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Prevailing Winds

Has Covid-19 Led to Financial Instability in China?

Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market.

The Chinese economy suffered an unprecedented shock during the Covid-19 outbreak, shrinking 6.8% during the first quarter of 2020 compared to the same period last year. This was the first economic contraction acknowledged in official Chinese government statistics since 1976.

To fight the spread of the virus, China implemented a severe lockdown in late January across large swathes of the country. On a scale previously unseen in history, China quarantined large sections of the country, closing transportation networks, mandating the isolation of individuals likely to be infected, and implementing temperature checks to enter major cities. Factories, restaurants, hotels and many other types of business experienced a sharp disruption as customers stayed home and workers were unable to report to their jobs. Additionally, national logistics networks were severely impacted by the travel restrictions. This quarantine lasted until April in some of hardest hit areas such as the city of Wuhan.

The Covid-19 crisis comes on the heels of a turbulent period for the Chinese economy. Over the past two years, China has experienced slowing economic growth, a large-scale financial crackdown, a sharp stock market selloff, and a damaging trade war with the U.S. Given this challenging environment, it’s worth reviewing how well the financial sector has held up and what risks remain on the horizon.

Banking Sector

The sudden economic shock from the lockdown threatened to severely damage the banking system. Banks faced not only a sharp increase in non-performing loans (NPLs), but also potential disruptions to funding in the interbank market. To prevent this, the People’s Bank of China (PBOC) took prompt action to ease financial conditions for both banks and borrowers.

To lower funding costs for banks, the PBOC reduced the required reserve ratio and guided interest rates lower through open market operations. Figure 1 shows the decline in government bond yields and the interbank interest rate as a result of these efforts. These steps have lowered funding costs for banks and allowed them to keep lending through the crisis.

Figure 1. Chinese Government Bond Yields and Interbank Interest Rates
Source: Wind Information.

To help borrowers, the PBOC directed 1.8 trillion renminbi (RMB) in re-lending funds towards small and medium enterprises (SMEs), businesses affected by the pandemic, and medical equipment manufacturers.1 Re-lending consists of the central bank lending to banks, who then make loans to designated groups.

Banking regulators have also instructed banks to continue making loans to enterprises affected by the pandemic, tolerate higher NPLs, and to delay interest payments until the summer. China’s fiscal authorities have cut taxes and fees for SMEs, reduced employer social insurance contributions, increased export tax rebates, removed tolls on expressways, and reduced gas and electricity rates.2

The result of these efforts is that credit growth in China remained robust throughout the first quarter of 2020. Figure 2 shows the year-on-year growth rate of total credit and RMB bank loans.

Figure 2. Growth Rates of Total Credit to Non-Financial Sector and RMB Bank Loans in China
Source: Wind Information.

The strong growth of bank loans has helped to offset the continued contraction in shadow banking. As shown in Figure 3, several of the main shadow banking products (trust loans, entrusted loans, and bankers’ acceptances) all declined year-on-year due to government regulators’ ongoing crackdown on financial risks. Fortunately, regulators have shown a bit of flexibility by indicating that the implementation of the new asset management rules aimed at banks and insurance companies may be delayed.3

Figure 3. Growth Rates of Shadow Banking Products in China
Source: Wind Information.

Chinese banks entered this crisis with relatively high capital buffers. As shown in Figure 4, the average Core Tier 1 Capital Adequacy Ratio for Chinese commercial banks was 10.92% (vs. 8.5% regulatory minimum) and the Total Capital Adequacy Ratio was 14.64% (vs. 11.5% regulatory minimum) at the end of 2019.

Figure 4. Capital Adequacy Ratios for Commercial Banks in China
Source: Wind Information.

Nonetheless, the lockdown and the ensuing economic disruption will certainly have an impact on bank profitability. Banks are likely to see a large increase in non-performing loans from SMEs, even with the government’s support measures. SMEs already faced excruciatingly long payment cycles from their larger customers, particularly state-owned enterprises (SOEs). This payments chain is almost certain to get extended even further as a result of the economic slowdown, putting further stress on SMEs.4 Additionally, early reports show that activity levels for SMEs are bouncing back much slower than for large enterprises.5

To deal with this challenge, Chinese authorities are likely to offer more direct support to banks and SMEs. China’s Politburo, the country’s top government leaders, recently announced that it was going to issue special treasury bonds, a product that has only been used a few times in the past.6 One such issuance was to support a recapitalization of the banking system during the late 1990s in the wake of the Asian Financial Crisis. It remains to be seen how this new round of special treasury bonds will be used, but it will likely provide some type of support, directly or indirectly, to strengthen banks and SMEs.

