China's Bad Credit
There is good news when it comes to China’s scary and still-growing pile of debt: At least the government recognizes the problem. Its attempts to mitigate those risks, however, seem doomed to fall short.
The government’s recent decision to create a market for credit default swaps is a case in point. The idea, as elsewhere, is to give banks and investors a means of pricing and trading the risk of Chinese companies defaulting on their debts. The need is obvious: Official measures of non-performing loans are worsening, while unofficial estimates say their share may have reached anywhere from 8 percent to 20 percent. Anything that spreads that risk should improve financial stability.
Yet, as envisioned, this new CDS market is unlikely to do much to improve the situation. For one thing, all but the largest companies already have to purchase credit insurance when taking out loans from giant state banks. There’s no pricing differential on this insurance, of course. But for the new system to function effectively, the government would have to let markets freely set the price of credit risk.
China doesn’t exactly have a stellar record of allowing markets to set prices in any field, whether in stocks, real estate or currencies. If credit default swaps started to indicate a rising risk of default at a major state-owned company, it’s hard to imagine officials wouldn’t intervene to reverse that impression.
This is dangerous on multiple levels. Already, several Chinese credit insurance firms have collapsed because they underestimated credit risk, forcing government bailouts. Continuing to underprice risk will only encourage the over-allocation of credit that’s gotten China into trouble thus far.
There’s also little reason to think that creating a CDS market would shift risk away from the most vulnerable banks. In a heavily concentrated banking and lending market such as China, where major financial institutions all trade with each other, swaps are likely to produce no net change to risk levels.
Think of a simple example. Assume that Bank A has loans totaling 100 billion yuan but wants to protect itself against the risk of default by buying a CDS from Bank B that covers these companies. Now assume that Bank B does the same to cover its 100 billion yuan of loans, with A as the counter-party. If we assume these are similar baskets of loans -- a reasonable assumption for major banks within a single country -- then there’s been no net change in credit risk for either bank. All they’ve done is swap credit risk, convinced that as outsiders, they can assess the health of loans better than the loan officers involved.
Finally, unless major outside investors enter the market to relieve the burden on China’s banks, risks will remain concentrated. The likelihood of such an influx is slim; foreign investors are the ones most concerned about the explosion in Chinese credit. Even the Bank for International Settlements and International Monetary Fund, neither of which can be described as anti-China scaremongers, have raised major concerns about the blistering pace of credit growth.
Given outsiders’ inability to invest at truly market-dictated prices -- or to repatriate earnings at will or, at least, in sufficient quantity to fundamentally alter their risk calculations -- there’s little reason to believe they’re going to assume the liability for China’s credit bubble.
If China wants to avoid symbolic gestures, there are better ways to address credit worries. Despite the unveiling of its much anticipated debt for equity program last week, neither banks nor firms seem anxious to participate. As one banker noted, “If you’re a good company, you wouldn’t want to give banks any of your shares. And if you’re a bad company, we wouldn’t want any of your shares.”
Shifting risks between the same group of banks and related financial institutions isn’t going to solve this problem. Banking regulators need to press actual deleveraging and what are expected to be significant recapitalizations.
China should also introduce stricter rules on financial transparency, to produce higher-quality information for listed firms. Even though official data for major banks indicates non-performing loans are only about 1.5 percent of the total, bank stocks are being priced as if all their equity will be required to cover loan losses. Since investors have no faith in the data, they latch onto worst-case scenarios, which itself creates greater risk.
None of this is to say that China is wrong to introduce credit default swaps. But, given the way the government has interfered in other markets, not to mention other existing hurdles, the new system is unlikely to improve credit allocation as dramatically as is needed. At some point, China will have to learn that simply creating an asset to trade doesn’t make a market.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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