Zhiguo He on Chinese Financial Sector Risk in the age of Fintech

Zhiguo He is a Chinese financial economist serving as the Fuji Bank and Heller Professor of Finance at the University of Chicago Booth School of Business, where he has taught since 2008. He is also a research associate at the National Bureau of Economic Research, faculty co-director of the Fama-Miller Center, member of the academy committee at the Luohan Academy, and special-term Alibaba Foundation Professor of Finance at Tsinghua University. He earned his Ph.D. from the Kellogg School of Management at Northwestern University.
Patrick Coe CMC '21 interviewed Zhiguo He on March 15, 2021.
Photograph and biography courtesy of Zhiguo He.

Perhaps we can begin with an overall view of risks in the Chinese financial sector.  We hear a lot about China’s high debt-to-GDP level and the Chinese government’s efforts to de-leverage the economy.  Why is the Chinese government concerned about risks in the financial sector?  

Beijing realized that it could be extremely painful cleaning up the mess in the banking sector in the early 2000s when the Big Four (Industrial and Commercial Bank of China, China Construction Bank Corporation, Agricultural Bank of China and Bank of China) were recapitalized, which means that tons of money was injected into these banks. It was very costly, and you might wonder why they did it. While there has been a lot of financial risk in China’s banking system, it still remains the predominant financing source for Chinese economic activity. The government could not afford instability in the banking sector at the level of the 1990s. 

The health of the financial sector is something that always keeps Beijing awake at night. The persistently high debt-to-GDP ratios have been a primary focus. Additionally, the level of corporate sector debt is indeed much higher than in the rest of the world. Of course, there is no clear definition for what debt-to-GDP is too high or too low. People are still debating it. Some say the US is getting too high, while others say it’s not high enough and we can go further. It is itself a very important question but oftentimes with elusive answers; Beijing is quite cautious on this front and I personally think that is the right attitude to have. 

How would you evaluate the progress of the Chinese government in controlling and mitigating risks in the financial sector so far?

While its efforts have been painful, overall progress is not so bad to be honest. Most of these issues are interconnected with other policy problems facing the government. For example, the government’s actions in the banking sector are linked to the housing market, which represents a whole other problem.  All of these things are much harder to deal with than they were 20 years ago, when you could basically let everybody fail and then recharge the banking sector and privatize part of it. Now, that would be much harder to do and more destructive to the economy. But why am I saying that its progress has not been that bad? Because at least from the corporate sector side, they have been pretty successful at deleveraging state-owned enterprises (SOEs). 

In the end, China is a half-planned economy, and the half owned by the state is supposed to follow government guidance. In 2016, you can clearly see that most SOEs cut their borrowing after the government encouraged them to do so. However, there have also been a lot of unintended consequences. If you look at the composition of debt, you realize the non-SOE sector started to borrow a lot more. Despite cuts in SOE borrowing, debt was still needed to keep the economy growing. If you clamp down on the state side of the economy, then the private side will fill the void. That’s why in the year or so following its 2016 directive, the economy slowed down since the US-China trade war in 2018, and a lot of non-SOEs that borrowed a lot in 2016 got into trouble. At this point, the government is very closely monitoring the problem and doing a pretty good job given how complicated the process is. 

How has the emergence of fintech in China complicated the government’s task of controlling risks in the financial sector?

First of all, let me clarify that at this point fintech really does not complicate the risk of the financial system in China. Rather, a large portion of the risk comes from the fintech sector itself, which is relatively small compared to the traditional banking system. The fintech sector emerged in 2013 and 2014. It had an ideal environment to grow in China because of high demand for financial services; thanks to the clumsy state-owned banking system, many were looking to borrow, including non-SOEs and consumers. But more importantly, there is also a large supply of fintechs. There was high supply because so many entrepreneurs were willing to enter the market as there was virtually no regulation. When the high demand of fintech services was combined with a lot of smart people with technology who could supply it, there is no real surprise at how fast the market grew. 

The regulators’ attention really started to focus on fintech from around 2015 to 2016 given the huge growth in debt. After that, there were many directives from Beijing to reign it in. Again, it’s not that easy to do. We can look at how they approached the problem on a firm-by-firm basis, but the fintech is slightly different from other financial markets. Fintech firms have more to do with the consumer side, which has unique features in terms of regulation. So, has it complicated the job of reducing debt? I wouldn’t say so. At this point, most fintech companies and consumers have shifted to traditional banks or other small credit companies. Basically, they’ve moved from the shadows to the under-the-sun sides of the economy that are easier to regulate.  

