By Chelsea Rodstrom, Global X Research Analyst
Expanding alongside China’s enormous and complex economy, the country’s capital markets and broader financial system are becoming increasingly influential on the global stage. As the country liberalizes access to foreigners, modifies lending policies, encourages the adoption of new technologies, and expands services to a growing middle class, we could witness a new era of growth for China’s Financials sector.
As the fourth installment in an ongoing series that explores the 11 major economic sectors in China, this piece provides an in-depth look at the key stats, notable companies, and thematic tailwinds that characterize China’s Financial sector, tracked by the Global X MSCI China Financials ETF (CHIX).
China’s Cautious Convergence with the West
It is unsurprising, given the history of their economies, that the US and China’s financial systems look quite different. In the 1980s, China began developing a more modern banking system under the close oversight of the People’s Bank of China (PBOC), with the establishment of four state-owned enterprises (SOEs) or the “Big Four”: Industrial & Commercial Bank of China (ICBC), Bank of China (BOC), Bank of Communications (BoCom), and Agricultural Bank of China (ABC).
Later, the PBOC oversaw the establishment of an additional three policy banks to execute government spending priorities: Agricultural Development Bank of China (ADBC), China Development Bank (CDB), and Export-Import Bank of China. By the early 2000s, the government liberalized some aspects of the tightly controlled sector, such as allowing smaller banks to raise capital, foreign banks to conduct limited operations in China, lending to consumers and private businesses, and market mechanisms to move interest rates.
Big Four
While the original Big Four still dominate China’s financial system, the landscape is now more dynamic with public and private institutions, as well as state owned enterprises (SOEs), playing important roles. As policy shifts to allow more market-driven growth, innovation arises – some positive, like the rise of mobile payments, and some negative, like the emergence of the shadow banking system.
Such changes present new challenges, but greater integration, expansion, and diversification of China’s financial system may help stimulate further economic growth, while deconcentrating industry risks.
China Financials: Industry Breakdown and Key Stats
Financials is the largest sector in China, with roughly $4 tn in total market cap.1 It is a younger, yet sizably larger sector than its US counterpart, by both nominal market cap, market cap as a percentage of GDP, and total bank assets.2 Within the broad MSCI China Index, however, Financials is underrepresented as only the third-largest sector by weight due to various caps and inclusion factors – implying that investors allocating via broad index funds are underweight Financials relative to its true size.3
China Financials is a more Banking-and Insurance-centric sector than in the US, and is less focused towards Capital Markets and Diversified Financial Services. Given the enormity of the big four banks, large caps overwhelmingly dominate China’s banking industry, whereas midcap firms drive growth in the budding Insurance, Capital Markets, and Diversified Financial Services industries. These two industries are critical to the sector’s development and are expected to benefit from market liberalization, cross border flows, expanded foreign ownership and investment, as well as demand from households and private businesses for diversified financial products and services.
Investors unsatisfied with weak growth expectations and higher valuations in the US may find China Financials compelling. While China Financials has stronger projected sales growth versus the US, it is cheaper by price-to-earnings (P/E), price-to-sales (P/S), price-to-cash-flow (P/CF), price-to-book (P/B), and forward P/E and P/S metrics.
China Financials also offers investors share class diversification. Within indexes that are tracked by sector ETFs such as CHIX, most of the sector is made up of Hong-Kong listed H shares, but the incremental inclusion of onshore China-listed A shares into MSCI’s indexes broadens foreign investor access to the sector.
China’s financial system is one of the largest in the world, and although foreign participation is still relatively limited, at less than 6% in banking, stock, and bond markets, the inclusion of A shares reflects China’s progress in market liberalization.4
American Depositary Receipts (ADRs) are stocks of Chinese companies listed on American stock exchanges. A shares are listed on domestic stock exchanges in China and have been historically difficult to access. P Chips are stocks of companies operating in China, listed in Hong Kong, and incorporated in the Cayman or British Virgin Islands. Red Chips are stocks of companies based in China, incorporated abroad, and listed in Hong Kong. H shares are stocks of companies incorporated in China and listed in Hong Kong. Holdings are subject to change.
Banks Dominate, but Industry Diversification is Accelerating in Other Areas
Holdings are subject to change.
