For a long time, capital has played an irreplaceable role in China’s economic development. However, over this past period of time, there has been a trend of disorderly expansion of capital in China, which has brought important challenges to the supervision of capital factors and financial stability. Resolutely opposing monopoly and unfair competition and preventing the disorderly expansion of capital have become important policy tasks in the near future.

Basic performance of the disorderly expansion of capital

(1) Capital Expansion Models

Capital is one of the basic factors of production. Narrow capital mainly refers to equity capital, while broad capital includes not only equity capital but also debt capital. From the perspective of goals, capital expansion can be divided into industrial chain expansion, market-based expansion, resource-based expansion, and permit-based expansion. Product chain expansion mainly focuses on integrating upstream and downstream resources of the product chain to form economies of scale and scope. Market-based expansion aims to acquire a larger market share, focusing on horizontal mergers and acquisitions and economies of scale. Resource-based expansion aims to occupy various resources, such as technology, markets, and product chains, and pays more attention to the construction of ecosystems. Permit-based expansion uses institutional permits, business permits, or franchising for the purpose of capital expansion.

An understanding of capital expansion in terms of industries offers more direct policy value. There are three main modes of capital expansion: Expansion within the industry, expansion into related industries, and expansion into unrelated industries. First, an expansion within an industry includes horizontal expansion and vertical expansion. Horizontal expansion is mainly used to expand the scale of the industry, which is mainly manifested as “copying” the mature production, operation, or business model of an enterprise and expanding its production capacity, output, or service scope. For example, an automobile manufacturing company acquires or builds more manufacturing plants to produce multiple types of products. Vertical expansion is the expansion up or down along the product chain, the purpose of which is to internalize external costs, reduce costs, and improve efficiency. For example, car manufacturers may invest in steel, rubber, and other industries in the upstream of the product chain and invest in sales enterprises in the downstream of the product chain.

Second, the expansion into related industries refers to an expansion into other industries related to the development of a given industry. For example, in order to achieve diversified financing purposes, real estate companies invest, participate in, or even control commercial banks, industrial funds, or other financial institutions. Automobile manufacturers set up consumer finance companies for sales and service facilitation. Technology companies expand into fintech to improve their technological application capabilities and develop diversified financial businesses or, alternatively, traditional financial companies invest in setting up fintech companies or establishing e-commerce platforms to cope with the pressure of digital transformation.

Third, the expansion into unrelated industries is mainly into areas that are not clearly related to a given industry. For example, network service providers and real estate companies investing in automobile manufacturing; air-conditioning manufacturers investing in mobile phone manufacturing; home appliance companies investing in pharmaceutical and biological industries; computer companies investing in transportation services. This type of expansion is all about investing in other areas that are not part of a given industry. There are three potential reasons for large corporations to diversify across borders. The first is diversification and expansion based on development and transformation. When this occurs, corporations are very optimistic about the development prospects of hot industries and make cross-border investments for higher profits or for business transformation. The second is for a diversified expansion based on corporate valuation or financing convenience. Hot industries may be very attractive to other investors, and the market valuation premium can be used to increase the overall valuation of the company so as to improve its balance sheet and ease pressure on capital financing. The third is diversification and expansion based on the transfer of funds. When it is difficult to continue financing in an industry or for a project, it is relatively easy to obtain investment through hot projects, funding for which can then be transferred to the original industry or other unrelated fields.

(2) Main manifestations of disorderly expansion of capital

There may be a certain degree of rationality to capital expansion whether from the perspective of goals or from the industrial dimension. However, when capital expansion deviates from national policy goals and from basic value principles, arbitrarily raises the “threshold” of competition, and is used to conduct regulatory evasion or arbitrage, it gradually devolves into disorderly capital expansion. The disorderly performance of resource-based and license-based capital expansion has become more prominent, while the disorderly expansion of capital in unrelated industries has grown quite serious.

The disorderly expansion of domestic capital is universal, to a certain extent, and it is more serious in the integration of industry and finance, in real estate, and in the financial sector. At the industrial level, the disorderly expansion of domestic capital runs through a larger part of the industry, gradually forming alienated industrial capital, real estate capital, and financial capital. The use of capital factors and capital expansion permeate all areas of economic development, while disorderly expansion is more prominent in asset management, real estate, local financing, emerging technologies, and other fields. In the financial sector, some real enterprises and financial institutions, in the name of diversified expansion or comprehensive operation, control or hold various types of financial permits, substantially carry out mixed operations, and even evade supervision with the support of capital operations and conduct regulatory arbitrage to form alienated financial capital.