Capital Markets

As shown in Figure 5, China’s stock market suffered a sharp decline in late January at the outset of the lockdown. Chinese stocks tumbled again in late February as global markets went into freefall. Shares have recovered somewhat since then, returning to levels seen in the second half of 2019. Throughout this period, fund raising in the stock market via initial public offerings (IPOs) and secondary offerings for non-financial corporations managed to grow in year-on-year terms.

Figure 5. Wind Information All A-Share Index
Source: Wind Information.
Past performance does not guarantee future results.
The Wind Information All A-Share Index tracks Chinese A-Shares traded on the Shanghai and Shenzhen stock exchanges. It is not possible to invest directly in an index.

Compared to previous market corrections, Chinese authorities appear to have intervened to a lesser extent. In contrast to 2015 and 2018, Chinese regulators have not organized industry bailout funds, compelled SOEs to engage in large scale buying to support the market, or suspended large numbers of stocks. The stock market, however, has benefited indirectly from the various fiscal and financial support measures put in place by the government to help companies.

The domestic bond markets also continued to function well during the crisis. The PBOC’s efforts to increase liquidity throughout the financial system have helped to guide bond rates lower. As shown in Figures 6 and 7, government and corporate bond issuances grew while borrowing rates declined. For the larger Chinese companies that typically issue bonds, this has helped to provide a much-needed line of financing. The central bank’s efforts have also bolstered borrowing by local governments as they ramp up infrastructure spending to stimulate the economy.

Figure 6. Growth Rates of Corporate and Government Bond Issuance in China
Source: Wind Information.
Figure 7. Corporate and Local Government Bond Yields in China
Source: Wind Information.
Note: Yield to Maturity (YTM) is a concept used to determine the rate of return an investor will receive if a long-term, interest-bearing investment, such as a bond, is held to its maturity date.

The stability in the onshore bond market has not been replicated in the offshore USD bond market. Absent the support provided by the PBOC to domestic markets, borrowing rates for Chinese issuers in the offshore market have increased, spreads have widened dramatically, and overall issuance has declined. One of the groups most affected by this are Chinese real estate developers, many of whom turned to the offshore market after facing borrowing restrictions onshore. The offshore bonds issued by some developers are now trading at discounts, indicating significant levels of distress, while the onshore borrowing for the same entities remains largely unaffected. Offshore investors appear to be pricing in the possibility that these developers will face restrictions on their access to dollars from the State Administration of Foreign Exchange (SAFE), as part of China’s capital controls.

The Exchange Rate and Foreign Reserves

One pressing question has been whether the Covid-19 crisis would lead to significant capital flight out of China. From the data so far, this does not appear to have occurred. As shown in Figure 8, the exchange rate of the RMB to the U.S. dollar has depreciated only modestly since the start of the crisis. In fact, the RMB has been one of the more stable emerging market currencies during this period.

Figure 8. U.S. Dollar (USD) to Chinese Renminbi (CNY) Spot Rate
Source: Wind Information.

The data does not appear to show significant intervention by the PBOC to maintain the exchange rate. As shown in Figure 9, foreign exchange reserves declined moderately over this period, about 43 billion USD-equivalent since the end of 2019. This decline has been driven by the strength of the U.S. dollar, which reduces the value of China’s non-USD reserve holdings relative to the U.S. dollar, a decline in overseas asset prices, and a moderate amount of capital outflows. The apparent lack of large-scale intervention by the PBOC in the first quarter of 2020 is a striking contrast to 2015 and 2016, when China spent 1 trillion USD-equivalent of its foreign exchange reserves defending the currency.7

Figure 9. China’s Foreign Exchange Reserves
Source: Wind Information.

For the time being, pressure on the capital account has been eased by the drop in outbound tourism due to the pandemic. Nonetheless, capital outflows still remain a possibility, and China maintains a web of capital controls that help to slow the flow of funds outside of the country. Despite these risks, Chinese authorities do not seem to be backtracking on their commitment to further open the capital account. For example, China has not taken steps to reduce the flows of funds via the Stock Connect and Qualified Foreign Institutional Investor (QFII) programs, despite net outflows in February and March. Additionally, regulators have relaxed rules around cross-border lending and borrowing, streamlining the approval process and increasing the amount that enterprises and banks are permitted to borrow and lend cross-border by 25%.8

Sources of Risk – Small Banks, Real Estate Developers, and Exporters

While the Chinese financial system weathered the Covid-19 crisis well in the first quarter, significant risks remain. The preeminent risk is the threat of another outbreak of the virus that would necessitate the re-imposition of lockdowns. In addition to this general risk, there are several clusters of heightened risk across the economy.

