China is opening its financial firms to more foreign ownership. The opportunity might seem tempting. But developed-world buyers should beware -- it’s possible that it’s a trap.
On Nov. 10, Vice Finance Minister Zhu Guangyao announced changes in the rules limiting foreign ownership of Chinese financial companies. Foreign investors will now be allowed to take controlling interests in Chinese securities firms, insurance companies, asset managers and futures traders. Banks may soon follow.
That sounds like a move toward greater openness for the world’s biggest economy. If so, it would run exactly counter to the recent trend of increased Chinese protectionism and economic nationalism. Why would China open its financial system to foreign investment even while it slowly closes off its consumer markets? I suspect that this move toward openness and globalization might not be all that it appears.
China’s financial system has been on shaky ground for at least two years now. The root cause is a cooling of the country’s rapid economic growth.
This was a natural and predictable slowdown, caused by the drying up of rural surplus labor, an aging population, rising labor costs and peak coal production. But even as the economy slowed, housing and stock prices kept rising. With asset valuations still gaining while the fundamentals slowed down, a correction was likely. For a while, it looked like a stock market plunge in 2015 was the beginning of the bursting of a huge bubble.
Capital flooded out of China for more than a year.
The government was forced to sell a sizable chunk of its foreign exchange reserves to prop up the yuan. Eventually China’s government managed to clamp down on the capital flight.
But there is a definite sense that China’s financial system is still on thin ice. For one thing, the country’s total debt level has risen a lot.
A high amount of total debt can signal systemic financial fragility. When everyone owes everyone else money, a negative shock to the economy -- or even just a spontaneous panic -- can upset the system by causing a lot of borrowers to default at the same time. When financial firms are highly leveraged, it also makes it easier to have a bank run or a similar liquidity crisis.
China’s growth continues to slow, while its debt levels -- and housing values -- are still rising. Many believe that the real estate market is in bubble territory. And the country’s corporate sector has taken on quite a lot of debt that it might not be able to pay back if growth slows more -- a realization of lots of bad corporate loans could send China’s big banks into insolvency.
Perhaps with these risks in mind, People’s Bank of China Gov. Zhou Xiaochuan recently warned of a “Minsky moment” in the country’s financial industry -- the moment, named after American economist Hyman Minsky, when overborrowing leads to an asset price collapse.
Many observers waved off Zhou’s warning -- after all, plenty of people claimed to have sighted bubbles in China and been wrong the past few years. But the central bank head is putting his money where his mouth is, injecting large amounts of cash into the financial system -- not something they’d be likely to do unless they thought they needed to.
So the chance of a Chinese financial crisis may really be in the works this time. And if the country’s leaders are worried about an imminent crash, it seems like a smart thing to do would be to execute a pre-emptive bailout. And the cheapest way to bail out finance companies is with an injection of foreign money.
Western capital might be just the dumb money that China’s strained financial firms need. With stocks, real estate and basically every other asset in the rich world looking expensive, developed-country investors are desperate for some yield. China, with its huge market and still-rapid growth, is always a tempting bet, but especially so now that there are few good investment options.
A rush of foreign investment into Chinese finance companies would certainly help cushion them against any burst housing bubble, liquidity crisis or wave of corporate bankruptcies. The Chinese government would still have to do plenty of bailouts, but now foreign banks would share much of the pain. Like the European banks that invested in US housing-backed bonds before the 2008 crisis, Western investors might get fooled into buying at the top.
So before throwing money at Chinese finance companies, Western investors -- especially systemically important institutional investors -- should think twice. The developed world just managed to recover from the aftermath of its own giant bubble -- it certainly should be wary of increasing its exposure to a Chinese one.
By Noah Smith
Noah Smith is a Bloomberg View columnist. -- Ed.
