In the past two months, China has suffered its first domestic bond default in recent history and a series of small bankruptcies that have some investors fretting the country could face its very own “Lehman moment”.
But behind the lurid headlines and fear of financial panic, something more complicated is happening.
These systemically insignificant financial failures are being hyped up by China’s state-controlled media – and then unwittingly amplified by the international press – as part of a campaign of government-sanctioned “Potemkin defaults”.
Led by the People’s Bank of China, the central bank, which has responsibility for maintaining stability in the financial system, Beijing has launched a campaign of highly public, but controlled defaults as a way to tackle moral hazard and impose market discipline.
At the same time, for any bankruptcy or default that could threaten regional or systemic stability, the government continues to step in quietly and co-ordinate loan rollovers and bailouts.
That is not to say the small defaults that have happened are fake or there are no serious risks in the debt-laden Chinese system.
The risks have ballooned as China has added new credit roughly equal to the size of the entire US banking system in just the past five years.
Total debt as a percentage of GDP has increased from 130 per cent in 2008 to about 220 per cent at the end of last year, according to estimates from Fitch Ratings.
An increase of that speed and scale has almost always been succeeded by a crisis in other economies.
The big concern in China is that much of the debt build-up – as much as half of all credit extended last year by some estimates – has happened in the opaque and lightly regulated “shadow banking” sector.
Shadow banking in China is much less sophisticated or toxic than the financial engineering that happened on Wall Street before the 2008 financial crisis and its capacity to shake the broader system is also a lot more limited.
But that does not mean investors should not worry.
Much of the credit coming from the shadows goes to risky, high-interest loans to struggling property developers, steel mills or glass factories that cannot borrow directly from the more regulated state banks.
A sizeable portion of these multiyear loans are then repackaged into poorly documented financial products with maturities of just several months.
These are then sold through banks to ordinary investors with promised returns that are well above government-capped deposit rates.
When pressed by the regulators, banks insist any risk associated with these products is borne by investors but the vast majority of investors believe these products are ultimately guaranteed by the state.
After all, they were sold by state banks, sometimes with explicit but illegal guarantees from overeager salespeople, and until recently the government has always stepped in at the last minute to make sure these products do not collapse.
Speaking to the Financial Times on condition of anonymity, a senior Chinese official explained the dilemma in this way:
“On the one hand, if we really want to have a modern financial sector and a proper corporate bond market then we can’t continue to have zero defaults forever. But if there is a very sudden withdrawal of funds from the shadow banking sector it could create a serious macro problem.”
Given relatively low levels of central government debt, Beijing probably has the capacity to stave off a Lehman-style crisis by printing money and bailing out collapsing shadow banks in the event of a run on the system.
The overall financial system could also be stabilised as investments pulled out of risky shadow products were put back on deposit at the state banks.
But China’s economy is extremely reliant on credit-fuelled investment, particularly real estate investment, which directly accounted for around 16 per cent of gross domestic product last year, a level approaching Ireland’s or Spain’s before the financial crisis.
In a situation where shadow bank funding dries up for risky real estate, steel and cement projects, China’s biggest problem would not be a financial crisis; it would have a growth crisis as new investment disappeared.
This is why the government is trying desperately to manufacture some high-profile model defaults.
If Beijing can use these examples to convince investors to pay attention to risks while simultaneously stopping those risks from becoming reality, then it will have pulled off a remarkable feat.