One locus of risk is the stability of China’s smaller banks. Many of them were distressed prior to the outbreak and the current situation has only exacerbated their woes. Last year, China had to organize a rescue for several small banks that needed recapitalization. As many small banks tend to focus on SMEs, it’s likely that the large expected increase in SME NPLs will hurt small banks disproportionately. The Achilles’ heel of smaller banks is their weak funding bases. While smaller banks have received larger required reserve rate cuts compared to larger banks, they continue to rely on wholesale funding via the interbank market. As their financial condition continues to deteriorate, smaller banks may find themselves cut off from funding as larger banks begin to view them as credit risks.

Real estate developers are another cluster of risk. The real estate market saw a sharp decline in sales due to the quarantine. In order to sustain sales, some of the larger real estate companies offered steep discounts to buyers. These developers tend to be highly leveraged and many of them have large U.S. dollar borrowing amounts. The stress in the offshore borrowing market means that their USD debt is now significantly more expensive to service. While real estate unit and land sales have recovered somewhat in March, it’s likely that this year’s real estate transactions will remain well below 2019 levels. Several local governments have taken small steps to lessen some of the housing purchase restrictions in place to prevent speculation, but so far a nationwide relaxation of real estate market controls has not occurred.

China’s export-focused industries are also in jeopardy. Due to the growing global pandemic, China’s exporters face a sharp drop in overseas demand. Some exporters are reportedly seeking to reorient towards the domestic market, but that solution may not work for many companies.9 With much of the global economy facing a steep recession, it seems unavoidable that many exporters will be driven out of business, especially those in low value industries with razor thin margins. Though China is less reliant on exports than previously, a sharp drop in exports has the potential to create financial dislocation and significant job losses.


While China’s financial system may have performed well during the initial stages of the Covid-19 crisis, it is by no means completely out of the woods. The current stability could give way to volatility if the preceding risks grow beyond the capacity of policymakers to manage. Additionally, this crisis has taught the world that some of the most important risks are the ones that are completely unexpected. As such, vigilance will be required to ensure China’s continued financial stability.

China’s overall economic response to the crisis has been relatively measured compared to the massive fiscal and monetary responses seen in the U.S. and other countries. Whereas the Federal Reserve has taken unprecedented action to support banks, financial markets, and small borrowers, the steps from the PBOC have been more incremental. China’s fiscal stimulus has been similarly restrained. Government spending in response to the Covid-19 crisis is estimated to be around 2.5% of gross domestic product (GDP), far smaller than the 11% of GDP currently committed by the U.S. government, or the 13.4% of GDP China spent during the 2008 crisis.110 Chinese authorities appear to be balancing the economy’s need for support against the risks of exacerbating China’s high debt levels and economic imbalances. Only time will tell if China’s more moderate approach is sufficient given the current economic challenges.

Nicholas Borst,
The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
  1. Policy Responses to Covid-19,” International Monetary Fund, 10 April 2020.
  2. Zhang Yue, “China to Intensify Fiscal and Financial Support to Tide Businesses Over Difficulties,” The State Council of the People’s Republic of China, 14 April 2020.
  3. Wu Xiaomeng and Timmy Shen, “Extensions Possible for New Asset Management Rule Compliance: Regulator,” Caixin, 3 February 2020.
  4. Andrew Foster, “Seafarer Overseas Growth and Income Fund – Portfolio Review Fourth Quarter 2019,” Seafarer Capital Partners, 19 February 2020.
  5. 疫情下的中小微经济恢复状况,” Tsinghua PBSCF, 10 April 2020.
  6. Wu Hongyuran, Zhang Yu, and Timmy Shen, “China Will Tolerate More Debt to Help Virus-Stricken Economy,” Caixin, 30 March 2020.
  7. Nicholas Borst, “China’s Crackdown on Financial Risks,” Seafarer Capital Partners, 13 July 2018.
  8. Jane Hui, “China Tax Center - China Tax and Investment Express,” EY, 20 March 2020.
  9. 周潇枭, “支持出口转内销,选择性征收关税扩围至所有综保区,” 21财经, 14 April 2020.
  10. “Supporting China’s Infrastructure Stimulus Under The Infra Platform,” Infra Update, The World Bank, June 2010.