China’s deleveraging campaign was the critical event that ended the country’s unprecedented post-crisis credit expansion.
The crackdown on “shadow” financing channels made China’s financial system safer in the short term, but it also slowed the economy substantially while creating new forms of credit risks.
The timeline below describes the campaign in four stages:
Background of Deleveraging
The 2008 post-crisis stimulus effort led by local government investment was the landmark event that started China's unprecedented credit expansion.
Thousands of local government financing vehicles (LGFVs) were established and eventually became the key clients for shadow banks. The post-crisis stimulus effort triggered surging property prices and rising government debt, causing regulators to respond by trying to limit banks’ lending to these two sectors.
Shadow banking was born as a channel to bypass regulatory restrictions on lending and maintain credit to property developers and LGFVs. As the business grew, banks found other benefits to shadow banking, including reducing capital usage, boosting leverage, and concealing nonperforming assets.
Financial innovation was encouraged and wealth management products (WMPs) were considered a supplement to banks’ liability management given that deposit rates were fixed. Each financial regulator produced its own regulations to encourage the shadow banking business and boost asset growth.
Trusts, fund management companies, and brokerages became the “three musketeers” of the shadow banking business.
Participant: China Securities Regulatory Commission (CSRC)
Regulators encourage expansion of shadow financing channels
Throughout 2012, the CSRC issued a slew of regulations allowing fund management companies and brokerages to serve as channels for shadow banking business. The channel business for brokerages started shrinking in February 2014, and the fund management channel business started shrinking in November 2016. Trust companies became one of the most important channels for shadow banking activities.
Participant: China Banking Regulatory Commission (CBRC)
Wealth management products face first asset allocation restrictions
This was a key stage in the deleveraging process. Before Circular 8, banks invested funds raised via WMPs into shadow banking channels free of control. After Circular 8, funds raised via WMPs were still channeled to shadow banks but were capped at 35 percent of WMP proceeds. Banks increasingly used “purchases under resale agreements” to continue shadow banking investments after these regulations.
Experiments in Deleveraging
The landmark event at this stage was the June 2013 interbank market crisis, when some banks defaulted on their repo transactions, short-term repo rates spiked to over 20 percent, and the world believed the Chinese financial system was collapsing.
The People’s Bank of China (PBOC) saw that the fast-growing WMP business was running out of control and tried to rein in its growth by tightening liquidity in the interbank market, resulting in the liquidity crunch. The PBOC failed and had to back off, which ended up kickstarting rapid growth of WMPs and shadow financing in the following years.
During the 2015 stock market rout, the chairman of the China Securities Finance Corporation said that WMPs provided over 3 trillion yuan in funding as the senior tranches of leveraged products speculating in the stock market.
Between 2013 and 2016, regulators experimented with their own versions of deleveraging efforts and policy swung between tightening and easing. In general, regulators became more concerned about shadow banking growth and started to tighten policy.
The PBOC forces the interbank market to the brink of collapse
The PBOC attempted to regulate banks’ WMPs and shadow banking business by squeezing the interbank market in June 2013. The effort backfired, short-term interest rates rose to 20-30 percent, and the PBOC was forced to reverse itself, which allowed shadow banking channels to grow.
Event: Regulatory Change
Banks are permitted to issue negotiable certificates of deposit (NCDs)
Growth in these instruments was very slow at first, but by 2017, NCDs became a key channel for banks to maintain interbank borrowing, replacing WMPs after additional regulations targeted WMPs.
Securities companies’ shadow banking activities face regulatory scrutiny
These regulations severely curtailed brokerage houses’ channel business from banks, part of a series of actions to limit cooperation between banks and non-bank financial institutions.
Participants: PBOC, CBRC, CSRC, China Insurance Regulatory Commission (CIRC), State Administration of Foreign Exchange (SAFE)
Regulations shift one form of shadow banking to another
Circular 127 was a foundational regulation banning banks’ usage of repurchase agreements to conceal assets, which was a critical method for banks to grow their shadow asset books and reduce capital requirements. The net result of the circular was to shift shadow banking assets to “investment receivables” and other forms of non-loan assets.