The forms of disorderly expansion of domestic capital is mainly reflected in five aspects. One is the issue of capital raising. Typical alienation methods are false investments, capital evasion, and illegal investments. The second is the expansion of capital with high leverage. Whether it is debt financing or equity financing, problems tend to arise, such as excessive debt or share transfers at high premiums. The third is the complex related-party transactions of capital. Some capitals take advantage of the loopholes in the supervision of separate industries and use a “sausage” or “nesting doll” approach to conduct multi-level, multi-subject, and cross-domain capital transactions. The fourth is to link to foreign capital. With the help of the so-called international influence and market credibility of some forms of foreign capital, capital expansion is carried out in various fields. Of course, some of this so-called foreign capital amounts to the alienation of domestic capital. Fifth is the disorderly exit of capital. Various trading markets and means are used to conduct transactions in a manner that seriously deviates from the fair value of the market. It is worth noting that the disorderly expansion of capital is prominent in large and medium-sized private enterprises though there are also many state-owned enterprises and financial institutions involved.

Potential risks of disorderly expansion of capital

(1) Increasing the level of institutional leverage leads to financial vulnerability

In order to obtain sufficient funds for capital operations, capital owners may use diversified financing tools, and the large disorderly expansion of capital may increase the leverage level of capital owners. For example, in order to expand capital, some listed companies use a large volume of equity pledge financing to obtain capital operation funds, which increases the leverage ratio of listed companies and exposes companies to liquidity vulnerabilities. This once triggered a major risk to equity pledge financing in China’s capital market. At the same time, excessive capital expansion may deviate from the main business of an enterprise.

(2) Deepening related risks and potential issues of systemic importance

The disorderly expansion of capital involves diverse entities, multiple financial businesses, and longer operational processes, which greatly intertwines different entities, businesses, and processes, leading to systemically significant risks. In particular, the disorderly expansion of capital at home and abroad in different industries and across markets hides complexities and results in an underestimation of risks. In the disorderly expansion of capital, regulators must re-identify systemically significant institutions and strengthen supervision.

(3) Attempting regulatory arbitrage and weakening the effectiveness of regulation

The disorderly expansion of a large amount of capital connotes regulatory avoidance or even regulatory arbitrage. If more micro-entities are involved, the effectiveness of supervision will be greatly weakened, and supervision may be inefficient or even ineffective. Taking real estate market supervision as an example, despite multiple releases of regulatory policies, housing prices may not stabilize, which can be directly related to the disorderly expansion of capital and the illegal entry of funds into the real estate market.

(4) Inducing market monopolies and destroying market ecosystems

Capital has a self-reinforcing agglomeration effect. During the process of excessive capital concentration and disorderly expansion, it is easy to form a dominant market entity in a given market which may even grow to become a monopoly. Taking a large internet platform as an example, the process of capital expansion may produce great network effects, extreme economies of scale, and the phenomenon of “winner takes all.” When the disorderly expansion of capital builds an ecosystem that is endogenously beneficial, capital owners will infringe on consumers’ rights and interests by means of differentiated markets, discriminatory pricing, and choice restrictions. Due to the disorderly expansion of capital and an eagerness to exit to benefit, some market players choose the “shortcut” of listing, to the point where financial fraud grows serious, to the point where some Chinese concept stocks have been considered “junk stocks” by foreign investors.

(5) Weakening the function of capital elements and impacting the efficiency of resource allocation

First, the function of capital elements in serving the development of the real economy becomes alienated. The scale of financial capital for short-term arbitrage continues to expand, idling arbitrage becomes more and more serious, and the function of capital elements to serve the real economy weakens. In the past decade, China’s incremental capital-to-output ratio has risen rapidly from around 3.5 to nearly 7, that is, only 1 unit of output is produced for 7 units of capital input; capital efficiency is extremely low. Secondly, the strategic orientation of capital factors to serve the country’s development is not sufficiently clear. The problems of capital “grouping,” “gathering,” and “taking over the baton” have grown more serious, making it difficult to effectively allocate capital in key areas and major projects in the national development strategy. Finally, the disorderly expansion of capital will hinder the development of innovation. Capital expansion substantially raises the entry barriers for potential market competitors, and innovative or disruptive technologies may be “hidden.”

An Analysis of the Root Cause of the Disorderly Expansion of Capital in China

As a production factor, the internal driving force of the disorderly expansion of capital mainly comes from the following aspects: The first is the inherent profit-seeking nature of capital operation. Capital raising, utilization, and exit operations are mainly measured by returns on capital, which makes capital operations inherently profit-seeking. This is especially true when profit is the only measure, such that capital operations and capital expansions will more likely fall into disorder. The second is that capital expansion enhances competitiveness. Weakening potential competition threats through capital operations is an important market behavior in the development of domestic and foreign market economies. In particular, industrial capital can establish an integrated product chain through vertical capital operations and expand market share through horizontal capital expansion. The third is to expand the “inventory” of interests through capital expansion. In the expansion of financial capital or monopoly capital, large capital owners or financial intermediaries mainly aim to expand their own permits, operations, and business scope so as to build an ecosystem that integrates diversified products and services and has self-circulating functions. The fourth is an attempt to circumvent regulation. Taking a bank’s on-balance sheet funds as an example, funds are constrained by the diversification of deposit reserves, capital adequacy ratios, and macroeconomic policies. However, turning such funds into off-balance sheet operations and capital operations in specific areas may present the bank with relatively low regulatory requirements, giving financial institutions greater incentives to participate in various “nested” and “roundabout” capital operations. Regulation-avoidant capital expansion is a major disruption to fair competition, orderly markets, and the regulatory system.

