began in 2018, ensnarled industrial companies even earlier than highly leveraged real estate developers. It’s a testament to just how capital-intensive these firms are, and how quickly they can slip into distress.
The most prominent case was the default of Tsinghua Unigroup Co. in late 2020, about one year before China Evergrande Group, the world’s most indebted builder. Unigroup was the closest thing China had to Samsung Group, the South Korean semiconductor conglomerate. Housed among its 250-some subsidiaries was Yangtze Memory Technologies Co., one of just a handful of domestic chipmakers within striking distance of the global leaders. Last year the company was placed on Washington’s lengthening US trade blacklist.
And yet there was no government bailout. Beijing allowed an apparent national champion, incubated by a top university that also happens to be Xi’s alma mater, to fail. That alone broke a few patriotic traders’ hearts. They learned that discarding fundamental credit analysis and co-investing in so-called strategic areas is a losing game.
After three years of Covid Zero’s snap citywide lockdowns and two years of regulatory crackdowns, global investors are asking if China’s entrepreneurs have lost their animal spirits and consumers are scarred. The same question should be posed to the country’s traders and asset managers: Do they still have faith in China’s financial future?
What’s left are the good old banks. In the past five years, loans to industrial companies more than doubled, to 19 trillion yuan ($2.7 trillion) as of the end of March, far outpacing those to real estate developers. Industrials and related trade sectors accounted for about 20% of the economy’s total new financing last year, up from just 4% in 2017. Clearly, factors other than economics are contributing here. In China, the government often relies on so-called window guidance—verbal orders to lenders—to speed up lending to strategic areas.
Meanwhile, banks’ funding pressures are easing, helping to solidify their dominance. They no longer have to fret about deposit outflows, after consumers learned through unfortunate experience that other types of seemingly safe investments can backfire.
Late last year, Beijing announced an easing of its Covid policy and vowed to stabilize the property market. That led to expectations of a growth boom, and bond yields spiked. Many wealth management products that invested in government securities and high-quality corporate debt incurred large paper losses on their holdings. By December, more than one-fifth of these investments “broke the buck,” reporting assets worth less than their face value.
Chinese savers fled. The 1.5% they could get from a one-year-term deposit at banks wasn’t generous, but it was better than losing money. Household deposits as a percentage of the economy’s funding source recovered to 42%, up from 36% in 2017, when Ant’s money-market fund drew savers.
For years, Beijing has been trying to diversify its financing channels, hoping to expand beyond hard-to-price bank loans to capital raising in the public sphere. In 2019 the government launched a Nasdaq-style tech board in Shanghai, allowing startups to go public faster. More registration-based initial public offering reforms followed, all designed to help tech firms tap the equity market.
In the past three years, more than 60% of equity raising on the Shanghai and Shenzhen stock exchanges went to the manufacturing sector. These firms now account for more than half of mainland bourses’ market cap.
However, from a macro viewpoint, these improvements are tiny and negligible. Bank loans are even more prevalent now, accounting for 63% of the economy’s total financing, from a low of 58% in 2017. Meanwhile, the share of funds raised via equity and corporate bond issues, which the government hopes to develop, has remained stagnant at about 12%.
Lenders are able to reclaim the crown in part because of regulatory crackdowns on so-called shadow banking—and the entire financial system is safer because of that. Although it’s a pity that public markets aren’t able to step into its place.
A nation’s financial future has a lot to do with the nature of its economy. A consumption-oriented society, such as the US, gives rise to a more diverse ecosystem of funding options. Consumers may feel more comfortable trading Big Tech stocks. They use Amazon.com, Apple and Netflix and can form investment views based on their personal experiences.
The opposite is true in China, where the government thinks an industrial upgrade, rather than domestic consumption, will drive the economy in the future. The development of its capital markets is thus necessarily slowed. It’s difficult for asset managers—not to mention retail investors—to pick winners out of thousands of small, highly specialized manufacturing firms. It’s a costly, labor-intensive endeavor.
To be sure, banks’ rising dominance doesn’t mean bankers are having a good time. Policy-driven loans have eroded lenders’ operating margins, and the biggest firms are periodically asked to bail out their smaller, failing regional peers. As a result, their return on equity has been halved, from more than 20% a decade ago to 9.3% in 2022.
Knowing their outsize economic might, Xi needs to ensure that bankers behave. His powerful anticorruption czar inspects big state-owned financial institutions regularly, promising to catch “tigers” and “flies” alike and cracking down on a wide range of offenses from bribery to dereliction of duty. Xi is cutting bankers’ pay, too. With youth unemployment at 20%, millions of fresh university graduates are waiting to join the profession at a fraction of the prevailing compensation.
This underscores that banks have become public utilities. Do utilities know how to pick national champions better than professional asset managers?
As long as the government’s industrial drive continues on steroids, banks have nothing to worry about. No one else is racing them to fuel Xi’s ambitions.
Ren is a Bloomberg Opinion columnist covering Asian markets. This column doesn’t necessarily reflect the opinions of Bloomberg LP and its owners.
(Corrects the currency shown in the second chart to yuan instead of dollars.)
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