China's Hidden Risks Rise
A major factor behind the soaring growth of risky wealth-management products in China is that investors typically think the government stands behind them. Lately, nervous regulators have been emphasizing that this isn't so. But they'll have to do a lot more to change expectations in a state-dominated economy.
Wealth-management products are short-term, high-yielding investments that are issued by banks. The market for such products is now worth close to $4 trillion, or nearly 40 percent of China's gross domestic product. Banks are heavily reliant on them for liquidity, and investors have come to view them as more or less risk-free, thanks to previous government bailouts.
This is a problem, as China's regulators well know. And officials have recently started signaling that the days of limitless government support are over. They're trying to establish a market in credit-default swaps, to better price and manage credit risk. They're imposing some mild new restrictions on WMPs, meant to rein in new issuance. Officially, even corporate defaults are up, suggesting that the government is finally getting serious about imposing losses on investors.
But there are reasons to doubt this new resolve. For one thing, regulation remains deficient. Banks are still allowed to hold wealth-management products off balance sheet, which allows them to stay within formal lending limits and meet capital requirements. When financial companies sell structured products, they typically partner with state-owned banks, lending a sheen of respectability to highly risky securities. Wealth-management products are even allowed to invest in wealth-management products, thus intensifying risk across the board.
And implicit bailouts -- despite the rhetoric -- are still rising. Some of the most toxic corporate assets in China are being restructured to avoid significant investor losses. Rather than imposing pain on banks that made reckless loans, the government is bailing out investors with little hope of recouping their capital. Even "bad banks" -- asset-management companies created to soak up bad loans from struggling lenders -- are selling bonds to buy the toxic debt, thereby piling leverage upon leverage.
Worse, all this may actually reinforce the perception that the government will step in, as it has so many times in the past. When a hugely risky product from China Credit Trust Co. nearly defaulted in 2014, and protesters promptly marched on a branch of the Industrial & Commercial Bank of China, the primary sales agent, the government arranged for a white knight to make investors whole. When Bohai Steel Group was teetering last year, a city government stepped in to restructure its debt while imposing almost no losses.
This kind of thing has intensified moral hazard at every level. Talk to most any investor in China and they clearly expect that financial products are "guaranteed." The same goes for local governments, banks and wealth-management firms: No one fears significant losses, and everyone expects the government will save them when things go south.
They may not be wrong. China's government is now engaged in a game of chicken. Impose losses on investors, and it risks triggering a run on the bank; continue bailing out investors, and it risks creating a problem that will swallow the economy whole. So what to do?
There's plenty of talk about merging regulatory agencies or creating new working groups. But none of that will help until the government resolves to start imposing meaningful losses, lowering overall leverage and reducing the economy's addiction to credit. Doing so will require a delicate balancing act.
In other countries, bankruptcies usually result in debtholders losing 50 to 75 percent of what they're owed. In China, that number is closer to zero for major companies. To avoid triggering a wave of defaults, regulators should allow for haircuts of, say, 25 percent -- enough to cause pain, but not enough to cause a panic. By publicly backing failing firms while still imposing losses, the government would begin to force companies to reckon with market forces while containing anxiety.
Authorities also need to crack down on the risky lending practices that caused such problems to begin with. Some banks still hold more than half their assets off balance sheet, and their capital ratios would be well below required levels if they were forced to report them accurately. As long as regulators approve of such practices, they're encouraging reckless behavior.
Without reform, risks will only accumulate until losses can no longer be supported, in which case China will have an even bigger problem on its hands. And that's what makes moral hazard so pernicious: Delaying the pain only compounds the risk.
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