China’s Looming Debt Bust

The article in the May 7 issue of The Economist on the coming debt bust of China’s financial system failed to move the RMB or other financial markets unlike what happened after similar comments by Soros and Bass earlier in the year. What has changed since the latter’s comments? Has there been a real change in the fundamentals of the Chinese financial system, or has the market simply changed its perception of the problem? 

The Chinese financial system is one of the largest in the world with an asset size of more than RMB 200 trillion, while total social financing (loans) stands at more than RMB 130 trillion at the end of the first quarter in 2016. The colossal size of the system makes it a slow-moving train and any problem takes a long time to work out. It is the return of faith in the government that has changed market sentiment from extreme pessimism to a certain degree of guarded optimism. The turning point happened around the time of the G20 meeting of finance ministers and central bank governors in Shanghai at the end of February. 

In that meeting, Finance Minister Lou Jiwei and People’s Bank of China (PBoC) Governor Zhou Xiaochuan showed in their press conference that they were well aware of the problems facing China and that the government was taking active steps to stabilize the attack on the RMB and staunch the massive capital outflows between November and January. Those three months saw the Chinese government lose more than USD 300 billion in foreign exchange reserves and severely dented public confidence in the capability of China’s monetary and finance authorities. 

The subsequent National People’s Congress meeting in March showed China’s strong political commitment to tackling the twin issues of financial sector risk and slowing growth. A series of crackdowns on improper financial dealings and improved real economic data after the congress further demonstrated the government’s ability to confront both financial risk and slowing growth with carefully calibrated policies. They helped to change market sentiment by April.

The stability of the financial market in China is a result of renewed confidence in the government’s ability to stabilize growth while slowly working out the leverage problem, as well as some benign economic data from March going forward. Is optimism warranted? 

Based on The Economist, optimists on China draw comfort from two ideas. First, in the last 37 years of reform, the Chinese government has consistently shown that once they identify problems, they have the will and skill to fix them. Second, state control of the banking system gives the government time to clean things up. The magazine feels that optimists are too complacent to believe that the same will happen this time around. It rightfully points out that historically, the speed with which China has built up its financial system’s leverage has always caused meltdowns. How can China be different this time?

There are two important factors that may differentiate China from past examples. First, China’s unusually high savings rate of almost half of its GDP make its financial sector’s leverage problem a strictly domestic affair. The absence of cross-border capital outflows under a capital control regime means that the government can easily stabilize a domestic financial sector meltdown with the fiscal and monetary tools under its command. Second, China’s high savings rate and underdeveloped equity market naturally result in a high level of corporate debt. The current debt-to-GDP level of over 260 percent is not that abnormal once the savings rate and bank-dominated financial system are taken into account. 

Of course, financial crises often happen unexpectedly and are path dependent. It is easy to pin down the necessary conditions of a meltdown, but difficult to make the case for sufficient conditions. Perhaps the best guard against the Chinese financial system’s meltdown will be the first condition that The Economist mentions: Chinese authorities must show once again that they have the will and skill to tackle a problem once they have identified it. 

The interview with a “person of authority” on the Chinese economy that made the front page of People’s Daily on May 9 hopefully demonstrated that senior leaders are indeed well aware of the problems facing China today. The interviewee’s expressed conviction that the country can afford an “L”-shape economic trajectory and properly balance deleveraging with structural reform is a welcome change from an earlier policy that emphasized growth at all costs.