Will China’s Financial Bust Ever Come?

What we can learn from other economies

By Paul PanckhurstPaul Panckhurst and Adrian LeungAdrian Leung
November 14, 2016

Credit booms often end badly – and China is in the grip of a major one.

On the face of it, the warnings flashing from a key credit gauge back the bearish views of people like hedge fund manager Kyle Bass, who predicts a spectacular Chinese bust, requiring a rescue of the financial system.

China's reading is the nation's highest on record in the gauge released by the Bank for International Settlements. It's the single most reliable indicator of looming financial crises, according to the BIS, which found in a 2011 analysis of 36 countries that a majority of banking crises followed readings higher than 10 percent.

China Flashing RedCredit-to-GDP gap since 1995
The credit-to-gross domestic product “gap” focuses on the amount of credit provided to households and businesses as a share of gross domestic product. It shows when the ratio of credit to GDP is blowing out – suggesting a credit boom and the risk of trouble brewing.
Nordic and Japanese crises in the late 1980s and early 1990s followed blow-outs and, likewise, the data flashed red for the U.S. during that country’s boom, which morphed into the global financial crisis.
U.S. Financial Meltdown
The gauge is overstating the dangers for China, according to Ming Ming, the head of fixed-income research at China’s biggest brokerage, Citic Securities Co. He questions some of the BIS methodology and also says the gauge doesn’t account for national differences.
“Every country is different in its economic structure and the relationship between the government and banks,” said Ming. “A lot of assets held by Chinese banks are government debt, so as long as the government is repaying its debt, we won’t see a massive outbreak of defaults or a banking crisis.”
One problem is that the warnings can come so early. In the case of Spain, a nation ultimately undone by property bubbles, the gauge started flashing red in 1999 but the crisis didn’t begin to unfold until nearly a decade later.
Spain Through the Roof
Sometimes it never comes. Australia entered the danger zone in late 2004 and stayed there until 2008 – but dodged a meltdown. Academics and economists still debate the reasons, which may have included the quality of lending and some policy moves to shore up financial stability.
Australia's Missing Crisis
Many analysts argue that a banking crisis in China is far from inevitable, for reasons including the state’s resources, a mostly government-owned financial system, capital controls, and limited overseas debt.
“We’re not going to see a banking crisis in China the way we did in the west in 2008 or in Europe in 2011,” Nobel laureate Robert Engle, a professor of finance at New York University’s Stern School of Business, told Bloomberg Television in September. Still, Engle, who studies systemic risk, sees a threat of economic stagnation because of the drag on productivity from misdirected credit.