In this newsletter, I’ll be running transcripts of two excerpts of recent ChinaTalk episodes. The first is a conversation I had on Friday with Rhodium’s director of China Markets Research, Logan Wright, discussing Huarong. The second is an excerpt of a show I recorded with two leading Japanese think-tankers, Yuka Koshino and Akira Igata, on Japan’s China policy.
How Huarong Explains China’s Creaky Financial System
Jordan: Huarong: what is it and why is it in the news today?
Logan: Huarong is the largest of the four asset management companies (AMCs) created in the aftermath of China's 1990s bad debt cleanup. Those institutions were originally designed to dispose of bad debt by buying non-performing loans at low prices, holding onto the assets, waiting for them to appreciate in value, restructuring them and selling them off to make a small profit for the state. More generally, AMCs were designed to remove bad assets from banks’ balance sheets so that banks could continue lending without being burdened by nonperforming loans (NPLs). They did that business for several years but then rather than being wound down, Huarong and the three others started expanding. They started adding new business lines—some of them have even gone public and been listed.
That's the context through which we're now discussing what's going on with Huarong, as some of the bonds that the institution has sold have started selling off because the company hadn't filed its annual results in a timely fashion. Markets started speculating about the potential for problems of bad debt or other financial irregularities with the firm. More fundamentally this raised the question of when the state will provide support for some of these institutions that they had previously effectively guaranteed. The reason that this sort of incident with Huarong right now is getting so much tension is because there have been numerous credit events in China in recent years.
The bedrock of moral hazard, where you had widespread implicit guarantees, started breaking down really fundamentally with the default of Baoshang Bank in May, 2019. Then you started to see more and more defaults among state-owned enterprises on their corporate bonds, including some by very prominent local state-owned enterprises, most notably Yongcheng Coal last October & November.
So now the market is looking around and saying, “Where is this new market discipline going to stop and where is the government actually going to step in and back up some of their assets as they had done in the recent past? At what point can we decide that state guarantees are going to extend now that the previous implicit guarantees have been broken?” That’s the fundamental issue that the market is grappling with, not the specific problems at Huarong. All of a sudden, some of these implicit guarantees have broken down and you can't really be sure what is an effective market pricing of credit risk and what is something that might spill over into broader contagion.
Jordan: So I'm about to run an interview that we did a little over two years ago on your 2018 report Credit and Credibility: Risks to China’s Economic Resilience. How does this issue connect to those themes? What has changed since late 2018 to bring us to the situation we are today, where debt is such a problem that half of the Chinese Super League is going out of business (defending champion Jiangsu FC just disbanded) and it seems like every other week we have some sort of bank run or credit issue?
Logan: The idea of Credit and Credibility, which Rhodium and CSIS wrote in 2018, was to flip the China financial crisis narrative on its head. Rather than ask, “Why is China going to have a financial crisis?” or “Is China going to face a financial crisis?” We tried to answer the question of “Why has China been so resilient so far?” and “How can we explain that resilience despite the fact that China has seen the largest single country credit expansion in the last century (at least), yet there hasn't been a sharp slowdown in growth or a significant financial crisis?”
The point we made at that time was that it wasn't really anything fundamental about China's economic situation. This was not about China's savings rate. This was not about the internal nature of China's debt. It was not about special tools that the state had at its disposal to manage financial risk. It was really about the fact that the Chinese government had extensive credibility to step in and backstop any losses before they would materialize. Therefore market participants didn't have to worry as much about the crisis because every time that there was some sort of financial distress, you could expect a very rapid and meaningful and successful government intervention. The point we made in that report is that was an unsustainable strategy, precisely because Beijing had no intention of backstopping some of the increasingly risky and peripheral assets within the banking system.
At that time we were talking about issues like peer-to-peer lenders. As credit continues to expand more and more of that shadow banking activity and riskier lending has started to default and therefore it requires Beijing to basically make a choice: are they going to step in or are they going to back away and let investors take additional credit risk on some of these defaulted loans? So that's where we were in 2018.
Fast forward a little bit and the debt problem has continued growing.
The COVID-19 outbreak basically offered a temporary respite for some very understandable reasons—the government didn't want to enforce austerity and see additional defaults and bankruptcies during the immediate aftermath of the outbreak. They told banks to exercise forbearance and rollover loans.
But the debt problem itself has become increasingly unmanageable for a growing number of borrowers and different types of borrowers. We're seeing different types of these borrowers default, particularly local governments. What the Huarong situation (similar credit events beforehand) signifies is that the market just can't be sure about how Beijing or local governments are going to make these choices. As we like to say, there's now a question of “Are local governments really a source of stability reinforcing these guarantees or are they a source of risk in the market based on how they might allocate assets—either protecting investors or potentially exposing them to defaults?” That's the context of the news about Huarong.