Banks: Within Financials, banking is the largest industry and currently represents more than half of the sector’s market cap. Since the early 2000s, banks have grown rapidly, fueling demand for fixed asset growth by issuing local debt. These banks buttressed China’s economic expansion by supporting growth across sectors.
Controlling over $14 tn of assets, the largest of these banks still dominate. But the banking system is diversifying. The largest, state-owned, banks in the first tier; regional banks dominate the second and third tiers; and smaller institutions – including disruptive fintech firms backed by nonfinancial conglomerates – comprise the fourth tier.
Smaller firms are increasingly important, as they provide new services and reach new customers. These firms also boost competition and promote financial inclusion as institutions are forced to innovate to defend their market share.5, 6, 7
SUB-INDUSTRY LEADERS: CCB, ICC, BANK OF CHINA
Insurance: With shifting consumer habits and demographics, technological innovation, and government initiatives, China’s insurance industry is expected by some to become the world’s largest by the mid-2030s.8 As China’s population ages and incomes rise, consumers are spending on higher-quality services and personalized products, including insurance and annuity products. These trends have made this industry one of the fastest-growing in the sector.
Health insurance premiums are projected to roughly double as a percentage of revenues for Chinese insurers from 2013.9
Annuities are especially popular products among China’s wealthier and senior populations as they allow older generations to smooth the financial burden incurred by children born under the one-child policy.
Capital Markets and Diversified Financial Services: Capital Markets and Diversified Financial Services, including Consumer Finance, are key growth areas in the sector. This industry includes China’s mainland and foreign securities industry, from large brokerages to smaller firms offering a range of services from asset management and investment advisory, to investment banking.
Long Term Policy, Demographics, and Regional Trends Support Growth
China’s complex financial system continues to evolve rapidly as the private sector plays a larger role, China integrates further into the global financial system, and the country’s consumers and businesses demand new products and services. State ownership and influence still shapes policy and the industry writ large, but China’s private sector is now the primary driver of China’s economic growth.12 Smaller and foreign firms are helping reshape Financials and by promoting competition and catering to new customer segments.
Government Policy Encouraging Liberalization, Attracting Foreign Investments, and Incubating Growth: China’s economic expansion was historically driven by policy directives from Beijing and executed by SOEs. Its massive credit growth was driven by state-owned banks lending mostly to other SOEs favored by Beijing in strategic areas. These firms focused on building out the infrastructure and facilities for manufacturing, which were critical to China developing into the world’s largest exporter. However, as China shifts its dependence away from exports and towards consumption, the banking system is pivoting to meet new consumer demands and complement government support for new consumer, wealth management, and health care segments. Recent policies, reforms, and developments impacting China’s Financials sector and foreign investors are highlighted in the table below.
Expanding Credit to Formalize the Informal Segments: Chinese SOEs and conglomerates typically receive preferential treatment in the domestic credit market, sometimes crowding out the private sector and households.
SMEs and consumers are often forced to borrow through small-loan companies, pawn shops, and P2Ps. Left improperly supervised, these practices threaten to perpetuate shadow banking or predatory lending practices, exacerbating market inefficiencies and nonperforming loan exposures (NPEs). The growth of shadow banking also complicates growth for SMEs that have inadequate access to credit because of a crackdown on lending practices more broadly. The PBOC and China Banking and Insurance Regulatory Commission (CBIRC) addressed this in December when it announced that qualified peer-to-peer (P2P) lending companies can apply for micro lending company (MCC) licenses. Such regulations may formalize online lending and fintech platforms to bridge funding gaps, while imposing tighter controls over NPE to promote sustainable credit growth and consumption.
Enhancing Competition with Greater Foreign and Private Ownership: By reducing government ownership, smaller and foreign financial institutions may improve market competition and efficiency. After the PBOC announced that it would remove foreign ownership limits of securities businesses and fund management companies in 2020, JPMorgan became the first US bank to receive approval from China’s Securities Regulatory Commission (CSRC) to launch a majority-owned joint venture Chinese securities business. Several other policies introduced over the last decade also ease foreign access, including the Stock and Bond Connect programs introduced in 2014 and 2017.13 Relaxed restrictions prompted greater inclusion across global benchmark indices last year, resulting in MSCI’s decision to raise its A share inclusion factor from 5% to 20% and JP Morgan’s inclusion of Chinese government and corporate bonds into its Emerging Market Bond Index (the EMBI).14 Greater inclusion in these indices promotes stability within the sector by stimulating cross-border flows, foreign ownership, and long term investments.
