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I get a lot of emails and phone calls asking me what I think is the likelihood of a sharp financial “adjustment” in China, and what the impacts are likely to be.

The first point to make is that it is a safe bet that China will experience financial instability, and not necessarily because of anything endearingly Chinese.  Given the experiences of other countries, and given the state of the Chinese financial system, the argument that it will suffer from a crisis is very, very plausible, and not worth, in my opinion, betting against. 

The obvious “generic” arguments are the easiest to set out.  No large country that I know of (and probably no small one, either) has ever been able to combine rapid growth and social transformation without periodic financial crises.  In fact offhand I cannot think of any country that has a functioning financial system and that hasn’t suffered periodic financial crises.  In the 19^th Century, for example, the US seemed to be hit by a serious panic every ten to fifteen years, on average, and it suffered at least two or three financial crises during this period that were devastating.  During its own history China has suffered financial crises or panics, most recently in 1993-94 and 1997-98, but also throughout the 20^th century and of course earlier (there is a fascinating story to be told about the relationship between China’s great remonetization in the late Ming and early Qing periods and the plundering of silver from the Americas)..

Against this, many China scholars argue that China today is sui generis – so different from everyone else that it can’t be judged by laws or experiences that have worked elsewhere.  The only reasonable response I can give to such an argument is that I have never worked in a country (the US, France, Brazil, Mexico, Peru, Spain, Haiti, Pakistan, Argentina, to name a few) that wasn’t at least as sui generis, nor have I ever worked in a country whose own specialists hadn’t also assured me at least a few times that because of their unique histories and circumstances these countries were too different to bear easy comparison with the rest of the world.. As silly as this sort of provincialism may seem to many, it has been a powerful undercurrent in the thinking of many China specialists – foreign as well as Chinese.

If China is indeed “different”, it is different in ways that don’t give me much confidence in the safety of its financial system.  Its banking system is filled with current and future bad loans; its bank managers are among the least experienced in the world in risk management and credit allocation; it has almost no financing alternatives to the banks; government credibility tends to be very brittle in China; and the national balance sheet is much weaker than that of many other countries that subsequently experienced crises.

The second obvious argument for arguing that China is at risk is also a “generic” argument and does not rely anyhting that is specifically Chinese.  This is the observation that in every case of an economy that experienced excess liquidity conditions for long periods of time, financial sector imbalances have always built up that were only discovered later when some event caused liquidity to dry up.  

One of my favorite economists, Hyman Minsky, makes the point that during periods of financial stability, institutions systematically increase their underlying risk.  There are at least two mechanisms by which they do so.  The first is that economic actors always adjust their behavior so as to obtain a risk-return tradeoff that they consider reasonable or appropriate.  It is not necessary for these actors to be risk lovers – it is only necessary for them to be willing to trade some risk for some return. 

During long periods of low risk, they naturally shift towards increasingly risky behavior until they have eventually achieved what for them is an appropriate trade-off.  Of course what is rational for each individual actor increases the riskiness of the whole system, and creates balance sheets that are more susceptible to unexpected shocks.  When the shock finally comes, volatility usually shoots up and the adverse impact on all the now-riskier balance sheets catches everyone by surprise.

The second reason has to do with everyday sorting mechanisms.  In periods of low volatility, individuals and institutions that take on higher levels of risk tend to outperform the rest.  During sustained periods of low volatility and high levels of liquidity, any financial institution will find that the bigger risk-takers -- including, most importantly, the ones that ignore the risk of of illiquidity --  have moved up the hierarchy at the expense of the more risk averse, so driving the whole institution towards greater risk-taking and greater susceptibility to a liquidity event (and this entry is being written during the sub-prime crisis, in case any reminders are needed of how that happens).  Similarly, during periods of low volatility more aggressive institutions will grow at the expense of less aggressive institutions, so driving the industry towards greater risk taking.

China is currently going through a financial sweet spot in which high growth, floods of liquidity, and low or negative real rates are rewarding the wildest risk takers handsomely, and it would be surprising if one result wasn't a systematic increase in balance sheet risks.  Plenty of liquidity has meant that loans can easily be renegotiated, and loan maturites can easily be extended, even if only to hide problem loans (a manager at the PBoC told me that he believes that this is why loan maturities began extending in 2004 onwards after the introduction of new monitoring systems to judge loan officers). 