By the way, the issues associated with the firm are not necessarily its core NPL disposal business. Rather it’s the fact that they've also been engaged in some of these other business lines like shadow banking. That's where we don't really know the extent of the bad loan problem or if there even is a bad loan problem.
We've just seen overnight that Beijing has stepped up and said that Huarong is operating normally. So this is an area where they've sought to reinforce their guarantee and to say these are institutions that are too big to fail and will warrant state backing. The important thing (and what ties into the credit and credibility thesis) is that was really the critical element—reinforcing stability.
It was the credibility of government's response to financial distress. It was not necessarily anything about the economic situation or the nature of the debt problem in China itself. They won't be able to make these choices to support all types of assets, only certain types and certain varieties of institutions… and that's exactly the question the market is grappling with right now.
A few weeks back I discussed Japan’s China challenge with Yuka Koshino, a Research Fellow at the UK think tank International Institute for Strategic Studies (IISS), and Akira Igata, the Executive Director at the Tama University-affiliated Center for Rule-making Strategy (CRS). Joshua Fitt of CNAS cohosted.
Japanese Public Opinion Towards China
Jordan: So let's start with a little recent Japan-China history. I am looking at a graph from 2002 to 2020 that Pew did polling the Japanese population on attitudes towards China. In this chart, we start at 42% dislike and are now at 86% in 2020, which is I think a global high in terms of the percent of people who have a negative view of China. Yuka, mind walking me through this recent history and the major events that have swung these numbers back and forth over time?
Yuka: One of the key highlight events was the 2010 Senkaku Incident when a Chinese trawler basically had a collision with the Japanese coastguard’s patrol boat. The Japanese government detained the captain of the Chinese ship and the Chinese government made a lot of assertive actions, including halting rare earth exports to Japan.
That was also when the Chinese economy surpassed Japan's economy. So that was really a key point to show the impact that China’s rapid economic and military growth could have on Japanese politics, diplomacy and security. Also after that, there were an increasing number of Chinese boats and activities around the Senkaku Islands. That was the time the Chinese security threat became much more vocally discussed in Japanese policy debates.
But then if you look at it, there's also this term when unfavorable views towards China decreased around 2018. One of the key events was Prime Minister Abe’s visit to China in October 2018 during the 40th anniversary of the conclusion of the Treaty of Peace and Friendship between Japan and China. There was this rapprochement period under Prime Minister Abe. He was really trying to make it one of his diplomatic big goals to invite Xi Jinping to Japan. But still, as I mentioned, underlying security conditions have not really changed or improved and I think that's a reflection of the very high unfavorable views by the Japanese people towards China.
A poll focusing on Japanese nationals called Genron NPO taken in late 2019 showed security issues impact on Japanese views towards China.
I think the top three reasons for the negative views were around the security issues, which shows that the Japanese public is very much aware of the security activities conducted by China. So to top three were: (1) the intrusions around the Senkaku islands, (2) China not abiding by the international rules and norms, and (3) actions in the South China Sea.
It shows that the Japanese public is thinking beyond the Senkaku Islands and is also very much aware of China’s actions in the South China Sea as well.
Jordan: Ezra Vogel wrote a book called Japan and China: Facing History which takes you all the way back to the tongue dynasty. That book did a really good job looking into Reform and Opening and the role Japan played. It was part a bit of guilt for what happened in the first half of the 20th century, as well as a major business opportunity for a lot of these Japanese firms to be really some of the first ones in alongside with the early folks from Taiwan who were making investments to really kickoff industrialization and China. So there was actually a lot of goodwill in the seventies and eighties which has slowly but surely been eroding over time with respect to how the Japanese look at China.
Josh: Japan seems to be way ahead of the curve on thinking about supply chain risk analysis. I was on a research trip with some co-authors of a report on forging an alliance innovation base in October of 2019, long before the pandemic spurred many places around the world to think about insulating their supply chains. Why do you think that is? Why do you think Japan was a first mover in this?
Akira: I’m not sure if we can say that Japan is ahead of the curve in terms of supply chain risks because it really depends on who you talk to. Let's take the Japanese government, for example, which I think has done a great job establishing subsidies for companies to diversify supply chains.
I think the way they are framing it is great because they're not saying that these government subsidies are for promoting Japanese companies to decouple from China, right?
