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China Isn't Ready for Creative Destruction

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Has China's Joseph Schumpeter moment arrived? China has suggested its decision to roll out deposit insurance for bank accounts beginning on May 1 will usher in a wave of creative destruction, chastening the cronyism that plagues the country. And there is some logic to the official spin. There's a flip side, after all, to Beijing's declaration that normal consumers will be kept safe in a period of market turmoil -- namely, the banks themselves could be permitted to go bust.

If there were reason to believe that would really happen, it would be an important step toward straightening out China's financial system, and to achieving the country's longer-term goal of making the yuan a global reserve currency. Unfortunately, China's system of moral hazard won't be worth much until it passes far more ambitious financial reforms. Here are three reasons why.

First, China's banking system is still very closely tied to the state. China has a long history of organizing bailouts for state-owned companies, including one of Asia's biggest-ever bank bailouts in 1998. "As long as banks are state owned and senior officers are appointed by the organization department of the Communist Party," says Shanghai-based Andy Xie, former Asia-Pacific chief economist at Morgan Stanley, "reforms will always be superficial."

When Beijing allowed the solar company Shanghai Chaori Solar to default on domestic bond payments in March 2014, it seemed to signal a shift. But that turns out to have been an aberration. In the 12 months since, China hasn't seen any further defaults. An important upcoming test will be how Beijing handles the Shenzhen-based real estate developer Kaisa, which could soon renege on its U.S. currency notes. Whether Beijing lets Kaisa default will say far more about its commitment to capitalism than the creation of deposit insurance.

Second, China may not even know the extent of the problems in its financial system. Guan Jianzhong, chairman of China's Dagong Global Credit Rating Group, recently told Bloomberg News that the debt ratings issued by his "irresponsible" Chinese competitors are often "useless." He went on to say that “the ratings are creating credit risks and blindfolding people, instead of revealing the risks.”

Questionable accounting practices also extend to China's local governments, which have amassed at least $4 trillion of debt. Their use of off-balance-sheet financing vehicles means even Chinese President Xi Jinping doesn't know the true magnitude of China's debt profile. Beijing won't be able to accurately assess the risk of letting individual companies or banks to go bust until China's regional finances are less opaque, its companies more shareholder-friendly, and its shadow-banking sector less massive.

Third, there's reason to doubt the commitment of Chinese policymakers to creative destruction. Consider China's central bank governor Zhou Xiaochuan. On Monday, he lowered mortgage requirement to save China's markets from turmoil. He also assured Chinese investors that more such measures might be on the horizon, insisting “China can have room to act” to keep the economy afloat in tough times.

Zhou's statement came at a time when China's economy seems to be vastly overcapacity and on the downside of a credit glut that's pushing the country toward deflation. A government committed to capitalism would seize the opportunity to let creative destruction do its work: an economic slowdown could pop the country's growing bubbles in credit and real estate. Beijing, however, has so far shown little interest in cleaning up the previous decades of economic excess.

It's safe to say that China's leading economic actors have taken note of this hesitance, and will continue to act accordingly -- that is to say, irresponsibly. And the creation of deposit insurance is unlikely to weigh very heavily in their decision-making. 

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Willie Pesek at wpesek@bloomberg.net

To contact the editor on this story:
Cameron Abadi at cabadi2@bloomberg.net