China has a debt problem, and most of the market is well aware of it at this point. We had written on this topic just a couple of months ago, noting that China’s increased debt-load across the country can make it even more difficult to recover from this most recent bout of weakness. Nonetheless, it was still somewhat surprising to hear such a public admission of vulnerability from a Chinese regulator, as this weekend the governor of the People’s Bank of China, Zhou Xiaochuan, warned that the ratio of corporate lending to GDP had become too high, saying that the country needed to develop more robust capital markets to help offset this concern.

The premise of developing more robust capital markets, either with the Shanghai-Hong Kong Stock Connector opening up the Bond Market for foreign investors, more freely allows for capital to flow in and out of China. In essence, this would allow for more foreign investors to take on these risks rather than Chinese investors.

The bigger question is whether massive injections of foreign capital would be enough to help the Chinese economy turn the tide. As has been widely noted upon the conclusion of China’s annual conferences and at the 13th Fifth plenum (China’s five-year plan), reform of SOE’s, or State-Owned Enterprises is high on the list of China’s to-do items. And one of the big reasons is the inefficiency that will often come from a government-owned business. Just three weeks ago, Bloomberg wrote an in-depth piece on the city of Tonghua, entitled ‘Death and Despair in China’s Rustbelt.’ The article outlines China’s attempt to convert a steel mill that was operated by a SOE to private ownership. This didn’t work out well, and with recent reports to expect up to 1.8 million layoffs as China makes cuts to Coal and Steel industries, this could present considerable volatility moving forward.

And while these risks are very real, and while the warning from Governor Zhou may seem imposing, Chinese stocks put in a strong rally last night with the Shanghai Composite gaining +2.15% while the Shenzhen Composite put in a +2.68% incline. The likely cause for the rally: A State-Owned Enterprise, China Securities Finance Corp, announced that they’d start issuing loans to securities firms to buy stock. Of recent, Chinese stock performance has begun to mirror margin debt levels, indicating that the recent rally in Chinese equities has been debt-driven.