Financial markets are worried about the Chinese financial sector, with some even talking about the possibility of a 'Lehman moment', which would set off a major financial meltdown, as occurred in America in 2008. This would be very serious not just for China but for the global economy. China still accounts for close to half of global growth.
So just how likely is China to suffer a financial meltdown?
Today's story begins in 2009, when China offset the effect of the advanced-country financial crisis by administering a massive domestic stimulus, largely in the form of loosening the reins on credit. The flow of bank credit equaled 50% of GDP that year.
But the financial loosening was even greater than this figure would suggest. Until 2009 most credit had been in the form of bank loans, with much of this going to state-owned enterprises (SOEs). Since then, perhaps one-third of credit expansion has been outside bank balance sheets. Local government authorities have become large borrowers and the corporate bond market has expanded rapidly. Much of this lending was funded by 'wealth management products' and trusts rather than bank deposits. In short, detailed control over credit has weakened.
This freeing-up of the financial sector is by no means undesirable. The post-2009 expansion of the shadow banking system gave savers more opportunities to get a decent return, and provided funding for a wider range of expenditures.
The growth of the non-bank sector was, in fact, symptomatic of the breakdown of the tightly regulated financial system and mimics the path taken by financial sectors elsewhere. Large government-mandated reserve requirements constrain banks' lending and are effectively a tax on banks. The harder the authorities squeeze the banking sector, the more 'disintermediation' occurs. Savers find alternatives to low-interest bank deposits and unsatisfied borrowers eagerly use these non-bank funds.
To some extent the market is over-reacting to China's financial deregulation. When the People's Bank (PBOC; the central bank) tightened short-term liquidity in the middle of last year, some market commentators took this as a harbinger of a financial crash rather than a clumsy effort to move towards more market-oriented liquidity management.
That said, no matter how deliberate the deregulatory process, experience elsewhere suggests that financial deregulation is a delicate task. While borrowers and lenders gain experience, new institutions develop and the regulators learn how to do their new job, almost every country has experienced problems.
No matter how helpful to global growth, the 2009 credit stimulus was a shaky base for deregulation; not every burst of credit growth presages a crisis, but just about every crisis has been preceded by rapid credit expansion. Sorting this out will require the same sustained clean-up effort that China applied to its banks in the decade before 2008, with large write-offs of bad debt.
Financial deregulation is also coinciding with a tricky period in China's overall macro progress. China needs to change the mix of its growth dynamic, reducing dependence on investment and boosting consumption. Those of us who have been confident that China will be able to engineer this transition smoothly have taken comfort from the panoply of policy instruments available to the authorities. But if keeping deregulation on a smooth path cuts too sharply into investment funding, the authorities' room to manoeuvre will be constrained.
Recent months have seen a tentative progress on one fundamental transformation: the shift from a command-and-control credit system to one where prices and bankruptcy are used to discipline borrowers and evaluate investments. Default have been rare in China, largely confined to foreign creditors. Chinese authorities missed a recent opportunity to change this dynamic, with the eventual bail-out of a defaulting creditor by China Credit Trust. But now Chaori, a solar-cell maker, has been allowed to fail.
The trick is to create a threat of default which markets will see as idiosyncratic and associated with specific borowers, without triggering the over-reaction of a sudden systemic run on financial markets. China still has a lot more to do here (including introducing bank deposit insurance).
China has a few things working in its favour. The authorities have a tighter grip, and more instruments available, than the advanced countries had when they rushed headlong into deregulation, blinkered by the 'magic of the market'.
The market's hand-wringing should, in fact, give comfort that the Chinese authorities are 'on the job'. While it is true that deregulation has typically been accompanied by financial crisis, the historical experience is that crises were unexpected. Whether it was the US Savings and Loans crisis in the 1980s, the Asian crisis in 1997-8 or the 2008 financial crisis, these came as a surprise to financial markets and authorities alike.
The approach of the Chinese authorities is yet another example of 'crossing the river by feeling the stones'; cautious progress in deregulating interest rates, new rules on shadow banking, and permission for new financial institutions (including private banks). The strong macro position, with huge foreign exchange reserves, a current account surplus, low inflation and public debt less than 40% of GDP all suggest that this river will be safely crossed.
Photo by Flickr user Eric.