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How do Chinese non-financial corporations in risky sectors use international bond issuance to exploit interest rate differentials, engage in speculative interfirm lending, and evade prudential regulation?

Image courtesy of interviewee. November 14, 2024

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This video discusses the post-global financial crisis landscape regarding dollar liquidity, particularly in emerging markets, with a focus on China. After the crisis, companies in emerging markets began borrowing in dollars due to low interest rates, resulting in a significant increase in bond issuances by non-financial corporations—from about $300 billion in 2007 to over $1 trillion by 2016. A notable trend was the "carry trade," where entities borrowed in low-interest currencies to invest in higher-yield currencies.

China emerged as a major player in this trend, growing from 3% of international bond stock in 2007 to over 50% in 2016. However, China's financial system is not a full market economy, and lending is influenced by government regulations that direct funds toward specific sectors while limiting others deemed at risk, such as mining and real estate.

The regulations, aimed at curbing overcapacity and fostering greener industries, influence how firms borrow and lend. Large corporations often issue bonds abroad and then lend these to smaller firms in their sectors rather than investing the funds back into traditional banking. This video behavior is contrasted with Brazilian firms that typically deposit foreign funds in local banks.

Despite these actions, the speaker suggests that little risk management occurs in this inter-firm lending, presenting potential problems for financial stability. Recent measures taken by Chinese authorities indicate a recognition of the underlying risks associated with these regulatory practices. In summary, while increased borrowing behavior has led to substantial financial flows and sectoral lending shifts in China, it has also introduced complexities and risks that may not be effectively managed.

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Here are 5 key points from the video:

1. **Post-Crisis Dollar Liquidity**: After the global financial crisis, there was an overwhelming amount of dollar liquidity due to low interest rates in the U.S., which encouraged companies, particularly in emerging markets, to borrow in dollars.

2. **Surge in Bond Issuance**: The issuance of bonds by non-financial corporations increased dramatically, growing from around $300 billion in 2007 to over $1 trillion by 2016, with significant spikes occurring between 2008 and 2009.

3. **China's Unique Role**: China was a major player in this trend because it accounted for a significant portion of international bond issuances. However, its financial system differs from full market economies due to non-market determined interest rates and regulations that directed lending to specific sectors.

4. **Regulatory Impact on Lending**: Chinese regulations aimed at curbing credit to overcapacity sectors, like real estate and mining, indirectly led to larger corporations borrowing abroad to lend to smaller firms in regulated sectors. These regulations were intended to manage risk but shifted it to the non-financial corporation sector, which is less monitored.

5. **Lack of Hedging**: There is little evidence that Chinese firms effectively hedge the risks associated with their borrowing and lending practices. Companies that borrow abroad often do not manage the associated risks properly, potentially leaving significant risk in the system.

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Here are some key quotes and ideas distilled from the video you :

1. **Global Convideo of Dollar Liquidity**:
- "From a global perspective, there's an overwhelming dollar liquidity after the global financial crisis... interest rates in dollar were incredibly low."

2. **Emerging Market Borrowing**:
- "Companies in emerging markets decided it was a good idea to borrow in dollars because they could access credit at such low interest rates."

3. **Bond Issuances**:
- "Issuances of bonds by non-financial corporations increased dramatically... from about 300 billion in 2007 to more than 1 trillion in 2016."

4. **Carry Trade Explanation**:
- "What is carry trade? I basically borrow in a currency which has a low interest rate and lend in a currency that has a high interest rate."

5. **China's Role in Global Trends**:
- "China is interesting... because it is very big... and it accounted for more than 50% of international bonds... It is not a full market economy."

6. **Regulatory Environment in China**:
- "Interest rates are not fully market determined... regulations redirected lending to certain sectors."

7. **Regulations Impacting Credit Growth**:
- "Regulations aimed at limiting the growth of certain sectors, specifically mining, copper, and the real estate sector."

8. **Risk Management Concerns**:
- "The regulation... gives structure to banks to cut credit to certain industries... but you're moving the risk, not eliminating it."

