conomists seem to be fond of animals. Black swans are unexpected economic shocks such as the 2008 global financial crisis, the Brexit referendum and the Trump election. Now “gray rhinos” have come into focus. The meaning is explained in the title of a book published in 2016, The Gray Rhino: How to Recognize and Act on the Obvious Dangers We Ignore
, written by Michele Wucker, founder and CEO of Gray Rhino & Company in Chicago. The bursting of the housing bubble in 2008, as well as the aftermath of 2005's Hurricane Katrina, are actually gray rhinos that would have been avoided if enough attention had been paid to the obvious signs of danger, according to the book. Keen readers include Chinese policymakers and economists.
In mid-July, a meeting was convened by China’s top minds, who vowed to avoid a systematic financial crisis there. The Communist Party’s flagship paper the People’s Daily then ran a series of editorials on the meeting. It called for precautions against both black swans and gray rhinos. Lurking financial risks have to be addressed properly and early. Otherwise, a devastating crisis can sweep the whole economy suddenly, just like “a slow-moving gray rhino getting violent in the blink of an eye.” It repeatedly stressed the meeting’s decision to “identify, warn of, detect and treat risks as early as possible.”
In the meantime, China declared a better-than-expected half-year growth score board. That has triggered heated debate on whether a new upward growth cycle is on the horizon. While the answer is not clear, there are also signs of gray rhinos beyond the financial system.
Where are the Gray Rhinos?
Guarding against systematic financial risk is regarded as the “bottom line” and has been made a top priority of China’s economic agenda. This fact speaks to the severity of the existing problems to be addressed by China��s financial markets. A number of risks have been specified officially. The national meeting highlighted the heavy debt ratio of Chinese companies, especially State-owned ones, as well as local government debt and misconduct in financial transactions. Shadow banking, the housing bubble and illegal fundraising were also on the list of gray rhinos given by the Office of the Central Leading Group on Finance and Economic Affairs at a press conference at the end of July. The People’s Daily called for close scrutiny of the isks in all major financial sectors, including credit, insurance and capital markets. Risks behind fintech, or financial technology, and information security were also spotted by the People’s Daily.
There is little surprise that these issues have found a place on the list. Problems had mounted for some time before they created a shock that hit each of the sub-sectors they are in or related to. Shadow banking, the de facto lending business kept off the balance sheets of banks, triggered a liquidity crisis on the interbank market in June 2013. A bull started to charge on China’s stock market in early 2015, despite the economic slowdown. It turned out to be a bull in a china shop a few months later. Prices suddenly nosedived. The government rushed to the rescue. However, the strong and direct intervention aroused huge controversy over whether the government had gone too far. In early 2016, insurance companies, which had always been expected to be long-term investors and thus “stabilizers” of the stock market, were found to have manipulated share prices and toppled well-performing management teams once they had bought out listed companies with investors’ money. Technology-oriented new financial products, including bitcoin and online lending platforms, have been plagued with either crazy volatility or fraud.
Analysts are divided over whether a gray rhino is at large in the housing sector. Huang Zhilong, director of the macro-economy research section at the Suning Institute of Finance, warned in his article for Securities News on August 5 that the housing frenzy could be “the biggest gray rhino,” due to the size of the market itself, its impact on other sectors, the large proportion of bank assets that mortgages make up and the rapid rise of household mortgages. Further concerns have focused on the shift of the housing spree to smaller cities in the first half of the year, which was boosted by policy restrictions in bigger cities, rather than economic growth and population growth in those smaller cities. However, Lian Ping, chief economist at China’s Bank of Communications, argued in his speech at a housing forum in Bo’ao, Hainan Province, on August 11 that a housing gray rhino was still a safe distance away. He argued that borrowing by both developers and households remained at a reasonable level for banks, and the high down payments provided an extra cushion against massive defaults.
Although these shocks flared up in particular, individual markets, the wider signals are alarming. The global financial crisis made evident how quickly a symptom in a single sector can spread across the whole financial system, until the economy and society as a whole catches a very bad cold.
Besides, these gray rhinos, with or without controversy, have already made China’s reforms more difficult and complicated. For example, the Party’s comprehensive reform agenda set in 2013 includes changes to the approval system for initial public offerings of companies, to let investors, not regulators, decide which are the good companies. In early 2015, the securities regulatory watchdog declared it would realize this long-anticipated reform that year. However, such a reform has remained uncertain since the stock market crash.
