China Defenceless Against Debt Crisis If Financial Sector Opened: Michael Pettis

A leading expert on the Chinese economy says opening of the finance sector could leave regulators defenceless against a debt-induced crisis.

China’s central government has repeatedly reiterated the importance of financial sector opening and reform since the 19th National Congress of the Chinese Communist Party in October.

In an opinion piece published by The People’s Daily on 22 November central bank governor Zhou Xiaochuan said that reform and opening of the financial sector was the key to prevention of systemic risk, while the CCP’s leading theoretical journal Qiushi has also published editorial pieces similar effect.

This drive for greater opening of China’s financial sector has most recently culminated in Beijing’s announcement following US President Donald Trump’s official visit that it would permit majority foreign ownership of key financial institutions, including securities ventures and life-insurance companies.

While the need for greater opening of Chinese finance would appear to enjoy consensus approval amongst the country’s top policymakers, Michael Pettis, professor of finance at the Guanghua School of Management, Peking University, points out that this bold  pursuit of this policy orientation could exacerbate existing problems within the sector.

In an opinion piece written for Bloomberg Pettis points out that Chinese finance remains “dominated by speculative investing and capital flight,” while the heavy hand of the state continues to keep insolvent “zombie companies” afloat.

According to Pettis the opening of China’s financial sector would only serve to exacerbate these distortions and misallocations in the system, as demonstrated by other episodes of overly hasty liberalisation, such as the egregious behaviour of US savings-and-loans institutions in the 1980’s.

An even bigger problem with opening of the Chinese finance sector, however, would be its negation of the ability of regulators to head off a debt-induced financial crisis by restructuring banking sector liabilities at their own discretion.

“Removing constraints on capital flows would strip the government of the weapons needed to defend against a crisis,” writes Pettis.

Pettis points out that debt remains the biggest problem for the Chinese economy at present, with a surge to over 260% of GDP from 162% in 2008 triggering widespread about the potential for breakneck credit expansion to trigger a financial crisis. 

While Beijing has launched a much-vaunted deleveraging campaign to contain excessively rapid credit growth, a recent Reuter’s analysis claims that the policy has done little to rein in debt levels in the corporate sector.

Beijing appears to be banking on reform policies that will led to productivity increases, enabling China’s economic growth to outpace debt and head off any potential financial crises.

According to Pettis, however, China need not be so concerned about its mounting debt burden triggering financial crisis as long as Beijing retains the power to avoid catastrophe by simply restructuring the liabilities of the state-dominated banking sector.

Pettis says policymakers should instead be more worried about China’s debt burden impeding economic growth by creating uncertainty about the allocation of future debt-servicing costs, in a process referred to as “financial distress” to which modern history has borne witness repeatedly.

Pettis claims that no excessively leveraged country has ever successfully outgrown its debt in the past two hundred years, without first forcing a sizeable portion of servicing costs upon another hapless recipient sector.

In 1919 Germany inflated its way out of debt, forcing the cost upon those with fixed incomes such as pensioners, while in 1990 Mexico shifted its debt costs upon creditors via discount restructuring, and just a decade previously China used negative interest rates to force the cost upon households.

For this reason Pettis believes China must effectively deleverage in order to achieve sustainable growth in future, and avoid a “lost decades” scenario of low growth that characterised Japan after 1990.

In his opinion the only “healthy” means to achieve deleveraging in China is to firstly compel local governments to liquidate their assets in order to channel the funds towards debt reduction.

The next, longer-term measure would entail reducing China’s dependence upon excessive investment to boost economic growth by expanding consumption, which in turn require a broad transfer of wealth from local governments to households.

 

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