They're saying that it is to diversify supply chains to deal with uncertainties including COVID-19. They're also packaging it in a way so that it's an investment promotion policy towards Southeast Asia. So I think there's a delicate balance of the need to decouple while making sure that they don't antagonize China too much.
At the same time, the amount of budget allocated to these supply chain diversification programs at the moment is minuscule at best. The budget is only about a few billion dollars for all industries in Japan.
If you compare this with what's being discussed in the US at the moment, the semiconductor industry alone will likely receive a few dozen billion dollars. So once again, I think the committee has done a great first step towards supply chain diversification, but they should try and get more budget for this.
Now there's also an increased interest in supply chain risk from the private sector as well. And I've been talking to many major companies from various industries and many of them are all starting to engage in a serious cost-benefit analysis of potential decoupling from China. Of course, the reason for this decision is a bit different depending on the industry.
For instance, high-tech industries are considering moving production away from China for security reasons because they don't want the product to be seen as being potentially compromised. For others, such as apparel industries, they're primarily concerned about supply chain risk is more about reputational damage. Recent reporting on forced labor programs in Xinjiang and Tibet has been problematic for Japanese fast retailers like Uniqlo or Muji. Companies like Muji do not want to be branded as a company that used forced labor to produce their products, as a company that's indirectly contributing to human rights violations. Then you look at pharmaceutical companies and they're looking at diversifying the supply chain away from a single country because of COVID-19.
Akira: One important development regarding Taiwan and Japan recently is of course the Chinese ban on Taiwanese pineapples. China's official statement is that they needed to ban the import of Taiwanese pineapples for bio-security reasons. But to me, this is stereotypical Chinese economic coercion against other countries, which we have seen in the past, like banning wine from Australia or canola oil from Canada or salmon from Norway. All of which were done for various political reasons. We now have a very clear track record of China using important restrictions for political purposes.
So I think that Japan, Taiwan, and other democratic countries should think about new ways to decrease the effect of these Chinese economic measures and to deter China from employing them in the first place.
For example, there are a couple of ways to do this. We can try as a group of countries to diversify our exports’ reliance on China by buying off of each other or arranging some kind of an international mechanism to help those who are affected by politically motivated import bans. Or, maybe we can create a domestic counter boycott campaign that can be launched quickly, like what the Taiwanese did this time around.
Jordan: If China decides to pick a meme thing to ban in terms of Japanese imports, what's your bet on what you think they'll opt for? We've seen Australian wine, Taiwanese pineapples, what food companies should be quaking in their boots in Japan?
Akira: Maybe 10 years ago, China imported frozen gyoza from Japan and there were some safety issues. So maybe China can do that against us and say, “Japanese frozen gyoza is also dangerous for biosecurity reasons or something.” That would be my guess.
Jordan: So everyone in China worried about their gyoza fix, be sure to stock up now because you heard it here on ChinaTalk first: gyoza is going to be the first domino to fall in our coming East Asia trade war.
Josh: My bet is on musk melons.
Jordan: Yuka, thoughts on Taiwan?
Yuka: Taiwan is becoming more and more important in discussions on economic security, including supply chains on conductors, but also as a like-minded partner promoting real space order. In terms of digital issues, I think it's also very important to include Taiwan on rules making on data flow. For instance, this year, Japan is going to be the chair of the discussion to expand potential membership of the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP). So I think it's really important that we start thinking about how to include Taiwan and also to prevent Taiwan from becoming isolated in these international trade mechanisms.
Akira: Recently I have been invited to or have received information about many Japanese businesses thinking about doing simulations of business continuity plans if and when the Taiwanese contingency occurs. I think this is a very interesting trend because in the past I've been part of many North Korea contingencies and how the Japanese businesses must work to evacuate their employees and families from South Korea if that happens.
But I haven't seen too many of these with regards to Taiwan. So I think this is one indication that many Japanese companies are now starting to be aware is that perhaps a China-Taiwan confrontation is potentially possible. And when that happens, and there are many Japanese companies which have supply chains and factories in Taiwan, they really have to start thinking about actual, tangible BCP plans.
On the left, “waaaah, now that we’re not in the UN how are we going to influence the world?” (swole doge know your meme for the unacquainted)
Tweets of the Week
Daniel Ahmad @ZhugeEXTencent's TiMi Studios, the developers of games such as Honor of Kings and Call of Duty Mobile, generated $10 billion in 2020. This makes it the #1 studio by revenue during the year, and that's just 1 studio in Tencent, not the entire company. https://t.co/mifOhWQlqg
And lean into 1 on 1 class