Good news; Chinese defaults are rising rapidly
By Scott Sumner
No, this headline does not reflect any ill will toward the Chinese economy, rather I am celebrating a rare victory in the war on moral hazard.
In the US, the problem of moral hazard seems to be growing worse over time. It began with FDIC insured bank deposits. Then the doctrine of “too-big-to-fail “was added. Then Fannie Mae and Freddie Mac were implicitly backed. Later, their backing was made explicit. Now there’s talk of bailing out student borrowers, and pension fund bailouts may be coming down the road. Federal flood insurance encourages construction in flood prone areas.
I have frequently argued that moral hazard plays a big role in modern financial crises, but it’s hard to get other economists interested in the problem. Most seem to treat it like a minor concern.
Therefore it’s nice to see a major economy taking important steps against moral hazard:
China’s had another record year of corporate bond defaults. That’s not a crisis. It’s a plan.
A decade ago, defaults almost never happened, but that wasn’t because companies in China were always healthy. It was a reflection of the tightly controlled financial system, where companies were often linked to the government and bonds were largely bought by state-owned lenders. Authorities have often stepped in to ensure that financially troubled enterprises didn’t crash into default, out of concern over social unrest in the event of job losses or missed payroll payments.
This system imposed little discipline on borrowers. Now global investors are coming into China’s bond market. Though many companies are still state-backed, policymakers are getting more comfortable with defaults. Without them, bond buyers would have little incentive to make a careful assessment of a company’s creditworthiness.
Government guarantees of debt obligations lead to inefficient investment decisions. In China, this has shown up in the construction of numerous “ghost cities”, such as the Binhai area of Tianjin. I visited this area in August, and snapped a picture of a forest of empty skyscrapers:
If the Chinese government is serious about allowing debt defaults, it will reduce the incentive of investors to misallocate resources. This should make China’s economy more productive.