Who gets to make money and for how long?
Last Thursday China Shanshui Cement Group announced its default on RMB 2 billion of loans. As of this writing it isn’t clear whether or not lenders will be forced to absorb losses but I suspect that the default will be resolved by shareholders.
For much of this year credit spreads have contracted sharply even in spite of strong evidence that credit conditions are deteriorating. This seems to indicate that Chinese lenders are more convinced than ever that credit risk for a wide variety of public and private sector borrowers is effectively eliminated by indirect government guarantees which protect lenders from bearing loss.
Although the problem of moral hazard in China had been much discussed, and for many years, we have generally focused primarily on its impact on the capital allocation process. At the limit, however, moral hazard can have a significant monetary impact too.
If there is a limit to the ability of debt issuers to increase the money supply, what is the limit and what is the sequence of events that gets us there? The most likely limits are probably an elimination of moral hazard, perhaps as the consequence of a large, costly default, the imposition of debt-issuance constraints by the regulators, or an erosion of credibility, a process that can be highly self-reinforcing.
The current global crisis – the first stage of which occurred in 2008 mainly in the US, the second stage in 2009, mainly in Europe, and the third stage, affecting mainly China and the developing world, occurring over a protracted period beginning perhaps in 2013-14 – may be unique in history as the only global crisis to have occurred at a time of credible fiat currencies. This makes historical precedents less than wholly useful in setting out scenarios because it allows wider scope for monetizing debt.
The ability to monetize debt does not mean that the cost of these crises will be less, only that governments may have more tools with which to prevent the disruptive impact of defaults. In fact the historical precedents suggest that countries that are able to monetize bad debts tend to suffer lower growth over the long term than countries that are forced through the process of default.
It is not clear whether there is a limit to credibility in China or whether, like with Japan, credibility is maintained in spite of an inexorable rise in debt, albeit perhaps at the cost of economic stagnation.
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