How would you compare China’s experience with the fintech revolution with that in the United States, and what is it about the BAT that gives them an edge over American firms in terms of their valuations?

There are a lot of theories behind the truly fast growth of Chinese fintech companies. On the surface, you  see a salient difference between the US and China: in China, everybody has been talking about the so-called ecosystem. The best example of this is Tencent. Through Tencent, you can get WeChat where you can do almost anything within the app. Ant is also trying very hard to create this type of ecosystem in order to basically surround all sides of the shopping experience. You never really see this in the US. These firms in China want to build an empire and build an ecosystem so that they can grab customers in every possible aspect. In the early years, this was actually really good, but at these mature stages there are now risks of monopoly power. Why did this happen in China? Again, one reason is the lack of regulation. In China at that time, there was no regulation at all. 

The second point is that relative to US, the so-called market mechanism is much weaker in China. There is the economic theory, by Ronald Coase (1937), that if there is something that the market cannot do, firms will do it themselves, which in turn determines the boundary of firms. In essence, you can either use a laundry service from the market, or do it yourself. In China, it was commonplace for each firm to provide its own medical services, schools, and restaurants for its staff. Why? Because their employees could not get these services from the larger market. This is sort of the phenomenon with the BAT: they wanted the market to complete some services for them. In the US, that is easy. But in China, these firms needed to do more in-house to ensure proper delivery times among other things. But once they started doing things themselves, they realized it’s actually a pretty good idea because there is no regulation. That’s why in China, firms build empires and, in the US, firms are more specialized.

A very public spat between Jack Ma and the government led to Ant Group Co. Regulators forced Ant to make changes that severely hampered the firm’s appeal to investors.  Was the government justified in taking these actions?  How could these regulatory measures constrain Ant Group’s operations?

What you don’t hear in the Western media is that there were some sound reasons for the government to look into this issue. Imagine you are an investor and you bought the IPO shares in Ant that are valued really high. Suppose a week later you heard that, all of a sudden, the banking regulators say Ant needed to be regulated because it is run like a bank but with leverage as high as 100. Would you be happy as an investor? No. Now roll it back, what’s the game that regulators, investors, and Ant were playing? Jack Ma and everyone else knew that there would be some form of regulation coming, given the nature of its business. Did anyone know the details of the consumer loan business? No. But once the IPO prospectus for Ant Financial was released, which I read, you could immediately see that the leverage was insane. People guessed it would be high, but no one had the number. Then when people saw the real numbers, they were shocked. Their financing is mostly done by so-called asset backed securities (ABS). The leverage numbers were far above 100 times. So, something needed to be done about it because it gave Ant far too great of an advantage over traditional banks. Of course, if you are doing banking services some regulations are necessary where typically, at most, you leverage up by about 12 times. It is also true that Jack Ma’s comments at the time were not helpful and likely triggered this problem.  From the government perspective, both Ant and Tencent will probably be restructured as some financial holding company, rather than a tech company. The bottom line: any financial holding company needs to have a 10% capital ratio imposed. This will limit growth. 

Where do you see the future of fintech headed in China? In the aftermath of both the pandemic and deeper regulation, will the fintech sector be as dynamic as it was before?

I don’t think it will grow as quickly as it did between 2014 and 2015. Those were the really striking growth years. Fintech unleashed many aspects of China’s consumption and economy, both of which were good. The future of fintech in China is certainly in blockchain, but not BitCoin.  The future will include mainly using the idea that blockchain is a multiparty distributed ledger, with multiparty cooperation, so that they can eliminate the chance of fraud. This will pave the way for the next few decades of fintech growth. It is a slightly different way to grow, but I am very positive on this. The pandemic was a great help for fintech, more so in the US where the pandemic shifted people’s behavior into digital consumption. In China, not so much, as there was already a lot of digital consumption. The regulators will simply focus on the liability side of these firms that function like banks, and it really is just about one thing, capital or equity ratios. From this perspective, there should be much less excitement for the future in terms of growth, although I am quite positive on the breakthroughs in terms of technology itself.

Patrick Coe CMC '21Student Journalist

Peter K Burian, CC BY 4.0 <https://creativecommons.org/licenses/by/4.0>, via Wikimedia Commons

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