Participant: State Council
New budget law takes effect
The new budget law in 2015 was designed to ban local government borrowing through channels other than bonds. In response, local governments were able to lobby for larger swap bond programs to exchange their existing debt, and the new law generally did not prevent localities from borrowing through other channels. Local government debt continued expanding despite this attempt at fiscal discipline.
Event: Regulatory Change
Insurance companies enter shadow banking
The ceiling on interest rates for universal life insurance products was lifted. Insurers also started engaging in the shadow banking business by pooling money from retail investors through universal life insurance products and investing into the interbank market and the stock market. The rapid growth of these products also allowed some insurers to become far more aggressive in investing abroad.
Participants: China Securities Finance Corporation, PBOC
China’s equity market bubble peaks, starting a major market rout
Highly leveraged margin trading funded via shadow banking was one of the critical forces behind the stock market bubble in 2015. The chair of the China Securities Finance Corporation estimated that 3.5 trillion yuan in WMP funds had helped to fuel the bubble. Beijing attempted to control margin lending, and the market collapsed. The China Securities Finance Corporation borrowed around 2 trillion yuan from the interbank market, and the PBOC was one of the primary vehicles of the stock market bailout. Equity valuations have not returned to 2015 levels since.
Participants: PBOC and multiple agencies
Regulations encourage internet finance growth
These regulations encouraged the growth of internet financing, which later became a key target of the deleveraging campaign. The regulatory liberalization was designed to encourage some competition within the state-owned banking system.
Event: Monetary Policy Action
The PBOC formally liberalizes deposit rates
The PBOC removed the formal ceiling on deposit rates and floor on lending rates in October 2015, but in practice, a de facto ceiling on deposit rates remained in place, enforced through banks’ self-discipline system.
Deleveraging discussed as a policy objective for the first time at the Central Economic Work Conference
The Central Economic Work Conference statement in 2015 was the first official mention of deleveraging. The meeting statement read: “The meeting noted that next year's socio-economic development, especially structural reform, will be a difficult task. Regarding strategy, [it was announced] China must maintain steady progress, and manage the pace and intensity of development. Tactically, China must prioritize key pain points, including focusing on cutting production overcapacity, reducing inventories, deleveraging, cutting costs, and mitigating shortcomings.”
Event: Monetary Policy Action
PBOC introduces a new macroprudential regulatory framework
The PBOC introduced its macro-prudential adjustment (MPA) mechanism, which was one pillar of its “two pillar” monetary policy framework. The framework was established primarily to control shadow banking activities and limit other systemic financial risks.
Regulators impose new limits on shadow banking activity from life insurers
CIRC started introducing limits on universal life insurance products used for shadow banking, which started to control their rapid growth.
The Deleveraging Campaign Begins, Focused on Monetary Tightening
A People's Daily interview with an “authoritative person” widely believed to be Liu He launched the deleveraging campaign with a discussion of China's high leverage ratios and warnings about debt, saying that “a tree cannot grow to the sky.”
The appearance of the article effectively ended the internal policy debates surrounding deleveraging and triggered more coordinated government efforts to reduce risks in the shadow banking sector. These started with monetary tightening steps in late 2016 and then expanded to regulatory tightening efforts in 2018.
Participant: People’s Daily
Event: Government Meeting
People’s Daily Interview with an “authoritative person” launches deleveraging campaign
The interview with an “authoritative person” in the People's Daily on May 9, 2016, was the formal announcement of the start of the deleveraging effort for both internal and external audiences. The interview was thought to be conducted with Liu He, the head of the office of the leadership group associated with economic and financial affairs at the time, or someone who effectively spoke for the viewpoint of Liu’s office.
Event: Government Meeting
Politburo affirms deleveraging goals
The Politburo’s statement from its economic work meeting for the second half of 2016 reaffirmed the importance of deleveraging as a fundamental reform of the financial system. The statement read, “The key to reducing overcapacity and deleveraging is to deepen the basic reform of state-owned enterprises and the financial sector.”
Event: Monetary Policy Action
Longer reverse repo transactions start monetary tightening effort
After six months, China's central bank reintroduced 14-day reverse repos on August 24, 2016, which triggered an adjustment in money market rates. The PBOC started guiding short-term interest rates higher to reduce the attractiveness of leveraged positions in shadow banking assets, beginning monetary tightening.
