While some officials and analysts are worried about a slowing Chinese economy and the potential hit to commodities and trade, others singled out the government’s attempt to end assumptions of implicit state guarantees throughout the financial sector as a far more serious flashpoint.
“China has a lot of growth left,” said Standard & Poor’s chief economist for Asia Pacific Paul Gruenwald, in an interview with Emerging Markets. “It’s roughly two thirds of the way through a process of urbanisation,” he said. “It just passed 50% urbanisation ratio and it’s going to go to 70%-75%. They’re not building bridges to nowhere yet, and there are still plenty of second and third tier cities that need schools and hospitals.”
The real rising risk is China’s attempt to move from an environment of pervasive explicit and implicit guarantees, to one where “lending is based on risk and the interest rate is doing the work,” he said. “The price of lending needs to be redone and there are going to be some wobbles as they go through this.”
The market will have to learn, for perhaps the first time, how to price risk appropriately. But the question is how much the Chinese authorities will have to do to drill the lesson home.
“You can see how it might go badly for a while,” said Gruenwald. “A stimulus plan is easy — you tell the state banks to lend to state enterprises to support investors. But changing the financial behavior of investors and issuers is tricky.”
DELICATE DEFAULT
China has already allowed a corporate bond from Chaori Solar Energy Science and Technology to default. But it avoided a trust product default earlier this year, which implies the authorities are highly aware of how delicate this process of shifting investor attitudes really is.
“The first trust product to face difficulties was in January,” a senior capital markets analyst told Emerging Markets. “But it appears that someone picked up a red telephone, some people took some haircuts and some other people wrote some cheques. The fact that a default was avoided suggests we should in turn expect China to avoid the process becoming climactic.”
But moving from a world in which there is an implicit state guarantee for almost everything to one where the only guarantees are for deposit insurance and some strategic state enterprises will require some deft handling.
“The question is how to convince the market that it’s the new regime and it’s really going to happen,” said Gruenwald. “If you can do this by letting a handful of private sector firms default and everyone reprices the risk that’s great, but the problem is they are going to have to do more than that — they are going to be tested.”
The fact that they are going to be tested during a colossal process of deleveraging makes it all the more important that they pass these tests, and pass them well.
“Every time policymakers in a deleveraging cycle have become hairy chested and decided that now is the time to teach investors a lesson the fairytale doesn’t end well,” the market analyst said. “The time for hairy chests is when credit is expanding, not contracting.”