Editor’s note: Recently, the China Special Assets 50 Forum was held by the Research Center for Special Assets of the National Institution for Finance & Development (NIFD) in Beijing. The forum participants exchanged views on special assets disposal and industry trends and discussed how financial technology, or fintech, may contribute to special assets disposal efficiency and effectively manage financial risks. Li Yang, chairman of the NIFD, delivered a speech at the forum highlighting the importance of placing liabilities and assets under the same framework in order to arrive at a comprehensive and precise assessment of China’s financial risks. An open and inclusive market environment and the use of modern fintech tools, together with effective institutional mechanisms, are conducive to forming a special assets market with a level playing field. Such a market will increase asset allocation efficiency and protect state-owned assets.

Today, our discussion of the disposal of special assets is of great significance. The reason is that this issue is closely related to the prevention and mitigation of financial risks - the most important of the “three tough battles,” on which we have focused over the past few years (the “three tough battles” refer to preventing financial risks, reducing poverty and tackling pollution).

I. Assets Must Be Analyzed under the Balance Sheet Framework

In the perception of the average person, financial risks stem from liabilities, and when talking about China’s financial risks, the debt ratio and leverage ratio come to mind. By comparing such indicators with those of other countries, one concludes that China’s situation is alarming. Most people utilize this analytical structure. However, it is lopsided to evaluate financial risks only from a debt perspective, which overlooks the use of borrowed funds. There is a great deal of difference in the efficiency and risk exposure of funds for different purposes. It has always been the NIFD’s stance that liabilities should be examined in light of assets. In other words, we believe that the issue of liabilities should be investigated under the balance sheet framework. The reason is simple: In reality, all debts are borrowed for specific purposes. In order to arrive at more insightful and relevant conclusions, we must compare the purposes of borrowed funds. This approach makes a particularly striking difference when considering government debts.

China’s local government liabilities are widely seen as detrimental to China’s economy. However, if we compare the purposes of funds borrowed by the Chinese government and those borrowed by foreign governments, we will notice a huge difference. In Western countries, government liabilities are in large measure borrowed to support government consumption. Even if funds are raised for social security or medical insurance, they still end up in consumption. In other words, most government debts in Western countries are consumed, and in the foreseeable future, Western governments will continue to raise debts to fund their consumption. China’s situation is quite the opposite. In China, in most cases the government, especially local governments, raise debts to make investments. The use of borrowed funds, therefore, will more or less leave some assets that generate income. The formation of the wealth underlies the foundation for debt repayment.

The message is that if we consider government financial risks according to the use of the borrowed funds, our conclusions will be entirely different. For a few years, the NIFD has been formulating and releasing China’s national balance sheet. This May, we released China’s leverage ratio for the first quarter of 2019. Our study indicates that in the first quarter of 2019, China’s leverage ratio increased by 5.1 percentage points. Such an increase would constitute a burden for any other country. However, in China, most liabilities are backed by newly created assets, so the rising leverage ratio is not a cause for concern. If we introduce a new analytical approach and look at financial activity from the perspective of a holistic balance sheet, we will surely reach totally different conclusions. Such is the importance of methodology.

If such assets are taken into consideration, China’s financial risks from the liability side diminish. This is the most [K1] important takeaway from our forum: The research on assets, which forms a closed loop with research from the perspective of liability, is important. This complete system gives us a more comprehensive view of China’s financial risks and helps us advance supply-side structural reforms and boost financial efficiency.

II. We Should Open up the Asset Disposal Market and Adopt Innovative Ways of Asset Disposal

Non-performing assets used to be disposed of in a murky and secretive manner. There is a saying in the industry that non-performing assets have to be packaged, discounted, or brought to the court for disposal. Such traditional ways of disposal have become obsolete. As China found in the previous round of disposal of non-performing assets, the so-called non-performing assets may not be bad assets. Here, I would like to quote Alibaba Auction’s tagline: “There is no bad assets, only misplaced asset.” This inspiring concept is excellent for analyzing non-performing assets. Some assets are perceived by some [K2] investors as bad assets, whereas in the eyes of other investors, they could be good assets. One type of assets could be bad assets in one financial or economic environment, but turn out to be good assets in another financial or economic environment. Therefore, we need an open environment and an open market for assets to be fully and truthfully presented to all investors for effective allocation. We should make the assets that we believe non-performing and so should be disposed of available to the public for the public to decide what to do with them.