New controls are imposed on fund management companies
These regulations were among the steps targeting the fund management channel business of shadow banking, which started to shrink.
Participant: Financial Markets
Sealand Securities threatens default on entrusted bonds
Sealand Securities, a small securities firm, refused to honor certain entrusted bond contracts in December 2016, and market participants became concerned that other similar contracts may not be accepted. Money market conditions tightened significantly, and the PBOC was forced to extend trading hours to prevent interbank market defaults that might have triggered another crisis on par with the interbank market stress of June 2013.
Event: Monetary Policy Action
PBOC strengthens controls on WMPs, within macroprudential assessment
The PBOC includes off-balance sheet WMPs into its MPA management, limits short-term debt and long-term investments, and strengthens its commitment to “deleveraging.” This was one example of the central bank using its macroprudential tools to target shadow banking channels specifically.
PBOC interest rate hikes begin
Monetary tightening steps guided short-term interest rates higher in order to squeeze financial leverage, totaling 30 basis points from January 2017 through April 2018. This worked to a certain extent in reducing financial institutions’ leverage, but it failed to reduce corporate leverage. Both property developers and local governments were generally not sensitive to rising interest rates during this time, although that situation changed for property developers as the market corrected in 2021 and 2022.
PBOC working teams start drafting a unified asset management rule
The fact that the drafting process for these regulations started more than a year before the rules were implemented revealed how difficult it was to balance competing interests and highlighted the obstacles to implementation of the key regulatory tool for deleveraging.
Multiple regulations from CBRC target interbank and shadow financing
A flurry of circulars from the banking regulator targeted interbank and shadow banking business between March and April 2017.
Participant: National Financial Work Conference
National Financial Work Conference is held in Beijing
The National Financial Work Conference was held every five years and the 2017 meeting formally established a new “super-regulator” for China's financial sector, which was eventually unveiled as the Financial Stability and Development Committee. The conference also strengthened the leadership’s rhetorical commitment to deleveraging goals. The statement said, “We should focus on strengthening financial supervision and hold the prevention of systemic financial risks as a bottom line by accelerating the construction of relevant laws and regulations, improving the corporate governance structure of financial institutions, strengthening the construction of macro-prudential management systems, strengthening functional supervision, and paying more attention to behavioral supervision.”
Draft version of unified asset management rule is released
The initial version of the rules that would impose new controls over WMPs was released in November 2017, before final implementation in April 2018.
Event: Government Meeting
The State Council’s Financial Stability and Development Committee (FSDC) is established and holds its first meeting
The FSDC was established to strengthen control over the financial system and prevent gaps within the existing regulatory structure, which had allowed shadow banking to flourish.
Participant: Office of the Leading Group for the Special Campaign against Peer-to-peer Lending Risks
New regulations focus on controlling peer-to-peer networks
The crackdown against peer-to-peer networks continued. New regulations required local governments to complete registrations of peer-to-peer networks for eventual regulation.
New regulations unveiled, limiting banks’ cooperation with trust companies
Banks were instructed to curtail cooperation with trust companies, one of the primary channels for shadow banking activities.
New regulations on interbank NCDs released
The PBOC started regulating NCDs more stringently to avoid them being used as alternatives for WMPs. The regulations included a limit of interbank liabilities to one-third of total liabilities within the quarterly MPA assessment and included NCDs within those calculations of interbank liabilities. They also limited NCD maturities to less than one year in duration.
Deleveraging Efforts Intensify, Shift to Regulatory Tightening
The landmark event at this stage was the publication of a new asset management rule in April 2018 that applied to almost all investment products and WMPs.
The measures reduced the scope for regulatory arbitrage and ended up producing a record slowdown in credit growth in 2018. The PBOC offset some of the financial pressure caused by these new rules by easing monetary policy.
Participants: PBOC, CSRC, SAFE, China Banking and Insurance Regulatory Commission (CBIRC)
Unified asset management rules released as the centerpiece of regulatory tightening
The unified asset management rules were the primary regulatory instrument of the deleveraging campaign. The new rule applied to all asset management products and tried to reduce the scope for regulatory arbitrage, limiting both banks’ usage of WMPs and channel business with third-party asset managers. The introduction to the regulations stated: “China must standardize the asset management business of financial institutions, unify the regulatory standards for similar asset management products, effectively prevent and control financial risks, guide the flow of social funds to the real economy, and better support economic restructuring, transformation, and upgrading.”