The disorderly expansion of capital has specific institutional and mechanism roots. First, there is an institutional mismatch between separate supervision and mixed operations, which enables capital owners and financial intermediaries to take advantage of the lack of supervision or the ambiguity of supervision by separate supervisors to conduct regulatory evasion and regulatory arbitrage. Secondly, there is a functional trade-off between financial development and financial supervision, which makes some financial supervisors place financial development above financial supervision. The level of investment in financial supervision resources is relatively insufficient, and the effectiveness of financial supervision must be further improved. Some regulators have adopted an attitude of “ignoring” the disorderly expansion of capital or even becoming a “catalyst” thereof. Thirdly, there are distorted interests of high financial inhibition and high returns on capital patterns. Important achievements have been made in the market-oriented reform of the financial system in the past, but the domestic financial system as a whole is still under severe financial repression. Various types of capital compete to enter the financial system to obtain financial permits and business licenses, and the disorderly expansion of financial capital has an inherent institutional driving force. Finally, capital supervision lacks a long-term mechanism. “As soon as it is released, it will be chaotic, and if it is managed, it will die” is a major problem in the supervision of China’s economic and financial sectors. Taking the recent regulatory policies against monopolies and unfair competition and preventing the disorderly expansion of capital as an example, before the fourth quarter of 2020, the regulatory authorities rarely took targeted regulatory measures. Afterward, many authorities intensively introduced many policies or measures, exhibiting “temporary” and “emergency” regulatory characteristics.

Policy Suggestions on Improving the Supervision of Capital Operations

The disorderly expansion of capital contains major risks, and it is necessary to re-understand the function and status of capital from the perspectives of the state, regulatory authorities, and capital system in order to better serve the real economy. In the new stage of development, China needs a capital market and its regulatory system with prominent elementary functions, compliant operations, reasonable costs and benefits, effective regulatory constraints, and strong protections for rights and interests.

(1) Adhere to the functional orientation of capital elements and optimize the economic functions of capital elements

First, continue to give full play to the function of capital as a factor that serves economic growth and further strengthen the decisive role of the market in resource allocation. Second, give full play to the characteristics of internal agglomeration and external drainage of capital in an orderly manner and attract more resources to be allocated to key areas and key links of economic and social development. Third, make full use of the resource allocation functions of capital and the correlation network of financial markets and further exert the link that capital plays in product chain repair, value chain reconstruction, and internal and external economic interaction. Fourth, give full play to the advantages of capital and technology integration and build a new paradigm of technology-driven inclusive finance, rural revitalization, and common prosperity.

(2) The “underlying logic” of the economic system has not changed which is to fully protect the legal rights of capital owners

The “underlying logic” of China’s socialist market economy has not changed: The institutional framework of China’s full respect for capital and its owners’ rights and interests has not changed, and the guarantee of capital and its legitimate rights and interests will not change. In terms of guiding market expectations, enhancing market confidence, and stimulating the vitality of the economy, the state must clearly strengthen capital supervision and prevent the disorderly expansion of capital in order to better exert the function of capital elements and effectively protect the legitimate rights and interests of capital owners and compliant capital operations in order to mobilize the enthusiasm of market players.

(3) Deepen the supervision of capital factors and build a long-term capital supervision mechanism

First, it is necessary to strengthen the supervision of capital expansion. Incorporate capital operations and capital expansion into the scope of supervision, avoid insufficient supervision, gaps, and even loopholes, and support institutional supervision. Focus on functional supervision and deepen supervision, emphasizing the supervision of commercial banks, non-bank institutions, and capital markets, the supervision of equity operations, and the supervision of debt operations. Substantially improve the compliance and robustness of the system of capital operations. Second, the supervision of disorderly expansion of capital must clarify the established standards for the orderly expansion of capital. By clarifying the established compliance procedures, investment scope, and policy orientation for capital expansion, capital operations can be referenced, and capital expansion then can have a “red line” of awareness and a bottom-line for discussion. Thirdly, the regulation of capital expansion should be based on the rule of law. By improving the legal system, fully defining the responsibilities, rights, and interests of capital owners, capital intermediaries, and capital regulators, and giving fair, just, and open “consistent treatment” to all market entities such as state-owned enterprises, private enterprises, and foreign-funded enterprises. At the same time, the boundaries of regulators should be effectively defined, and supervision should be adhered to in accordance with the law. Fourth, strengthen the coordination of capital supervision policies, avoid “fluid” supervision, and at the same time fully evaluate the potential side effects or risks of supervision policies, and improve the coordination and suitability of supervision policies. Fifth, focus on vigilance against the disorderly expansion of large capital and overseas capital and be alert to threats to financial security, data security, and national security.