Plenty of liquidity has also meant that corporations can easily borrow and speculate on real esate and financial markets as a way (a horribly pro-cyclical way) of jacking up profits.  There is little doubt that an awful lot of money, which doesn't really need to be repaid just yet, has been put into non-productive investment.  As Yale's Robert Shiller put it, "My view of booms is that they generate laxity in standards for loans."

When you add to the mix the observation that combating rising unemployment is probably the government’s leading concern, and that one way to increase employment in the short term is to loosen investment criteria, and it would be very surprising if serious imbalances weren’t being built.

The two “generic” arguments presented in the earlier entries do not require any specific knowledge about China.  The first argument is that every rapidly growing country runs into periods of financial instability, and China will be no different.  The second argument is that any financial system that enjoys a long period of financial stability and excess liquidity is highly likely to build up imbalances that will require some adjustment. 

China's reserves increased by $117 billion in 2003, $207 billion in 2004, $209 billion in 2005, $247 billion in 2006, and $266 billion just in the first half of 2007.  Each dollar of reserve growth is matched by an increase in currency and central bank bills in circulation.  China's money base has been growing at a rapid and accelerating pace.  China has had too much liqudity for too long, and and with its rigid and opaque financial system, the adjustment is probably inevitable and likely to be painful.

These “generic” reasons as to why we should be concerned are, to me, pretty compelling.  China is undergoing conditions – rapid economic growth under conditions of explosive growth in liquidity and credit, low or negative real interest rates, and significant policy intervention – that have almost always led, in other cases, to financial imbalances, and it would be strange to assume that they would not in this case. 

It is not necessarily the case, however, that an adjustment need be violent.  This depends on the structure of the financial system and the national balance sheet. If balance sheets are strong, the adjustment can be localized; if the financial system is healthy and flexible, the transmission into the real economy can be minimized; and if government debt levels are low, financial authorities can counteract the impact of the adjustment.

But there are very China-specific reasons that give cause for worry.  Financial crises occur when a country, whose balance sheet includes a lot of unstable, or badly structured, debt, is affected by an adverse shock that sets into motion a collapse in the balance sheet.  An economic crisis follows only if and when the financial crisis is transmitted into the real economy – almost always by shutting off the ability of producers and/or consumers to finance their activity.

What are the conditions for balance sheet instability?  In my book (The Volatility Machine) I list three.  There must be high levels of debt.  The relationship between assets/operations and debt/debt financing must be “inverted”.  And there must be self-reinforcing, sometimes referred to as pro-cyclical, mechanisms imbedded in the balance sheet.

What is a high level of debt?  There is actually an easy way to answer what seems like an impossibly difficult question: a high level of debt is whatever the market considers at any given time to be too much debt.

This answer is not a cop-out.  When the market believes that debt levels are too high it responds by forcing the yield to rise, and it is precisely high yields that are the problem.  They are a problem not because (or not mainly because) the government must now pay a lot more for new borrowings, so jacking up the fiscal deficit.  They are a problem because exisiting debt changes the incentive structure for old and new investors.

The higher the real yield on exisiting debt (the lower its price) the greater the share of the benefits of new investment that accrues to old lenders, and the smaller the share that accrues to new investors.  This is because improvements in the country's repayment prospects are shared between the exisiting creditors and new investors. 

This doesn't matter when repayment prospects are very high, since the share of the improvement that goes to existing creditors is very small (they are already highly likely to get repaid).  But it matters a lot when the market thinks repayment risks are very high (i.e. the real yield is very high).  For option geeks the relative share of any change in asset values that debtors and equity investors receive is referred to as delta.

The higher the delta for debt, the lower for equity, since delta must always add to one (i.e. 100% of the change in asset value must go to debt and equity investors), and by definition the smaller the share equity investors get of any change in asset value.  This creates a disincentive to invest and an incentive to disinvest (as any banker who deals with debt restructuring knows).  When investors believe a country has too much debt they force changes in the value of debt (increase yields) that automatically causes reduced investment or even disinvestment, and this has an obvious adverse impact on the ability to pay.  This is one reason debt crises often seem to spiral out of control.

Is China at risk of having too much debt?  We don’t really know, but a very plausible case can be made that it is.  I have written elsewhere about my estimates for the government’s total debt levels – officially around 30% of GDP but probably over 60% of GDP when you include contingent liabilities arising from unrecorded provincial and municipal debt and non-performing loans in the banking system. It is not hard to make a case that in case of an unexpected economic or liquidity contraction, non-performing loans will shoot up and force attention onto the country’s real debt levels, and the market might judge these levels to be too high.

