China's "Other Sea"

Investors paying too much attention to China’s dispute over the writing of the navigation rules in the South China Sea -- one of the world’s biggest trade routes -- have perhaps missed China’s “other sea,” the sea of debt that is threatening to derail its robust growth and progress in recent years. But the Bank for International Settlements (BIS) hasn’t.  In a recent report, the Swiss-based institution pointed to the rapid rise of China’s credit-to-GDP ratio, which now stands at 30.1, three times the threshold of 10 that indicates an impending financial crisis.  To be fair, China isn’t the only country with high credit-to GDP ratio. So does Japan, the UK, and the Eurozone. The trouble is that China's debt is a routine political process. China’s credit is extended from state-owned banks to state and province-owned corporations. By contrast, the situation is a credit risk management problem in the UK, Japan, and most of the Eurozone. Additionally, some of China’s state owned enterprises, which receive the loans, are stockholders of the state banks that provide them. That’s why nobody really knows what the size of China’s debt-to-GDP ratio is. Compounding the problem, parallel government ownership of both creditors and borrowers concentrates and magnifies rather than disperses and diffuses credit risk, leaving the Chinese economy vulnerable to a systemic collapse -- as the Greek crisis so colorfully illustrated. Worse, parallel government ownership of lending and borrowing institutions complicates creditor bailouts. The reason why the “haircut” of Greek debt had such a pervasive impact on the Greek economy was that government-controlled banks and pension funds were the creditors of the general government and government-owned enterprises. So the haircut shifted losses from one government branch to another. The situation is even more serious in China, where the outright simultaneous government ownership of banks, pension funds, and common corporations has yielded an odd state in which both the creditor and the borrower are government branches. Government-owned banks lend money directly to government-owned corporations -- which usually function as welfare agencies -- and to land developers, who are behind the country’s “investment” bubble, one of the engines of the Chinese economy. Could you imagine what would happen to financial markets if China suffers a Greek-style crisis, one day? That could, perhaps, explain investor skepticism over Chinese equities, which have been underperforming the neighboring market of India in the last year.