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Coming Out of the Shadows: Why China Needs a Lehman Moment

Feb 13 , 2014

Amid the turmoil roiling the financial markets in many emerging market economies, the attention of global investors is, strangely enough, squarely focused on a country that has so far stayed relatively stable– China.

Minxin Pei

The reason for such obsession with China is simple: China’s shadow banking system, a vast but opaque network of non-bank financial institutions such as trust companies, unlicensed credit brokers, credit guarantee companies, investment funds, and micro-lenders, seems to be on the verge of implosion.

In recent days, worries about the solvency of borrowers who have tapped China’s fast-growing shadow banking sector have risen sharply after one coal-mining company, Zhengfu Energy, announced it could not pay a 3 billion yuan loan ($500 million) due at the end of January.  Even though a last-minute rescue package cobbled together by the Chinese government managed to avert the first default of a loan product issued by China’s shadow banking system (which is estimated to have roughly 30 trillion yuan, or $5 trillion, in assets), it is clear that the Chinese government has an extremely difficult task in preventing the eruption of a financial sector crisis in 2014 (when $1 trillion debt in the shadow banking system will mature before May).

The brewing crisis of the shadow banking sector could not have occurred at a more inconvenient time for the Chinese government.   According to Beijing’s policy agenda, the priority for 2014 is to implement some of the key reforms announced at the third plenum of the Central Committee of the Chinese Communist Party (CCP) in November last year.  Managing a full-blown financial sector crisis, which the plenum did not anticipate, would be a huge distraction, to say the least. 

But the real policy challenge facing Beijing in addressing the looming crisis in the shadow banking system is that, if mishandled, this crisis could derail the CCP’s ambitious reform agenda.   Since the Chinese shadow banking sector is being propped up by the loose credit policy of the Chinese central bank (the People’s Bank of China) and loan growth close to 20 percent per annum, measures designed to mitigate the risks in the financial sector in general, and the shadow banking sector in particular, are almost certain to reduce liquidity.  Interest rates will rise.  Many debtors, denied access to new credit, could be pushed into default.  In the best case scenario, such defaults will not trigger a meltdown of the financial system (an unlikely scenario since most private sector debt is financed by domestic savings and Chinese savers maintain a high degree of confidence in the solvency of the banking system, which is backed by the credit and assets of the Chinese state).  However, growth will suffer as the oxygen of credit is sucked out of the Chinese economy.  The Chinese leadership will lose enormous political capital if their announced reforms are perceived as directly responsible for a dramatic fall in GDP growth.   As a result, Beijing may resume an unsustainable monetary policy and continue to support credit growth.  This may ensure a decent rate of growth for 2014, but at the expense of further inflating the bad loans in the financial sector.

Needless to say, in this scenario, it would be nearly impossible to implement the reforms announced last November.   The essence of these reforms is to rely on market forces to make the economy more efficient and allow creative destruction to sort out winners and losers.   By popping out zombie firms kept alive on credit from the shadow banking system, the continuation of the current credit policy will contravene the spirit of the CCP’s economic reform agenda.

The good news here is that, with leadership unity and political determination, Beijing can turn the incipient crisis of the shadow banking sector into a strategic opportunity.  China’s new leaders have been declaring for some time that they would be willing to endure very painful reforms in order to sustain long-term growth.  Restructuring the shadow banking sector is now a litmus test of the credibility of their resolve.

If we agree that the Chinese state has the financial means to restructure the shadow banking system (which has assets equivalent to 60 percent of GDP), then the challenge is to design a market-based approach that will liquidate zombie borrowers quickly (Zhengfu Energy is a classical zombie borrower).  Investors (mostly wealthy private individuals in the case of shadow banking) must pay a steep price for their failure to perform due diligence (so far, no private individual has lost money investing in products channeled through the shadow banking system).   Granted, the widespread practice of cross-collateralization (borrowers guaranteeing each other’s debt) is likely to trigger chain defaults if one zombie borrower goes under.  But this is an unavoidable price to pay.  Beijing would be far better off in the long run if it opts for intense short-term pain. 

In other words, China may need its own Lehman Moment now because it will clarify the leadership’s thinking, narrow policy options, and force long-delayed actions.

Minxin Pei is the Tom and Margot Pritzker ’72 Professor of Government and a non-resident senior fellow of the German Marshall Fund of the United States.

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