Given the size of the gray rhinos and the close relations between them, efforts at controlling them have brought about risks of creating new gray rhinos or black swans. Lin Caiyi, outgoing chief economist at Shanghai-based Guotai Junan Securities, has identified three gray rhinos. According to her article on the China Chief Economist Forum website on July 26, the first is that housing prices, if brought down by policies, could lead to more bad performing bank loans. The second is that the ongoing crackdown on financial irregularities could trigger “landmines” in the form of banks’ so-called wealth management products, which are sold to household investors who know little about the risks inherent in these products. The third is external. A possible interest rate hike in the US may hamper China’s efforts at containing excessive capital outflow.
A similar paradox has already spilled over from financial to industrial systems. China’s financial authorities have tightened their monetary policy and scrutiny of financial activities to curb asset bubbles, maintain financial stability and channel capital into the real economy. However, as a short-term byproduct of the efforts, the reduced liquidity affected the real economy. Lian Ping has noticed that interest payments by big industrial enterprises have increased fast since the end of 2016. It may indicate higher financing costs for them, and that for small and medium sized private businesses, capital is becoming harder and more expensive to access, he concluded in his article on the China Chief Economist Forum website on August 10.
In the past two years, local government bonds and public-private-partnerships (PPP) have been used to help local governments reduce their debts on the one hand and meet their needs for capital on the other. However, the PPP model, which is designed to attract private investment for infrastructure projects, has been misused by some local governments as a tool to simply borrow more. A recent report by the National Institution for Finance & Development at the Chinese Academy of Social Sciences called for vigilance against “increases in invisible debts” of local governments, referring to the debts in disguise of various government-led funds, construction funds for special projects, PPP and government- purchased services.
At the very least, gray rhinos, either real or potential, in the financial system have been identified, and measures have been taken to tame them. High leverage and regulatory arbitrage have been involved in nearly all financial shocks in recent years. For example, banks’ wealth management products have been invested in real estate, local government financing platforms and even the stock market via non-banking financial institutions such as fund management or trust companies.
To address this, the national financial meeting has decided to set up a commission to oversee the whole financial system to ensure stability and development across the market. Big cities like Beijing and Guangzhou have adopted new policies to encourage renting in the housing market to curb recurrent speculative purchasing. The Ministry of Finance warned recently that local governments will be held responsible for irregularities in financing PPP projects. In August, the Supreme People’s Court declared that 90 local courts specializing in corporate liquidation and bankruptcy had been established by the end of June 2017, up from only five in early 2015. They are part of the country’s efforts to reduce the heavy corporate debt ratio by removing so-called zombie enterprises that struggle to survive and depend on bank loans. The Supreme Court has also issued guidelines on hearing financial cases, including fraud and local government debts.
Potential gray rhinos outside the financial system need more attention. China’s GDP growth reached 6.9 percent in the first half of the year, well above the 6.5 percent growth target. As a result, the IMF raised its China growth predictions for 2017 and 2018. Between July 17 and 24, the median of the Bloomberg survey of 57 economists on China’s growth estimates for the third and fourth quarter were slightly higher than a month earlier. Debate abounds as to whether this good performance represents the starting point of a growth rebound.
However, a gray rhino may be lurking right in the most significant part of the economy. Contributing 63.4 percent of growth in the first half of the year, “consumption is the largest engine of China’s economy,” said Xing Zhihong, spokesperson for China’s National Bureau of Statistics, at a press conference in Beijing on July 17. However, there are worrying signs in this engine. Of the 6.9 percent GDP growth in the first half of the year, 4.4 percent is from consumption, lower than the 4.9 percent in the same period of 2016, noted Shen Minggao, chief economist at the Guangzhou-based GF Securities at the quarterly China Economic Observation Forum held at the National School of Development at Peking University on July 30.
Indeed, year-on-year consumption growth in July was already the lowest since March. Jiang Chao of the Shanghai-based Haitong Securities gave three reasons for this in his article for the public WeChat account his team runs. Firstly, households face much higher pressures in paying their mortgages and thus have to reduce consumption. Secondly, subsidies for vehicle purchases were cut in 2017, bringing down auto sales. Thirdly, consumption in the first half of the year was mainly boosted by housing-related products, including home appliances, furniture and construction materials. Sales of these products were down, in line with housing sales, in July. Two of the three are related to the housing market. Jiang’s team does not think the housing frenzy can continue. This is part of the reason why China’s economic growth will probably slow in the second half of the year, rather than starting a new rebound, his analysis concluded.
There are social risks after many years of economic growth. Professor Liu Yongqing of Tsinghua University described environmental pollution as the “gray rhino which deserves our vigilance most” in his remarks at a panel discussion sponsored by Sichuan Daily and published in the paper on August 9. “Economic growth at the cost of clean food, water and air is not what people want,” he stressed.
The difficulty in taming gray rhinos in the forest of China’s financial sector provides a lesson. Potential gray rhinos in other areas, especially in China’s largest growth engine and the purpose of growth, need to be detected and tamed before they grow too big to control.