Demographics Driving Sector Growth: China’s middle class, which is larger than the entire population of the US, is also one of the fastest-growing in the world.15 Chinese household savings are exceptionally high when compared against countries like the US or Japan. However, financial tools common in the US and Europe, like credit cards, mortgages, WMPs and insurance, are just now becoming popular in China. Between 2012-2019, credit-card usage grew by six fold and is expected to continue growing at a rate of 20% annually for the next two years.16 As a consequence, household debt as a percent of GDP has also grown rapidly, from under 20% in 2007 to over 50% in 2018.17 Such rapid growth begs questions about debt sustainability, yet China’s ratio of household debt remains far below many developed economies like the US. As consumers diversify their savings and increase their consumption, they will demand new savings, investment, and banking instruments. And while these trends may require novel regulatory approaches, the demands of a growing middle class in China continue to transform China’s financial system into one that more closely resembles more advanced economies.
Financials Look Abroad to Fuel Further Growth: Like firms in other sectors, Financials firms in China are looking to bulwark domestic growth by achieving greater economies of scale in smaller cities and abroad.
Global Expansion Extends Growth Runway: Chinese banks are scaling up their dollar-denominated assets and becoming increasingly competitive with multinational rivals by increasing capital available for cross-border transactions. Increased lending, balance sheet diversification, and overseas asset exposure should boost growth for banks, asset managers, and insurers – and may create positive spillovers for other sectors reliant on funding and advisory services from the Financials sector.18
Bond Markets Fuel Global Integration: The size of China’s bond market as a percentage of GDP increased meaningfully from 35% in 2008 to 90% in 2017. 19 Its onshore corporate bond market alone expanded to reach $4.4 tn in 2020, while China’s total debt in 2017 stood at 255.7% of GDP (versus 318% globally).20, 21, 22 Most of China’s total debt is derived from the corporate sector, and many firms are integrating with global financial markets as they expand their issuances to include dollar bond offerings.23 With the expansion of domestic bond markets and the inclusion of Chinese bonds into the JP Morgan EM Bond Index, China’s debt market could overtake Japan as the world’s second largest.24
Systemic and External Risks May Create Headwinds
Payments Difficulties and Funding Gaps Present Policy Hurdle: Financials face a slew of payment difficulties as some companies struggle to raise their receivables turnover because of a proliferation of commercial acceptances or discounting of bankers’ acceptances. These payments difficulties are exacerbated by slowing growth and trade uncertainties, and require calibrated policy responses to address funding gaps without over-leveraging the system.
Growth Slowdown Spurs More Stimulus: China’s GDP growth slowed to 6% in Q3 2019, weighed down by trade tensions and fears of a global slowdown. If exacerbated, trade tensions could dampen exports and consumption and create margin pressures for banks. To stimulate domestic growth, the PBOC cut medium-term, short-term, and loan prime rates (LPRs). Lower rates may encourage credit growth, but may cut into the net interest margin for lenders and could push yield-hungry investors towards riskier investments.
Curb Risky Lending Without Sacrificing Growth: Beijing is looking to rein in credit expansion, while avoiding cutting credit access to SMEs and households. This reflects a tension that is critical to understanding China’s overall debt problems. Complicating the issue is the prevalence of alternative lending sources, like local and provincial banks, which are responsible for opaque lending vehicles that are difficult to regulate. Beijing needs to encourage SMEs to borrow responsibly, without taking on too much debt or becoming reliant on shadowy institutions. Last year, the PBOC lowered rates to make traditional lending more attractive to SMEs, while discouraging over-leveraged firms from taking on more debt and simultaneously cracking down on shadowy institutions. These efforts showed some success, given that corporate credit growth declined in 2019, while bank assets grew modestly. Rates will likely remain low as the PBOC continues to lower borrowing costs to stimulate business spending and consumption, but will require supervision to ensure a healthy financial system.
