The weakest links
China’s debts are troubling – and not just because they’re alarmingly big. An equally worrying threat to the country’s prosperity is the complexity of those debts. That’s the trouble with China’s lengthening “credit chains”.
Imagine an economy with the simplest kind of credit chain: one bank and a single corporate borrower. With only two counterparties, it’s easy for both sides to see when things are going wrong. Even if debts are large, it’s not too hard to come to an arrangement. If the government is willing and able to back one or the other, a crisis is unlikely.
China’s chaotic credit system is far removed from that model. Over the past four years, innovative financing has blossomed. Loans between companies, and trust products that pool funds and deploy them outside the banking system, expanded almost four-fold between 2010 and 2013. Some of those loans may even have been reinvested into new products. Depositors too have piled into new investments and online funds. The number of entities with a claim on another has multiplied dramatically.
Money can wend an elaborate path. For example, a saver may put their money in a short-term fund sold by a bank. The fund buys a bond issued by an industrial company. That company makes a loan to a supplier, which in turn extends trade credit to its customers. If any one of those links is broken, the whole chain will feel the strain. Even if the government wants to help, it’s not obvious where assistance should go.
The chains are getting longer because China’s capital allocation machinery is broken. Banks hardly lend to small businesses or private enterprises. And they can’t offer depositors a competitive rate of return on their deposits. That has created a demand for credit that companies, informal lenders and even individuals have rushed to fill. The banks themselves are the main peddlers of many products, which yield attractive commissions.
There’s nothing necessarily wrong with non-bank lending. So-called “financial deepening”, where equity and bond markets offer alternatives sources of finance, can improve efficiency. But China isn’t deepening in the typical way. Capital markets accounted for just one dollar in every seven raised in China in 2013.
Longer credit chains are dangerous because they make it harder for investors to price risk properly. A bondholder in a listed company can see where it stands in the queue for repayment. In most wealth management products, however, information on the underlying exposures is poor. Besides, customers who buy credit-based products may believe the banks that sold them implicitly guarantee repayment. The lenders themselves may think they’re not part of the chain at all.
When chains lengthen without adequate disclosure, investors can find they have claims on borrowers they never imagined. Worse still, other investors worry they are in the same boat. That, in a nutshell, is what happened in Western financial markets in the run-up to the 2007 financial crisis. Sub-prime U.S. mortgage debt was scattered throughout the fragile and opaque system through structured credit and the repo market. When the debt went bad, it threatened to drag down the whole edifice.
Though China’s financial system is not nearly as complex as Western markets before the crisis, measuring the length of its chains is already impossible. The central bank’s preferred measure of “total social financing”, which grew by 18 percent in 2013, covers part of it. Standard Chartered estimates all “formal” credit in China amounts to 231 percent of GDP, twice the level three years ago. But those measures don’t show how the same quantum of credit can pop up in multiple places.
Worse, China lacks efficient mechanisms to help creditors recover their money, adding to potential uncertainty. That is why the default of a bond issued by Chaori Solar on March 7 – China’s first – is significant. How it is resolved will be a crucial test.
The recipe for shortening China’s credit chains at least isn’t too complicated. Higher bank deposit rates, better governance at banks and clear, orderly default processes that help investors to price risk properly would all help. Instead, the authorities have dragged their feet. If that continues, the risk is that when lending chains start to snap, confidence will go with them.