9. **Behavior of Chinese Corporations**:
- "Chinese firms that borrow abroad want to behave like banks... they cannot just deposit the money in a Chinese bank."

10. **Shadow Interest Rates**:
- "The market interest rate, what is called the shadow rate, can be much higher than a regulated interest rate."

11. **Intra-firm Lending Dynamics**:
- "There is a matching between intra-firm lending between sectors... big corporations are more likely to lend to smaller producers within their industry."

12. **Lack of Effective Risk Management**:
- "There isn't much hedging... a lot of risk left in the system."

These quotes capture the core arguments and analyses presented in the video regarding the financial dynamics at play, especially related to borrowing practices in emerging markets, particularly China, and the regulatory and economic environment in which these actions occur.

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From a global perspective, there's a,

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there was a overwhelming dollar liquidity

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after the global financial crisis.

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It was the monetary policy response to the,

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financial CRI crisis and,

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and, interest rate in dollar were incredibly low.

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And, and companies in emerging market,

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decided it was a good idea to borrow a dollar

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because they could access credit at, such,

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such a low interest rate.

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And, the chief economist of the bank

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for international settlement,

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and many of his colleagues of, were the first

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to document this trend.

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And they showed that, issuances of bonds

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by non-financial corporations,

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so non-banks increased dramatically.

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And the stock of these bonds went from about,

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300 billion in 2007 to more than 1 trillion in 2016.

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And just in one year issuance doubled from about

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150 billion to 300 billion.

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So this was between 2008 and 2009.

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And what, she

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and colleagues show that most of these bonds were issued to,

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to, to play a game, which is called carry trade.

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What is carry trade?

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I basically borrow in a currency which has a low interest

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rate and land in a currency that has a high interest rate.

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And I hope that there is no depreciation

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and I'm gonna make money out of it.

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So, so that was the global trend. And so we focus on China.

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Why is China interesting?

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China is interesting for two reasons.

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The first reason is that China is very big

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and was a big player in this trend.

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So China went to, from being about 3% of this stock

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of, international bond in, in 2007, to be

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to account for more than 50%.

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So this in 2016. So it's a very rapid grow.

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And, and, and, but China also interesting

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because not only because it's big, but also

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because it's not a full market economy.

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And so the financial system doesn't work exactly like,

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in other countries.

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And we, exploit two characteristics

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of the Chinese financial system in our studies.

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The first one that,

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interest rates are not fully market determined,

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and the second sum regulation that redirected lending

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to certain sectors.

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So that's what we focus on.

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We use the terms risky

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and non-risky a little bit as a shortcut.

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So this is really based on some, regulations

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that were implemented by, the Chinese, authorities.

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And, and this regulation, were not really targeted

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to firms, but to sectors.

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So we refer to risky sectors or risky industry

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or other specific firms.

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Uh, so when I presented this paper,

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it's a little bit the saying, you know,

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Italians in general like pasta, I, but I might be Italian

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and not like pasta when I like it, but, so,

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but it's more a statement about a group

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of firms rather than, to a specific firm.

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And this regulation were aimed at, at,

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limiting the growth of certain sectors,

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Uh, which were deemed to be in over capacity.

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And these were, specifically, mining

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and production of primary materials, so like iron

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and coppers and the real estate sector.

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So there were two important regulations.

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One issued in, at the end of 2009 in December, 2009,

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which was titled, the title is a bit cumbersome,

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but I'm gonna read it for you.

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It was titled, guiding Opinion on Further Strengthening

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Financial Services with a view to supporting the adjustment

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and rejuvenation of some key industry

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and restraining excess capacity in other industry.

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So it's really like we want to expand some sector

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and restrain other sector.

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And the second that was,

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implemented in May, 2010 was titled Notice on Financial

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Services to Further Support Energy Savings

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and Eliminate Backward Production Capacity.

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So you may think that this is a little bit more

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with an environmental angle.

