Does size matter?

CHINA FINANCIAL - In Brief 09 Jul 2015 by Michael Pettis

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The Chinese stock market panic is unlikely to trigger a financial crisis in China, but not, as many argue, because of its relatively small size and narrowly dispersed ownership. What matters is that although nationally there are significant mismatches between assets and liabilities among individual institutions and within particular sectors of the financial services industry, and these mismatches are highly pro-cyclical, China is protected from crisis by its relatively closed capital account, its high level of reserves, and most importantly of all, the fact that much of the mismatch between assets and liabilities are resolved on a system-wide basis through Beijing’s implicit or explicit guarantee of most components of the country’s financial system. China is protected from the risk of financial crisis, in other words, mainly by Beijing’s credibility, which remains very high. Without this credibility, more than three decades of rapid growth accommodated by a financial system designed for credit expansion has left the country with what would otherwise be an extraordinarily vulnerable balance sheet. Inevitably as the country unwinds the balance sheet mismatches, debt has grown more quickly than expected and the economy more slowly in a mutually reinforcing process. This will continue as Beijing rebalances the economy, temporarily increasing the country’s underlying vulnerability until it is able to rein in credit growth and resolve the uncertainty about how the growing gap between debt servicing costs and debt servicing capacity is assigned. As long as the credibility of the implicit Beijing guarantee is maintained, however, I think that while China suffers from excess de...