Editorial Board

How to Limit Chinese Markets' Contagion

Better data and less leverage would help.

Who stands to lose?

Photographer: Qilai Shen/Bloomberg

Monday's market gyrations highlight one of the biggest worries investors have this year: What would a slump in China mean for the rest of the world? It's a concern that the officials who oversee the global financial system could be doing much more to mitigate.

QuickTake China's Debt Bomb

China's leaders are trying to engineer an unprecedented transition to a consumer-driven economy -- a shift that will require them to abandon an investment-centric model that has produced rapid growth but also engendered huge debts and excess capacity. One possible outcome is a slowdown that weighs on the global economy for years to come. A scarier possibility is a more virulent financial contagion, as markets panic over losses suffered by the many foreign banks and investors that have piled into China in recent years.

So how to prevent China's difficulties from precipitating a global disaster? In the wake of the 2008 financial crisis, regulators arrived at a couple of strategies. For one, they need to gather and share enough information to figure out where risks are concentrated -- in this case, which institutions will incur the largest losses if, say, one country's companies start defaulting on their debts en masse. Also, they have to ensure that those institutions can absorb the losses without destabilizing the entire financial system. Countries with less-capitalized banking systems, for example, will be more vulnerable to contagion, experience shows.

Unfortunately, on both fronts, progress has been inadequate. Consider efforts to gather data on credit derivatives, which allow the risk of lending to be transferred among institutions and across borders. Regulators in different countries (and sometimes within the same country) have struggled to figure out how to share the information they collect. And in any case, their disparate rules for reporting such data make aggregation extremely difficult. As a result, it's impossible to tell who stands to take the biggest hit.

Efforts to ensure resilience have also fallen short. Granted, regulators have required the largest banks to finance themselves with more loss-absorbing equity capital -- they need, in the U.S., at least 5 percent of assets and, globally, at least 3 percent. But these levels are still below what research and experience suggest is needed to prevent distress and protect the broader economy. Other forms of loss absorption, such as bail-in-able debt, might actually spook markets, because they would require regulators to swoop in and take control of institutions that have burned through their equity.

This is no way to run a financial system. Back in 2008, regulators were shocked by the extent of global exposure and vulnerability to the U.S. real-estate bust -- a lack of preparedness that dealt a lasting blow to investor confidence. If regulators now want to calm markets' worries about China, they'll have to demonstrate that this time around they're on the ball.