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I wanna support certain industry which are more green

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and strain other industries.

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And so regulators issued these two,

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these two regulations with two objective in mind to,

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limit the growth to certain sector, which were deemed risky

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because were deemed too big,

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but also to reorient the economy in certain

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direction for our own purposes.

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The important thing is that this regulation,

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gave structure to banks to, cut credit

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to certain industry and give more credit to that industry.

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That's what we use in our, econometric exercise.

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We have this regulation that says, you know,

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certain firms should borrow less

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because there might be some risk to financial stability.

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And then if you have an action that goes

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around this regulation, well, you are moving the risk,

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you're not eliminating the risk,

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you're basically taking the risk from somewhere.

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You're actually taking the risk from the banking system,

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which is a regulated sector on which we have a lot

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of information to the non-financial corporation system,

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which is non regulator, which don't know much.

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So in a sense, you make the situation worse

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because, you know, the risk is still there,

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but now you're less able to monitor, this risk.

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Can me give you an example of what happens

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or happened in the typical emerging market as documented by,

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by hin, as I mentioned before in authors

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and what happens in China.

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So the first part is the same.

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So the company borrows abroad, so it should,

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a bonding dollar takes these proceeds not to invest

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or do what firms do,

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but takes the proceeds to behave like a bank

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to lend it to somebody else.

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How does this work? In Brazil, it's much easier.

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The, you know, large Brazilian corporation borrows abroad,

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brings the money in,

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puts them in a Brazilian bank in red eyes

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and gets the high interest rate in red eyes.

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And that's pretty much it.

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In, in China, this thing doesn't work. Why doesn't it work?

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Because for the reason I mentioned

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before, the Chinese banking system is highly regulated

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and interest rates are capped.

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So if I basically put my money in a Chinese bank,

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I'm gonna get very low interest rate

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because the interest rate is not a market interest rate,

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it's a regulated interest rate.

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If I wanna make money, I need to lend to somebody

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who pays me the market interest rate

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and this market interest rate,

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what is called the shadow rate,

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can be much higher than a regulated interest rate.

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At certain point it was 14 percentage point higher.

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So it's like a enormous difference.

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Uh, so if Chinese, firms that borrow abroad want

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to behave like banks,

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they cannot just deposit the money in a Chinese bank.

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They have to lend it to another firms.

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And that's exactly what we observe.

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So unlike Brazil in which the,

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the large corporation borrows abroad puts in a Brazilian

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bank, what we see is

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that the Chinese corporation borrows abroad

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and relent to another Chinese firm.

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We see we can observe the balance sheet of this firm,

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and we see that they issued a bond,

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that we have it on the liability side of the balance sheet,

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and then we see that it lends to another firm

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that we have it in the asset side.

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But e exactly how this happens,

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and if this regulation address it, we would like

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to know which type of firms borrow.

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And, and our intuition is that, you know,

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firms are more likely if they wanna behave like banks,

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they're more likely to lend to firms that belong

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to their own sector, right?

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Because they know more about these firms,

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they deal with these firms.

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And so we say, so there is a regulation that say, you know,

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you are in the cement industry

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and banks are not gonna lend to you anymore

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because there is a regulation that says, no, don't lend

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to the cement industry.

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And then we have a big corporation in the cement industry

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that is able to, if you're a small producer, you're not able

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to go abroad and float a big bond.

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Now we have a big corporation in this sector

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that goes abroad and,

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and we think, well, this guy is more likely to have demand

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from the small cement.

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So, and we see that they are exactly

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big corporation in the industry, which are curbed

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by this regulation that go and issue the bonds abroad.

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And, and there is a specific market which is called the

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market for entrusted loans and re

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and there we really see that there is a matching between,

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intra firm lending between sectors.

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So the true answer to this question is that we don't know

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because we don't have information,

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but we do have some anecdotal evidence

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that basically they don't manage this risk,

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or if they manage it, they manage a very small part of it.

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First of all, this makes sense

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because if you wanna make this carry trade opportunities in

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the moment you try to edge your risk,

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you are gonna lose the profits.

