Hang on, Hyman
China may be a long way from its “Minsky moment”. Rising leverage has prompted many to predict the kind of financial meltdown theorized by the economist Hyman Minsky. But China’s closed, state-controlled system is well placed to postpone such market panics. The bigger challenge is managing social tensions arising from slowing growth.
Minsky’s “financial instability hypothesis” described what the academic considered a structural feature of capitalist financial systems. The “speculative finance” of an economic boom, loans refinanced before they are repaid, yields to the “Ponzi finance” of a bubble, where borrowers take on new debt just to pay the interest on existing loans. A crash follows.
Many investors believe speculative finance is rampant in China. The total amount of new credit expanded by roughly 60 percent in the first quarter, but GDP growth was a mildly disappointing 7.7 percent. Corporate balance sheets are deteriorating: according to the International Monetary Fund, the earnings of Chinese companies were just 2.4 times interest payments in mid-2012, down from 4.4 times in 2003.
Then there are local governments, which have used financing vehicles to finance property development and infrastructure. Nobody seems sure quite how much they owe: a former Chinese finance minister recently put the figure at 20 trillion yuan ($3.25 trillion), double the officially estimated amount of loans.
To top it all off, debt is increasingly backed by short-term instruments, such as wealth management products which are distributed by banks but tend to be held off their balance sheets. As these investments mature every few months, the risk that savers will lose confidence is ever present. Ponzi-finance may have already arrived, and fears of a Minsky-meltdown would appear well-founded.
However, the Minsky-ites seem to have forgotten that their teacher thought a strong government could counter the destructive dynamics of unchecked financial capitalism. The Chinese state is probably still sufficiently powerful and financially active to prevent a meltdown.
For a start, it is the controlling shareholder of all the largest banks. The government can mandate that loans be rolled over or new credit extended. This is exactly what it did to counteract the 2008 economic slump. The state can also direct banks, insurers and other investment companies to keep buying corporate and local government bonds.
And if investors’ confidence did crack, the government could bail out the banks or the local governments directly. It did exactly that in 2003, by removing bad debts from banks’ balance sheets.
A repeat would undoubtedly be messy, and would send the level of government debt soaring. According to George Magnus of UBS, adding up local government debt, banks’ bad loans as well as bonds issued by state institutions and the now-defunct Ministry of Railways would lift the state’s total borrowings to 80 percent of GDP – more than four times the official figure.
Still, a rescue would be largely a domestic concern. Unlike most big countries, China does not depend on international investors. With tightly controlled capital flows, no foreign debt to speak of and more than $3 trillion in foreign currency reserves, the country is largely insulated from any Minsky-style run by international investors. A large-scale bailout would essentially involve reallocating resources from Chinese people to the Chinese state.
However, avoiding a panic could ultimately cause as many problems as it solves. Rescuing lenders and borrowers from their mistakes would reinforce the belief that, in China, normal market rules do not apply. That would further delay the point at which the country starts allocating capital on the basis of economic efficiency, rather than state direction.
Moreover, even if China avoids a meltdown, it can no longer continue to rely on credit to boost the economy. If less new lending slowed down job creation and the property market, an important store of wealth for China’s new middle class, the social consequences would be a huge test for the government’s political legitimacy. China’s “Minsky moment” may turn out to be not financial, but social.