What about the second condition of balance sheet instability – is China’s debt structure “inverted”?  An inverted debt structure is the opposite of a hedged structure.  When conditions on the asset side improve the debt burden declines, and vice versa.  Think of South Korea’s dollar debt in 1997 – when things went well, money poured into the country, assets increased in value, and profits rose.  At the same time the real appreciation of the Korean won was reducing the real cost of dollar debt. 

This is all fine and good and can induce feelings of euphoria when underlying conditions are doing well, but when things go badly on the asset side, for whatever reason, the whole system suddenly goes into reverse.  The debt burden balloons just when the borrower is least able to pay.  Again, think of South Korea after the sudden depreciation, when the value of dollar debt shot up just as the value of won assets was declining.

Much of China’s explicit debt is "hedged" – it is denominated in long-term fixed-rate RMB, so anything that causes interest rates unexpectedly to rise will automatically reduce the value of its obligations.  So far, so good. 

But a very large chunk of China’s debt – perhaps more than half of it – consists of contingent liabilities through the banking system.  This stuff is heavily "inverted" -- the debt burden is lightest when the economy is growing, and heaviest when it is contracting.  Right now conditions are as good as they can get – China is growing quickly, interest rates are low, and the economy is flooded with liquidity – and so the growth in NPLs is probably low (in relative terms, of course -- my guess is that they are still growing quickly if correctly accounted).  However should conditions change and China suffer from an economic or liquidity contraction, it is probably safe to assume that NPL’s will grow at a much faster rate than they are growing now, and we will see if the enormous increase in loans made during the last three years were always made to good borrowers. 

This is a classic case of an inverted balance sheet.  The liability side performs (relatively) well when the sun is shining and the economy is growing, but just when things get bleak on the asset side the debt burden begins to rise, catching the economy in a squeeze.

To address, finanlly, the third condition for balance sheet instability, does China have self-reinforcing mechanisms imbedded in its balance sheet?  I think there are two obvious ones.  The first of course is the normal reaction of banks to a sharp contraction.  The need to protect their own balance sheets will have them hoarding liquidity and cutting loans.  This merely reinforces the crisis and causes corporations and banks to scramble for liquidity, while also causing NPLs to rise.  Rising NPLs are self-reinforcing at some point because if they rise quickly enough, they force the banks to hoard even more, thereby throwing more borrowers into trouble and causing even more NPLs.

The second mechanism is the possibility of bank runs.  Most people don’t know that China has had bank runs in recent years, and my guess, from living through SARS and other credibility shocks, is that in Chinese cities government credibility is strong but brittle.  It may not take much for individual Chinese to lose faith in the ability of the government to protect their savings, and if they worry about their savings, their efforts to protect them (withdraw deposits) will just make the problem worse. 

The problem with bank runs is how easily they can spiral out of control.  We don't need everyone in China to give up all trust in the government's ability to protect them.  We only need a few (perhaps the more sophisticated) to be a little worried about a temporary problem.  If that worry causes them to withdraw deposits, and low interest rates make the opportunity cost negligible, they can quickly spark further deposit withdrawals as the problem "gradually" spreads (and with the ubiquity of mobile SMS, information can spread in a Chinese city today far more quickly then in Depression-era Smalltown USA).

It is not easy to predict how and when an instable balance sheet leads to financial crisis.  The point I would want to make here is that crises are inevitable, and China has many of the conditions that give reason to worry.  Unfortunately a lot of regulators, government officials, and bankers seem altogether too skeptical (and sometimes offended) about the claim that China could be at risk, when they should be worrying about contingencies (and to their credit, many people I speak to at the PBoC are concerned). 

There are a whole number of interesting and important questions that need to be addressed in order to understand the risks and move to mitigate them.  We need to guess what kind of shocks the national balance sheet is most susceptible to.  We need to figure out what changes need to be made to minimize that susceptibility.  We also need to understand the transmission mechanism from financial shock to economic shock, so that the government can plan what it would need to do to minimize its impact.

On this last point I am frankly a little worried.  My model of the world assumes that the greater the flexibility in the financial system, the more moving parts it has, and the clearer the rules of the game, the weaker the transmission from financial shock to economic contraction (the US is the prime example of a well-functioning financial system). 

If you agree, then you would have to be very worried about China.  The financial system is completely dominated by the banks, in a way that even Japan wasn’t in the 1980s, and the risk management and credit allocation mechanisms in the banks are rigid, opaque, and inexperienced.  This suggests that a financial shock could strongly affect economic growth.