China’s financial system is a paradox. Reform demands that the authorities relax their grip on banks and capital flows. But if they do, it could trigger the debt crisis the country has so far avoided.
On a broad measure, Chinese credit is now almost 200 percent of GDP, according to the International Monetary Fund. Such a level of borrowing is unprecedented among countries that are still developing.
The rate of increase is alarming too: at the end of 2008, total credit was just 129 percent of GDP. Much of the lending has been wasteful, funding unnecessary infrastructure or buildings that may never be occupied. Industries from steel to shipping to solar panels are being kept alive because state-backed lenders are reluctant to call in loans. Meanwhile, local governments have borrowed through opaque financing vehicles, accumulating a debt pile that the central government struggles to measure.
In most countries, such a rapid boom would have already become a painful bust. Yet China has so far avoided a crisis, and may continue to do so. Capital controls are part of the explanation: the government, banks and companies do not depend on flighty international investors for finance. That makes China less vulnerable to the self-fulfilling runs that threatened Western financial institutions five years ago.
The state also directly controls large parts of the financial system. Deposit rates are capped, guaranteeing banks cheap funding and borrowers low-priced loans. Meanwhile, big state-owned banks are tools of state policy. The government can tell them when to open their wallets wide - as it did in early 2009 - and when to put them away.
Much of what counts as debt in China is actually a claim from one branch of the government on another. State-owned banks lend mostly to state-owned companies. Local government borrowing can be seen as a disguised form of fiscal policy. Though the numbers are large, the government could afford to take these obligations onto its books. China has been here before. In the late 1990s as many as 30 percent of the loans on banks’ balance sheets had gone bad. The government stuffed the dud loans into bad banks, and partially floated the cleaned-up lenders on the stock market.
China would be ill advised to repeat the exercise: the cleanup bill is too large, and would fail to fix the flaws that led the problem. But continuing to pile up new credit while failing to recognise past losses risks throwing the country into a Japanese-style lost decade.
That is why China is preparing reforms. At the World Economic Forum in Dalian on Sept. 11, Prime Minister Li Keqiang spelled out a list of actions: liberalising interest rates, loosening capital controls, relaxing state ownership of the banking system, expanding capital markets, and introducing insurance on bank deposits.
If China really became a market-based financial system, interest rates would be set by supply and demand rather than government dictat. Loans would flow to the most profitable investments, rather than industries favoured by bureaucrats. Companies and local governments would suffer the consequences of reckless borrowing, while banks would be forced to recognise and write off bad debts.
The cleanup need not become a cataclysm: if China’s largest eleven banks wrote off 10 percent of their loans, they would need $500 billion in fresh capital, according to Reuters Breakingviews calculations. While large, this figure represents a little more than two times the pre-provision operating profit the same banks earned last year. Bad debts alone may create a mess, but they needn’t cause a crisis.
The bigger question is whether the state can give up control without sparking broader panic. Today, the government’s implicit backing helps maintain faith in bank deposits, state-owned enterprises, wealth management products, and debt issued by local government-backed vehicles. That faith remains untested: no domestic bond has yet been allowed to default.
Removing that guarantee is essential to reforming the financial system. But doing so, even gradually, could have all sorts of unforeseen consequences, from corporate bankruptcies to a massive downward repricing of financial assets. Solving that paradox could be the challenge that defines China’s next decade.