In October, at the annual Bund Summit in Shanghai, Jack Ma, the former chief executive of Alibaba, delivered a bold rebuke of China’s nascent financial system. In his speech, the 56-year-old billionaire sharply criticized the current system’s track record of underserving households and denounced President Xi Jinping’s quest to drastically reduce systemic financial risks. Regulators, he complained, are trapped by an antiquated “pawnshop mentality,” which requires borrowers to post collateral to access credit. What China needs, he declared, is a new way of thinking. In place of the global standard of asset-based lending, Ma painted a futuristic picture of a wholly credit-based system that would use intelligent algorithms and big data to accurately judge an individual’s creditworthiness. With such a system in place, “even the beggar,” he promised, “would be, and can be, creditworthy.”
Ma’s broadside on the direction of China’s financial system under Xi, a system typically characterized by convergence with international standards, came days before Ant Group’s IPO. The company, a financial conglomerate founded by Ma to address the inadequacies raised during his speech in Shanghai, was on track to raise a record US$34.5 billion. Had the IPO taken place, its listing on the Shanghai exchange would have signaled a watershed moment in the development of China’s capital markets.
Instead, regulators abruptly put Ant’s IPO on hold, citing new draft regulations with the potential to significantly disrupt Ant’s business model as the rationale for the unexpected move. While not unfounded, the new rules and Ant’s frozen IPO raise questions about the direction of China’s increasingly influential consumer lending space. While Beijing touts consumer credit’s pivotal role in the nation’s shift towards consumer-driven growth, regulators’ apparent aversion to the business model of internet-based lending platforms, as evidenced by the interference in Ant’s IPO, points to the challenges of simultaneously establishing the financial system’s credibility and increasing consumer spending.
Ant’s Rise in Online Consumer Finance
It is difficult to overstate the dizzying pace at which the Chinese fintech space has revolutionized how consumers save, invest, spend, and borrow. A range of financial services now allow Chinese consumers to manage their financial lives from anywhere in the world. The widespread adoption of smartphones, the advent of big data analytics, and the rise of blockchain technology led to the proliferation of fintech companies with access to the vast Chinese market and a better understanding of their customers’ behavior. The consumer lending arms of fintech companies went through several boom and bust cycles, ultimately producing a consolidated market with one company in particular, Ant Group, as its undisputed leader.
Before taking on its current form, Ant was rebranded several times. Initially spun-off from Alibaba as “Alipay,” the company was best known for its payment platform of the same name. With over 711 million monthly active users, Alipay has become by far the world’s largest mobile payment platform. To reflect the growing range of services that the company wanted to offer, Alipay was rebranded as Ant Financial in 2014. Soon afterward, the company began cross-selling other financial services to its existing user base via its Alipay super app. Of these services, its “CreditTech” segment, which handles consumer loans, now contributes close to 40% of Ant’s overall revenue and has enabled 20% of China’s total consumer credit balance.
Unlike traditional banks, which require borrowers to post collateral, Ant’s CreditTech services, Huabei (which extends consumer credit for small, daily expenditures) and Jiebei (which extends consumer credit for larger, one-time purchases), rely exclusively on their customers’ credit history to process loan applications. If a consumer wants to make a large purchase using credit, the company’s algorithms analyze data collected through Alipay and Huabei to decide whether a loan applicant is creditworthy enough to receive a loan from Jiebei. Application processing takes seconds, which allows consumers with enough credit history to access credit on demand and on the go. Predictably, the widespread adoption of such applications would turbocharge consumer spending in China.
Government Support for Consumer Finance
A key piece of the online consumer finance puzzle is government policy. Given Beijing’s central role in managing the economy, this should come as no surprise since few industries can truly thrive without the backing of the state.