Regional Bank Failures Shake Investor Confidence: China’s “Big Four” banks are making progress in reducing their NPEs, but some local and rural banks are moving in the opposite direction. While Beijing clamps down on “shadow banking” and WMPs, it is also putting pressure on China’s biggest banks to bail out these failing or overleveraged regional banks in order to maintain financial stability.
Corporate Bond Defaults Rise: Corporate debt in 2019 rose to 154% GDP, which suggests some firms may be taking on an unsustainable amount of debt.25 In 2019, a high-profile commodities trading SOE confirmed such fears, essentially defaulting via a debt restructuring plan. While this trend would be concerning if it continues, some onlookers see defaults in China as a healthy market-driven risk because SOEs were previously not allowed to default. And although corporate bond defaults are pushing towards an all-time high, the onshore default rate is still relatively low and consistent with last year at 0.5%.26
Conclusion
After decades of rapid development and reform, China’s Financials sector is now the largest in China and the largest Financials sector globally. Home to the world’s second largest equity market, and third largest bond market, Financials are at the center of financing China’s economic growth story.
This article first appeared on the Global X Research blog on January 30.
Photo Credit: philippe via Flickr Creative Commons
FOOTNOTES
1. Within the MSCI China Financials 10/50 Index. Source: MSCI as of Aug 30, 2019.
2. Vox EU – CEPR, “The Chinese banking system: Much more than a domestic giant”, Feb 2018. See also: Bank of Japan, CEIC, European Central Bank, FRED.
3. Versus the MSCI China Index. Source: MSCI as of Aug 30, 2019.
4. McKinsey, “China and the World Full report,” Jun 2019. According to the same source, foreign ownership accounted for roughly 2% of China’s banking system, 2% of the bond market, and 6% of the stock market (as of 2018).
5. Bloomberg as of Sept 20, 2019. Data is semiannual (mid-June).
6. Bloomberg as of Sept 20, 2019. Data is semiannual (mid-June).
8. Investopedia, “Introduction to the Chinese Banking System” Mar 1, 2019.
8. South China Morning Post, “China will become world’s biggest insurance market by mid-2030s, speeding past US on the way, says analyst,” Mar 7, 2019.
9. Bloomberg Intelligence, Jan 6, 2019 as of Dec 3, 2019.
10. World Economic Forum (WEF), “Explained, the role of China’s state-owned companies,” May 7, 2019.
11. The Shanghai- and Shenzhen-Hong Kong Connect programs allow shares to be traded in each market through each markets’ respective brokers and clearinghouses. These programs enable foreign investors to purchase mainland China listed securities and Chinese investors to buy foreign securities through Hong Kong. Similarly, the Bond Connect program is a mutual market access scheme permitting Chinese and foreign investors to trade across their markets.
12. Inclusion of China into the EMBI will, like its inclusion into MSCI’s indices, be scaled up over 20 months starting in April 2019. This will include government and policy bank bonds and will increase China’s weight in the index to 6.03%, according to Bloomberg and Reuters. See: Reuters, “Explainer: Why China’s inclusion in global bond benchmark matters,” Mar 29, 2019.
13. CSIS, “How well off is China’s middle class?” as of Jan 21, 2020.
14. SCMP, “Breakneck growth in China’s credit-card debt since 2012 raises worries about a potential bust, says ratings agency S&P,” Jul 5, 2019.
15. Ibid.
16. McKinsey, “China and the World Full report,” Jun 2019. According to the same source, inbound and outbound capital flows were roughly one-third of the US’s (as of 2017).
17. Marlene Amstad and Zhiguo He (University of Chicago Becker Friedman Institute), “Handbook on China’s Financial System: Chinese Bond Market and Interbank Market,” Mar 1, 2019.
18. Ibid.
19. Foreign ownership of government bonds overshadows corporate bond ownership, with more than 8% foreign ownership according to: The Asia Policy Institute and Rhodium Group, “Financial System Policy Reform,” Winter 2019.
20. CSIS, “Does China face a looming debt crisis?” as of Jan 21, 2020.
21. Bloomberg, “China’s $6 Billion Bond in U.S. Currency Gets Big Orders,” Nov 26, 2019.
22. Bloomberg, “Index Inclusion Seen Making China Bond Market No. 2 Globally,” Apr 1, 2019.
25. Bloomberg as of Jan 9, 2019.
26. S&P, Nov 2019.