In the previous round of non-performing asset disposal, we learned many meaningful lessons. One lesson learned is that non-performing assets cannot be disposed of in a closed environment. Our experience is that the balance sheets of companies must be brought into the light in order for investors and the market to make their own analyses and decide whether or not to take part in the disposal. Only in this way can the disposal of non-performing assets become more efficient. Only in this way will the whole process become more transparent and the financial industry connect more closely to the real economy. This approach will also systematically prevent government officials from making mistakes.

III. We Must Use Fintech Tools

Among the three “tough battles,” the alleviation of financial risks is the most prominent. It is a protracted, challenging, and arduous task, requiring innovation. A key direction of innovation is the full development and deployment of financial technology, or fintech. Non-performing assets contain an ocean of information, which can be recovered once processed with modern techniques. We need to extract this information from the assets using fintech tools to find potential investors and appropriate pricing. A price equilibrium should be reached through competitive bids from the parties of supply and demand. In the past, our market was less open. Even though we have now opened up our market, available information remains paltry and so are market participants. As an information industry, the financial industry must make use of modern fintech tools like big data and system platforms to form an effectively competitive market where the disposal of assets, or the allocation of assets as I deem to be more appropriate, will be more efficient. Frankly, our state assets can only be adequately protected in such a competitive market.

IV. Enhancing Institutional Development

Today, many leaders from regulatory agencies are present at our forum. In our daily work, we must have felt that the disposal of non-performing assets is a long-term and complicated issue. In my opinion, regulators, the industry and academia should work together to explore an effective mechanism for the disposal of non-performing assets. Our work should focus on the following directions:

First, we should adopt innovative financial tools. For instance, from a financial research perspective, asset-backed securities (ABS) can reveal various characteristics of the assets. Moreover, ABS packages are likely to form good assets through the rearrangement of cash flow and the introduction of new factors. In addition to the non-performing assets, ABS is also quite useful for good assets as well. In a word, we should give full play to financial engineering and use structured financial tools to restructure existing assets and reveal their optimal investment attributes.

Second, we have been working hard on the implementation of market-based debt for equity swap. I also serve as director of an academic committee of an inter-ministerial joint meeting. I said at a joint meeting that from a company’s financial perspective, debt for equity swap may not be the optimal financial choice. Swapping debts for equities means the transfer of short-term IOUs into long-term and permanent IOUs, which is costly. Corporate financial theory does not support this practice. Under China’s unique national conditions, however, reducing indebtedness and interest service have become macroeconomic priorities. Moreover, changes in property rights are not as important in China as in other market economies. For this reason, debt for equity swap has become one option for companies to deal with their financial troubles. That is to say, China’s unique political conditions, economic systems and financial structures have made debt for equity swap an effective means to manage its financial risks.

In reallocating assets and liabilities, we must have a clear idea about what problems can be solved by these measures, what problems have been solved and what new problems are created. If we take a closer look, the problems are actually quite complicated. If the debt for equity swaps are carried out between SOEs, the money just flows from the left pocket to the right. In this case, neither the debt for equity swap nor the equity for debt swap has much relevance to property rights. Such maneuvers only serve to reduce cost. However, if the debt for equity swaps are conducted between SOEs and private enterprises, which involve the transfer of property rights and institutional transformations, careful consideration may become necessary. This is what we mean by saying that debt for equity swap must be market-based and follow the rule of law.

Third, we should open up our doors and integrate China’s market into the global market. The escalating trade tussle between China and the United States has adverse effects on the whole world. Despite the setbacks, the Chinese government has announced that China’s opening up will not falter, and that our doors will only open wider. China’s asset reallocation should attract as many foreign investors as possible, which is a reflection of market-based asset allocation. I know that many foreign investors are interested in Chinese assets based on their strategic considerations. Many assets that appear to be worthless to us may be invaluable in their eyes. Through asset restructuring, it is possible that investors may find other conveniences and value from such assets. In the context of the China-U.S. trade spat, our disposal of non-performing assets and asset management should embody the national strategy of opening up wider to the rest of the world and share the concerns of our country.