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Um, we also see that the, all the companies

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that have a natural edge,

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and these are the companies that export

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don't borrow much abroad, which is

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Exactly the opposite.

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What you would would expect if the,

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this borrowing abroad was driven by some hedging behavior.

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So, so again, you know, we don't have hard evidence on this.

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It's more anecdotal evidence, more talking with people,

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but our impression that there isn't, much hedging.

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And so there is a lot of, risk left in the system.

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And in fact, we think that the authority realized this

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because in, in 2015, they issued,

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another directive which was titled Provisions on several

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issues concerning the application of law in trial

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of private lending cases.

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So that very, but again,

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that was aimed at curbing this inter firm lending

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because I think the, the authorities did indeed realize

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that there was a lot of, underlying risk,

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which was not being monitored.

Global Dollar Liquidity and Emerging Market Borrowing Trends

00:00:00 - From a global perspective, there's a, there was a overwhelming dollar liquidity after the global financial crisis. It was the monetary policy response to the, financial CRI crisis and, and, interest rate in dollar were incredibly low. And, and companies in emerging market, decided it was a good idea to borrow a dollar because they could access credit at, such, such a low interest rate. And, the chief economist of the bank

00:00:31 - and many of his colleagues of, were the first to document this trend. And they showed that, issuances of bonds by non-financial corporations, so non-banks increased dramatically. And the stock of these bonds went from about, 300 billion in 2007 to more than 1 trillion in 2016. And just in one year issuance doubled from about 150 billion to 300 billion. So this was between 2008 and 2009. And what, she

00:01:05 - to, to play a game, which is called carry trade. What is carry trade? I basically borrow in a currency which has a low interest rate and land in a currency that has a high interest rate. And I hope that there is no depreciation and I'm gonna make money out of it. So, so that was the global trend. And so we focus on China. Why is China interesting? China is interesting for two reasons. The first reason is that China is very big and was a big player in this trend.

China's Unique Financial Landscape

00:01:36 - of, international bond in, in 2007, to be to account for more than 50%. So this in 2016. So it's a very rapid grow. And, and, and, but China also interesting because not only because it's big, but also because it's not a full market economy. And so the financial system doesn't work exactly like, in other countries. And we, exploit two characteristics

00:02:04 - The first one that, interest rates are not fully market determined, and the second sum regulation that redirected lending to certain sectors. So that's what we focus on. We use the terms risky and non-risky a little bit as a shortcut. So this is really based on some, regulations that were implemented by, the Chinese, authorities. And, and this regulation, were not really targeted to firms, but to sectors.

00:02:36 - or other specific firms. so when I presented this paper, it's a little bit the saying, you know, Italians in general like pasta, I, but I might be Italian and not like pasta when I like it, but, so, but it's more a statement about a group of firms rather than, to a specific firm. And this regulation were aimed at, at, limiting the growth of certain sectors, which were deemed to be in over capacity. And these were, specifically, mining

Regulatory Measures for Sectoral Financial Stability in China

00:03:08 - and coppers and the real estate sector. So there were two important regulations. One issued in, at the end of 2009 in December, 2009, which was titled, the title is a bit cumbersome, but I'm gonna read it for you. It was titled, guiding Opinion on Further Strengthening Financial Services with a view to supporting the adjustment and rejuvenation of some key industry and restraining excess capacity in other industry. So it's really like we want to expand some sector

00:03:39 - And the second that was, implemented in May, 2010 was titled Notice on Financial Services to Further Support Energy Savings and Eliminate Backward Production Capacity. So you may think that this is a little bit more with an environmental angle. I wanna support certain industry which are more green and strain other industries. And so regulators issued these two, these two regulations with two objective in mind to,

00:04:11 - because were deemed too big, but also to reorient the economy in certain direction for our own purposes. The important thing is that this regulation, gave structure to banks to, cut credit to certain industry and give more credit to that industry. That's what we use in our, econometric exercise. We have this regulation that says, you know, certain firms should borrow less because there might be some risk to financial stability.