New liquidity indicators aim to control banks’ maturity mismatches
The CBIRC introduced new liquidity indicators, including a liquidity coverage ratio, to reduce the prospect of a maturity mismatch for banks.
First modifications easing the implementation of asset management rules introduced
This was a supplement to the new asset investment rule, moderating the impact of the rules to some extent. The key provision allowed banks to sell “cash-type” WMPs to avoid too sharp a contraction in their WMP business and interbank liabilities. Later on, cash-type WMPs became a key target of the deleveraging campaign.
Investors in failed peer-to-peer products protest in Beijing
Thousands of protesters came to Beijing’s Financial Street and the offices of the banking regulator to protest losses in peer-to-peer lending products. The protesters were generally placed on buses and sent home, without receiving any compensation for losses.
Participants: Central Committee of Chinese Communist Party, State Council
Regulatory controls on SOEs attempt to control debt levels
This was the primary regulation concerning SOE deleveraging. SOEs’ formal leverage ratios were required to drop by 2 percentage points from the end of 2017 to the end of 2020.
WMP departments separated from commercial banks
These new regulations required banks to separate their WMP departments from the bank and manage them in a separate entity.
Consolidation and Fallout
The bankruptcy of Baoshang Bank revealed the consequences of slowing credit growth in the shadow banking system and weakening implicit guarantees on some institutions.
Several other banks needed to be restructured after Baoshang, including Hengfeng Bank, the Bank of Jinzhou, and the Bank of Harbin. Supplementary rules concerning deleveraging continued to emerge, sometimes by easing previous rules.
The basic framework for deleveraging had been established at this stage. Deleveraging continued, but policy efforts have stabilized and are no longer intensifying.
Participants: PBOC, CBIRC
Baoshang Bank defaults, sparking contagion within the banking system
There were a series of bank failures, bailouts, and restructurings as a consequence of deleveraging and the contraction of shadow financing channels. These started with Baoshang Bank’s failure in May 2019 and extended quickly to the Bank of Jinzhou and Hengfeng Bank.
Tightening steps target trust loans
Further tightening steps targeted trust loans specifically. At this point, the other two channels (funds and brokerages) were already shrinking, leaving trusts as one of the only active channels for shadow banking business lines. Trust companies were required to shrink their trust loans by 20 percent every year over the following five years.
“Three red lines” for property developers’ borrowing imposed
This was the critical step that brought developers’ pre-construction sales model of financing to an end by reducing leverage through all forms. It started the property sector’s dramatic correction, which continues today, exposing the market’s imbalance between the pace of construction and fundamental demand.
Participants: CBIRC, PBOC
New restrictions on cash-type WMPs introduced
Notice by the China Banking and Insurance Regulatory Commission and the People’s Bank of China Regarding Matters Concerning Regulating the Administration of Cash Management-Based Wealth Management Products
Additional restrictions were imposed on cash-type WMPs, to reduce banks’ capacity to circumvent the asset management rules, as these rules had previously made exceptions for these types of WMPs.
China’s multiyear campaign targeting shadow banking effectively replaced one form of financial risk with another. While the system became less vulnerable to short-term funding squeezes and maturity mismatches, the deleveraging effort slowed credit growth substantially and created new forms of credit risks as borrowers lost access to financing. Property developers replaced shadow borrowing channels with direct borrowing from home buyers via mortgage loans, and the property bubble continued expanding.
China now faces difficult strategic decisions on how to manage financial stress while maintaining economic momentum in the years ahead. But no matter what choices Beijing makes, the pre-deleveraging model of economic growth has come to an end.
This report was made possible by the generous support of the Smith Richardson Foundation.
- Production and design by William Taylor, iDeas Lab
- Project and content oversight by Sarah Grace, iDeas Lab
- Copyediting support by Katherine Stark, iDeas Lab
Header: Chinese People's Armed Police walk past the People’s Bank of China (PBOC) in Beijing, China. (Emmanuel Wong/Getty Images)