2011 marked a pivotal year for economists because that is the year that public investment, largely driven by public policy, peaked as a share of China’s GDP. Since then, the return on public investment, represented by the rapid rise in the ICOR (incremental capital-output ratio), has fallen. With investment-driven growth becoming more expensive, in its 2016 five-year plan, the CCP promised to shore up consumer spending and buying power and transition away from the investment-led growth model.
Several concrete measures were adopted in 2013 to jumpstart this process. Operating area restrictions were relaxed, caps on consumer credit were revised upward, and the main shareholder of a consumer financial company no longer had to be an established financial institution. 2016 measures encouraged the growth of internet finance in more explicit terms by pointing out the industry as important to promoting China’s economic transformation.
In recent years, however, the pendulum has swung in the other direction as Beijing has pushed aggressively for consolidation and regulation to build confidence in the country’s financial system. The swift decimation of the country’s peer-to-peer (P2P) lending industry at the hands of regulators and Ant’s frozen IPO are sobering reminders of Beijing’s preeminent role in managing the economy.
Why Did Beijing Come Down on Ant Financial?
The unexpected hold on what would have been an IPO of historic proportions has left investors scrambling for explanation. Francis Lun, CEO of GEO Securities, offered a cynical explanation, claiming that Beijing came down on Jack Ma for his harsh rebuke of regulators. This sentiment has been repeated in mainstream Western media outlets with a CNN headline claiming that “Beijing just yanked Ant Group’s IPO to show Jack Ma who’s really in charge.”
While such explanations reflect a focus on Beijing’s preoccupation with ideology, they gloss over legitimate concerns regarding the sustainability of Ant’s business model and do not factor in central leadership’s strategic goals for the country’s financial sector – reducing leverage and attracting foreign capital.
The Basis for Limiting Leverage
For years, the rapid growth in Chinese corporate leverage led to speculation about the possibility of a giant debt bubble fueled by Beijing’s investment-driven economics. Even before the pandemic raised global indebtedness, corporate debt in China stood at an atmospheric 150% of GDP (US corporate debt, by comparison, stood at 70% of GDP). However, much of this debt is concentrated in SOEs that are unlikely to default thanks to virtually unlimited government support.
However, as consumption grows as a share of GDP, China’s debt structure will change over time to reflect higher levels of household debt. Unlike SOEs, households do not have access to cheap funding and can default if their incomes do not keep pace with their debt burden. Given the potential risk that consumer leverage poses to the stability of the domestic financial system, China’s regulatory bodies are determined to tightly monitor the consumer finance sector.
Attracting foreign companies
Another incentive Beijing has for eliminating systemic risk from the financial sector is the ability to attract foreign capital. The most recent addition to President Xi’s panoply of national strategies, dual-circulation, aims to substitute high-tech imports and export markets with domestic alternatives while taking advantage of foreign capital to finance the transition. To attract foreign capital, Beijing has removed the minimum asset requirements to enter the Chinese market, lifted limits on foreign ownership, and cut through red tape so that permits are issued to foreign financial institutions (FIs) on an accelerated timeline.
In addition to lowering barriers to entry FIs, Beijing needs to reform its financial markets to assure foreign entrants of a stable business environment by eliminating systemic risks. Attacking domestic sources of excessive leverage and reigning in financial institutions that become too big to fail are core to Beijing’s mission. These objectives also place Ant squarely in the sights of China’s regulators.
Ant’s Business Model: Light on Risk
Ant’s CreditTech services have a total consumer credit balance of CN￥1,732 billion. However, its IPO prospectus only lists CN￥36,242 million in its loans receivable. This means that only 2% of the loans that it originates actually appear on its balance sheet. Where do the other 98% of the loans go? According to the prospectus, they are either “underwritten by our [Ant’s] partner financial institutions or securitized.”
Of particular interest to regulators are the loans which are securitized and sold to other institutions. By packaging consumer loans into securities and selling them, Ant can obtain instantaneous liquidity on its assets which it can then use to issue more loans – a model that Chinese regulators find reminiscent of the 2008 subprime mortgage crisis in the US. By maintaining a light balance sheet, Ant’s revenue is exponentially proportional to the number of loans that it originates.