Regulatory Risks and Borrowing Dynamics in Emerging Markets

00:04:42 - around this regulation, well, you are moving the risk, you're not eliminating the risk, you're basically taking the risk from somewhere. You're actually taking the risk from the banking system, which is a regulated sector on which we have a lot of information to the non-financial corporation system, which is non regulator, which don't know much. So in a sense, you make the situation worse because, you know, the risk is still there, but now you're less able to monitor, this risk.

00:05:14 - or happened in the typical emerging market as documented by, by hin, as I mentioned before in authors and what happens in China. So the first part is the same. So the company borrows abroad, so it should, a bonding dollar takes these proceeds not to invest or do what firms do, but takes the proceeds to behave like a bank to lend it to somebody else. How does this work? In Brazil, it's much easier. The, you know, large Brazilian corporation borrows abroad,

00:05:45 - puts them in a Brazilian bank in red eyes and gets the high interest rate in red eyes. And that's pretty much it. In, in China, this thing doesn't work. Why doesn't it work? Because for the reason I mentioned before, the Chinese banking system is highly regulated and interest rates are capped. So if I basically put my money in a Chinese bank, I'm gonna get very low interest rate because the interest rate is not a market interest rate, it's a regulated interest rate. If I wanna make money, I need to lend to somebody

Chinese Corporate Borrowing Dynamics

00:06:17 - and this market interest rate, what is called the shadow rate, can be much higher than a regulated interest rate. At certain point it was 14 percentage point higher. So it's like a enormous difference. so if Chinese, firms that borrow abroad want to behave like banks, they cannot just deposit the money in a Chinese bank. They have to lend it to another firms. And that's exactly what we observe. So unlike Brazil in which the, the large corporation borrows abroad puts in a Brazilian

00:06:48 - that the Chinese corporation borrows abroad and relent to another Chinese firm. We see we can observe the balance sheet of this firm, and we see that they issued a bond, that we have it on the liability side of the balance sheet, and then we see that it lends to another firm that we have it in the asset side. But e exactly how this happens, and if this regulation address it, we would like to know which type of firms borrow. And, and our intuition is that, you know,

00:07:20 - they're more likely to lend to firms that belong to their own sector, right? Because they know more about these firms, they deal with these firms. And so we say, so there is a regulation that say, you know, you are in the cement industry and banks are not gonna lend to you anymore because there is a regulation that says, no, don't lend to the cement industry. And then we have a big corporation in the cement industry that is able to, if you're a small producer, you're not able to go abroad and float a big bond.

Risk Management and Intra-Firm Lending in China's Bond Market

00:07:52 - that goes abroad and, and we think, well, this guy is more likely to have demand from the small cement. So, and we see that they are exactly big corporation in the industry, which are curbed by this regulation that go and issue the bonds abroad. And, and there is a specific market which is called the market for entrusted loans and re and there we really see that there is a matching between, intra firm lending between sectors.

00:08:24 - because we don't have information, but we do have some anecdotal evidence that basically they don't manage this risk, or if they manage it, they manage a very small part of it. First of all, this makes sense because if you wanna make this carry trade opportunities in the moment you try to edge your risk, you are gonna lose the profits. we also see that the, all the companies that have a natural edge, and these are the companies that export

00:08:54 - Exactly the opposite. What you would would expect if the, this borrowing abroad was driven by some hedging behavior. So, so again, you know, we don't have hard evidence on this. It's more anecdotal evidence, more talking with people, but our impression that there isn't, much hedging. And so there is a lot of, risk left in the system. And in fact, we think that the authority realized this because in, in 2015, they issued,

Challenges in Regulating Inter-Firm Lending Risks

00:09:43 - issues concerning the application of law in trial of private lending cases. So that very, but again, that was aimed at curbing this inter firm lending because I think the, the authorities did indeed realize that there was a lot of, underlying risk, which was not being monitored.

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