Watching For China-Related Volatility In November

I agree that China is in a very different position than the US, but this isn’t necessarily a good thing. The main relevant difference is that because all the banks are perceived to be guaranteed by the central government, and Chinese households have a limited number of ways to save outside the banking system, it is unlikely that China will experience a system-wide bank run as long as the credibility of the guarantee survives, and runs on individual banks can be resolved by regulatory fiat (banks that receive deposits will be forced to lend to banks that lose deposits). We are not likely to see a Lehman-style crisis.

We are also not likely to see, however, the advantages of a Lehman-style crisis, and these are a relatively quick adjustment in the process of investment misallocation. I have always said that the resolution of the Chinese banking problems is far more likely to resemble that of Japan than the US, and instead of three of four chaotic years as the system adjusts quickly, and at times violently, we are more likely to see a decade or more of a slow grinding-away of the debt excesses. The net economic cost is likely to be higher in a Japanese-style rebalancing, but American-style rebalancing is risky except in countries with very flexible institutions – financial as well as political.

Pettis believes that China will not see a Lehman-style crash because the banks are perceived to be all government guaranteed, but the costs will be repaid in the form of Japanese Lost Decade(s) like slow growth.

I would, however, add one caveat to Pettis' analysis - we have no way of forecasting the contagion effects of a Chinese bad debt crisis. While the Chinese banks may be supported by the Chinese government, no one knows if any western large financial institutions are overly exposed to China's loan markets. Let's suppose that a large global bank like HSBC (it's only an example, I know nothing about HSBC's exposure to China) were to get severely impaired over a Chinese shadow banking system/subprime-style crisis (see my previous post The canaries in the Chinese coalmine for a discussion of the shadow banking system and wealth management products), could such an event create havoc in the global financial system? What if a Chinese banking crisis were to arise and global risk premiums on emerging market debt were to skyrocket, you can't tell me that these large global banks aren't exposed to emerging market debt in places like Brazil, India and Turkey. We saw a preview of what happened when the markets got just the whiff of Fed tapering - risk premiums on emerging market debt shot up and the risk of emerging market currency crises rose accordingly.

Notwithstanding my concerns over the contagion effects of a Chinese banking crisis, Pettis makes a good point about the resilience of China's financial system. While it could theoretically absorb the hit from a banking crisis, the costs are ultimately borne by the Chinese household. If that happens, you can forget about the stated strategy of re-balancing growth to the consumer as the household sector will be struggling with the costs of the aggregate costs of the bad loan writeoffs. Pettis made some important points as he addressed the issue that a lot of the bad loans don't matter because they are hidden and government guaranteed [emphasis added]:

Even those who do not understand why this reasoning is incorrect should know that it must obviously be incorrect. If it weren’t, any country could solve all of its debt problems merely by borrowing in a non-transparent way through the central bank. As the Greeks and the Italians most recently showed us, non-transparent borrowing may cause us to recognize a problems later than we otherwise would have, but it cannot solve the problem.

The reason is because in any case debt must either be serviced or the borrower must default. If the assets which were funded by the debt do not create enough wealth with which to service the debt, and if the borrower does not default, then by definition there must have been a transfer from some other entity to cover the difference between the debt servicing cost and the returns on the asset.

Typically this other entity, in China and elsewhere, has been the household sector, and in the case of China the transfer occurred primarily in the hidden form of severely repressed interest rates. Whether the transfer is from the household sector, however, of from other sector, this is where the problem of debt lies for China.

The IMF's wish list
Recently, Anoop Singh of the IMF penned an article in which he addressed these issues facing China, but in less alarmist fashion that I have. After outlining the challenges, Singh outlined the way forward:

Shifting to a sustainable growth path––one that uses resources more efficiently, is more inclusive, and more consumer-based––requires actions on several fronts: financial sector and fiscal reforms, as well as structural measures.

Further financial reforms are essential to contain the buildup of risks, enhance the efficiency of investment, and boost household capital income. The main dimensions of reform are deposit rate liberalization; the elimination of perceived widespread implicit guarantees on financial products and intermediaries through the introduction of deposit insurance, and a formal resolution framework for failing institutions; and gradually moving away from administrative guidance on credit allocation to adopting a policy rate as the main operating target for monetary policy.

Fiscal reforms, including giving local governments authority over their own revenue sources more in line with their expenditure mandates; shifting the tax burden toward progressive and efficient forms of taxation; and channeling dividend payments from state-owned enterprises to the budget; all these measures will complement financial sector reforms in addressing the vulnerabilities in local government finances, reducing excess investment, and boosting household consumption.

The third broad area––structural measures––will reinforce the impact of financial and fiscal reforms and enable a shift toward a growth model less reliant on capital accumulation and more dependent on the efficient use of resources (‘total factor productivity’ growth). The measures include leveling the playing field within and across sectors through deregulation and easing barriers to entry (particularly in services); raising resource prices to rationalize investment and protect the environment; and reforming the hukou (household registration) system to improve labor market mobility and achieve a more efficient matching of workers to vacancies.

Singh went on to say that he believed that the Chinese leadership is aware of what needs to be done:

Implementing these significant measures is a tall order and involves tough choices, including possibly accepting slower growth as the economy adjusts to the new path. But starting now will allow China to sustain its convergence to the level of higher income economies and deliver the benefits of growth to an ever-wider cross section of its population in a way that’s environmentally sustainable and sound. But delay reforms and the challenges grow larger, raising the probability of stalled convergence.

China’s leadership recognizes the challenges and has already indicated their reform objectives. The priority now is to lay out and then, critically, implement concrete reform plans to manage the transition to a new growth path.

The stakes are high, especially when : Is that bullish because it's finally facing reality and cleaning up its books, or bearish because it's a sign of weakness in the financial system?

No doubt we will see more announcements out of Beijing. Don't expect them to have too many specifics, rather, they are meant to set direction.

Will the market interpret the announcements bullishly or bearishly? I don't know, but as the chart of the Shanghai Composite shows, the index has already violated a technical uptrend and an important support zone, which indicates market nervousness.