Understandably, the major focus now is on the denouement of China’s looming debt crisis. Pessimists are concerned about a catastrophic crash. Optimists are more sanguine, expecting a soft landing with gradual reforms.
The crash scenario is predicated on continuing increases in debt levels and over-investment. Policy adjustments are fatally delayed. Ultimately, authorities are forced to tighten credit aggressively, triggering failures in the financial system and a sharp slowdown in growth.
Weaknesses in financial structure exacerbate the money market tightening, causing liquidity-driven problems for both vulnerable smaller banks and the shadow banking entities. The rapid decline in credit availability results in problems for leveraged borrowers such as those in local governments and property sectors. The larger banks which are likely to benefit from the flight to quality are unable or unwilling to expand credit to cover the shrinkage from smaller banks and the shadow banking sector, due to risk aversion or regulatory pressures.
The deceleration in credit growth and liquidity results in lower levels of economic activity. Combined with cost pressures and weak external conditions, Chinese businesses, which are major suppliers of cash to the economy, experience a decline in cash flows which compounds the liquidity problems.
Foreign capital inflows, which have enabled the People’s Bank of China (PBOC), the central bank, to provide liquidity to the financial system, slow and then reverse. At the same time, capital outflows, especially from corporations and also the politically well-connected and wealthy, increase, driving further contraction in credit.
The optimists counter that the debt levels, while high, are manageable because of high growth rates, the domestic nature of the debt, high savings rates and the substantially closed economy. They argue that the banking system has low leverage, a large domestic funding base and low levels of non-performing loans. They also rely on the high level of foreign exchange reserves and modest levels, at least by developed country standards, of central government debt.
The optimists believe that reform programmes, albeit slow in implementation, will ensure a smooth transition. China will rebalance its economy from investment to consumption. Deregulation and structural changes will improve the resilience of the financial system.
The strength of the banking system is probably overstated, primarily because of the understatement of bad loans and the relationship with shadow banks. Real levels of non-performing loans may be as high as 5-10 percent of assets, about 5 to 10 times the reported levels. The risk of a significant portion of assets held in the shadow banking system may ultimately come back into the banking system.
China’s forex reserves (invested in high quality securities denominated in US dollar, Euro and Yen) may prove difficult to realise without triggering losses or currency issues. More fundamentally, the reserves are not true savings, being matched by Renminbi created by the PBOC and paid to domestic entities in exchange for foreign currencies.
In effect, the flexibility of Chinese authorities to deal with any problems may be more constrained than assumed. But the risk of a major collapse while always present is, at this stage, low. A familiar endgame, entailing bank failures, depositor runs, massive outflows of foreign investors or a sovereign default, is unlikely. The central government is seeking to steer a middle path, which is both difficult and has significant risks.
Middle Kingdom, Middle Path
The strategy will entail continued credit expansion, providing liquidity, managing non-performing assets and using transfers from households to the financial and corporate sector.
The central bank will continue to provide abundant liquidity to the financial system through a variety of mechanisms. Lenders have been instructed to rollover loans to local governments which cannot be repaid out of cash flow. Chinese authorities subscribe to the theory that “a rolling loan gathers no loss”.
Authorities have altered regulations to allow local governments to issue public bonds, for the first time in 20 years. Defaults in shadow banking will also be managed. Where considered appropriate, banks and state entities will intervene to minimise investor losses, by taking over the loans or re-integrating assets into regulated banks.
A number of Trust Company and WMP investments have missed payments, with many having been rescued, sometimes under mysterious circumstances. One analyst told a reporter: “Moral hazard in China is state policy.”