Moody’s has finally recognized the dangers of instability in China’s financial system and economy. This past week, the ratings agency downgraded China’s debt one notch from Aa3 to A1. Although that might not seem like a lot, it’s Moody’s first downgrade of Chinese debt in almost 30 years; and that is something to take seriously.
The danger signals in China’s economy have been there for anyone to see, that is for anyone not in denial. But many are in denial, including other rating agencies, investors and journalists. Being in denial means ignoring the warning signs, just as rating agencies, investors, and journalists ignored the warning signs in the lead up to the global financial crisis.
Commercial towers are seen in Central, a business district of Hong Kong, Thursday, May 25, 2017. Moody's has cut its credit rating for Hong Kong hours after downgrading China for rising debt levels, which it said would have "significant impact" on the Asian financial hub because of their close links. (AP Photo/Kin Cheung)
To be sure, the late economist Hyman Minsky laid out the general warning signs in a framework he called the financial instability hypothesis (FIH). However, most ignored Minsky’s messages until it was too late. It was only after the global financial crisis erupted that the phrase “Minsky moment” became fashionable.
Coverage of Moody’s downgrade by The Wall Street Journal and The New York Times has nicely conveyed the key facts of what led Moody’s to downgrade China’s debt. But the coverage could do more by linking those facts to the FIH, in order to help readers connect the dots of how the worrisome pieces of the China puzzle fit together.
The key features of the FIH can be boiled down to six types of crisis warning signs, two signs that a crisis is erupting, and four types of policies for mitigating the magnitude of a crisis. The specific warning signs are not arbitrary, but instead characterize the evolution of systemic risk as the financial system moves towards the red zone during the latter phase of an economic expansion. In this regard, China's economy expanded at an official rate of 10.6 percent in 2010, but its more recent growth rate has been lower, 6.7 percent in 2016. Moody’s forecasts that over the next five years, the rate will continue to decline, falling to 5 percent.
What follows is a short FIH-based rundown on China, organized around the six warning signs. This rundown takes the key points in the media coverage of Moody’s China downgrade, and matches these points to Minsky’s perspective. In making the match, I hope to encourage journalists to organize their ideas so as to present the discussion in the context of the bigger picture, and thereby present their readers with a coherent view of what the facts mean for overall financial stability.
Excessive leverage: As a percentage of GDP, China’s debt at 164 percent is high for a developing country. In the first half of the century, before the financial crisis struck in 2008, China’s debt was stable. Since then, it has grown by 15 percent of GDP, per year. The lion’s share of that debt relates to businesses, and to a lesser extent local governments, rather than to households and the central government.
Surge in shadow banking: In the past, four large state-controlled banks dominated China’s banking sector. However, in recent years a shadow banking system has evolved, involving local and provincial banks that today account for roughly half of the assets in the country’s banking sector. While the state is the lender of last resort for the four large banks, the latter serve as the lender of last resort to the shadow banks. Therefore, imprudent risk taking by shadow banks holds the potential to shock China’s entire financial system.
Increased speculative and Ponzi finance: According to the FIH, a major source of financial instability is when borrowers count on price appreciation, in addition to cash flows, to make principal and interest payments. This feature is compounded by mismatching the maturities of assets (long-term) and liabilities (short-term), with borrowers needing to continue borrowing short term in order to avoid defaulting on their obligations. In recent years, banks in China have continued to make loans to state-owned firms that are experiencing financial distress, in order that these firms do not default. Minsky warned that such practices render the country’s financial system to become increasingly fragile.
Emergence of asset pricing bubbles: Although pricing bubbles were not highlighted in the media coverage of Moody's downgrade, in recent years China has experienced both a stock market bubble and a real estate bubbles. What does get highlighted is the use of financial innovation. In particular, shadow banks are partly funded by state-owned banks, and partly funded by selling wealth management products to customers. These products are often non-transparent in terms of risk, and indeed are used to finance highly speculative construction projects.
New era thinking: China’s reaction to the Moody’s downgrade has been to suggest that Moody's does not fully understand China’s system, which is different from corresponding systems in the West. To be sure, there are differences. Chinese central government debt is relatively low, as is residential mortgage debt. Chinese borrowing from the rest of the world is also low. On the surface, China scores favorably on three of the four FIH crisis mitigating factors: a large public sector able to increase spending to offset declines in aggregate demand, the power to create jobs when the labor market weakens, and the ability to rescue enterprises that are too big to fail. Notably, The Wall Street Journalreports that China has recently initiated efforts to reduce risky investment and financing practices by raising key short-term interest rates.
Regulatory failure: China scores less well on the FIH’s fourth crisis mitigating factor. Over time, its regulatory system has deteriorated significantly, especially as regards the country’s shadow banks, where the increase in speculative and Ponzi finance have been concentrated. Perhaps there is hope, as The Wall Street Journalreports that regulators have increased their oversight of investment products that feature highly leveraged bets in financial markets.
The six warning signs just described signal increasing financial fragility in China. In the FIH, there are two main indications that a crisis has erupted. The first indication that a crisis is erupting will occur when there is a run on Chinese financial institutions, especially the shadow banks. That is when the Chinese public will lose confidence in these banks. The resulting bank runs will feature a collapse in the markets for shadow banks’ wealth management products. A wave of defaults will follow. As the crisis evolves, larger firms will be pulled down by the failing shadow banking sector. Remember that the large state run banks are the shadow banks’ lender of last resort.