Because Ant bears none of the risk of the loans, it has every incentive to focus on loan volume rather than quality. Just as US banks began committing outright fraud once they had issued loans to every creditworthy household, Ant, regulators believe, would have a strong incentive to misrepresent the creditworthiness of their customers later down the road to continue issuing more loans and therefore grow revenue.
Too Big to Fail
Furthermore, Ant’s estimated valuation of US$313 billion is 20% of China’s current outstanding consumer debt of US$1.4 trillion. This raises another concern for regulators – that Ant may well become too big to fail in the vein of US banks after the housing bubble burst. Cognizant that the government would likely step in to prevent a string of insolvencies creates yet another inspiration for risky behavior. While Ant points to its customers’ low loan delinquency rate – roughly 1% in 2019 – regulators prefer to look at the set incentives likely to influence the company’s future behavior. And the dual-risk of being both too big to fail and a major catalyst for unsustainable leverage casts Ant as a major systemic risk in the eyes of the regulator.
Meanwhile, President Xi’s vision for the party puts it at the center of economic life, and the financial sector, which is largely the domain of state owned banks, is no different. However, party leadership becomes a hollow slogan when a private company is so big that the government would be forced to bail it out if it were to fail. Ant committed two unforgivable fouls in the run up to its IPO that were exacerbated by Jack Ma’s reckless showing in Shanghai. It ran afoul of regulators by bearing almost none of the risk associated with the loans it originates, and it earned the lasting suspicion of the CCP politburo with its apparent disregard for ideology in a political environment that increasingly values purity.
Fallout, New Rules, and Next Steps
Ahead of the IPO’s termination, Chinese regulators released a draft for new regulations that ultimately knocked Ant off the waiting list for the Shanghai and Hong Kong exchanges. Several of the new rules would have forced a change to Ant’s business model, but one in particular caught the eye of investors. According to the proposed rules, “In a single joint loan, the proportion of capital contribution of a micro-credit company operating a network micro-credit business shall not be less than 30%.” In other words, Ant, which currently passes on most of the risk for the loans it originates, would have to bear at least 30% of loan value. This would severely reduce the volume of loans that it can securitize to raise cash that is subsequently used to issue more loans, which is the primary driver of its revenues. Under the new model, Ant would still be profitable albeit not at levels to justify anywhere near a US$313 billion valuation. The new rules, in other words, treat Ant less like a technology company, which it claims to be, and more like a run-of-the-mill bank.
Ant became the behemoth of consumer finance it is today because it took advantage of the opportunities afforded by the confluence of policy, household economics, and technology innovation. Without an unfettered Ant, and with a much tougher regulatory regime in the pipeline, Beijing may have to devise alternatives to achieving its long-term strategic goal of becoming a consumer-driven economy. To bolster consumer spending, it can either extend credit to consumers or implement policies that raise household incomes. With regulations eliminating smaller players and forcing larger fintech companies to behave more like conventional banks, responsibility for tapping the consumer loan market would have to originate from the country’s established banks. This in turn would require explicit direction from Beijing to begin serving consumers. It would also require Beijing to make the politically difficult decision to reduce state backing for SOEs that make them virtually riskless investments in the first place.
At the Bund Summit, Jack Ma passionately persuaded his audience that “A new financial system is the way of the future.” China’s regulators, and leaders, appear to have a different vision. While both parties agree that China’s system requires reform to meet the needs of a new, consumer-driven economy, their roadmaps differ considerably. Regulators have made clear that they want a financial market that converges with international standards, and President Xi’s personal involvement with the IPO serves as a reminder of the central role of Beijing in the Chinese economy. For now, Jack Ma’s dream of using big data and intelligent algorithms to create a truly inclusive financial system will have to wait.