China: Who Gets To Make Money And For How Long? by Michael Pettis, Global Source Partners
Special points to highl ight in this issue:
- Last Thursday China Shanshui Cement Group announced its default on RMB 2 billion of loans. As of this writing it isn’t clear whether or not lenders will be forced to absorb losses but I suspect that the default will be resolved by shareholders.
- For much of this year credit spreads have contracted sharply even in spite of strong evidence that credit conditions are deteriorating. This seems to indicate that Chinese lenders are more convinced than ever that credit risk for a wide variety of public and private sector borrowers is effectively eliminated by indirect government guarantees which protect lenders from bearing loss.
- Although the problem of moral hazard in China had been much discussed, and for many years, we have generally focused primarily on its impact on the capital allocation process. At the limit, however, moral hazard can have a significant monetary impact too.
- If there is a limit to the ability of debt issuers to increase the money supply, what is the limit and what is the sequence of events that gets us there? The most likely limits are probably an elimination of moral hazard, perhaps as the consequence of a large, costly default, the imposition of debt-issuance constraints by the regulators, or an erosion of credibility, a process that can be highly self-reinforcing.
- The current global crisis – the first stage of which occurred in 2008 mainly in the US, the second stage in 2009, mainly in Europe, and the third stage, affecting mainly China and the developing world, occurring over a protracted period beginning perhaps in 2013-14 – may be unique in history as the only global crisis to have occurred at a time of credible fiat currencies. This makes historical precedents less than wholly useful in setting out scenarios because it allows wider scope for monetizing debt.
- The ability to monetize debt does not mean that the cost of these crises will be less, only that governments may have more tools with which to prevent the disruptive impact of defaults. In fact the historical precedents suggest that countries that are able to monetize bad debts tend to suffer lower growth over the long term than countries that are forced through the process of default.
- It is not clear whether there is a limit to credibility in China or whether, like with Japan, credibility is maintained in spite of an inexorable rise in debt, albeit perhaps at the cost of economic stagnation.
Debt continues to generate headlines in China. The announcement Thursday by China Shanshui Cement Group, a major cement producer, that it would default on RMB 2 billion of bonds (roughly $315 million) may or may not mark a new phase in the evolution of China’s financial system.
Defaults have been rare in China, and except for a few small ones with limited impacts, companies that are unable to repay their debts are usually whisked off into a mysterious process after which payments are generally resumed and no major losses taken. In the case of Shanshui, as far as I understand it, there is now a struggle among two groups that own significant amounts of stock in the company, one of which promises to make good on the defaulted payments if they are able to increase their ownership share, and the other reluctant to reduce their ownership and opposed to making good on the payments.
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It isn’t clear, in other words, how this will be resolved and whether or not lenders in fact will take significant losses, but the decision as to whether or not Shanshui’s debt holders will be forced to absorb losses is not a decision that will ultimately be determined by the quarrelling shareholders. It will be decided by whether or not Beijing decides that the positive impact of a default on the capital allocation process outweighs the negative impact of a disorderly adjustment in the bond markets as moral hazard dissipates. The role of defaults is to impose discipline in the capital allocation process, and they do so if they are credible – i.e. messy and painful enough, and cause enough losses, to put it bluntly, to scare lenders into choosing future borrowers carefully.
Because Chinese lenders have gotten used to a world of moral hazard, in which those who make bad loans are protected from losses because regulators will directly or indirectly step in and force relevant parties to resolve non-payments, by transferring resources from some other part of the economy, one obvious consequence is that while lenders might consider coupon levels, regulatory treatment, and political relationships in determining the allocation of their lending, they have been much less concerned with the profitability or productivity of the projects to which they lend. This has been a key factor in the China’s massive misallocation of capital.
Will the Shanshui default be credible enough to bring discipline into the market? One way to find out is to watch credit spreads. If it is credible, we should see credit spreads widen across the board, and unevenly, to reflect differences in credit risk among China’s many borrowers, many of whom are quite frankly on the edge of insolvency and only kept alive because of continued lending.
If China were a “normal” market, this credit-spread adjustment wouldn’t happen in an orderly way given how deeply the perception of moral hazard has determined lending. Investors would sell credit risk very quickly and spreads would widen by much more than required by credit fundamentals, partly to reflect uncertainty about true credit risk and the extent of moral hazard, partly because in a market in which there is significant downward re-pricing of risk, the liquidity premium is very uncertain, and partly to reflect straight hysteresis effects.