China's debt bubble is a corruption bubble

The Financial Times offers what's probably the most bullish defense of the heavily indebted Chinese financial system in recent memory, essentially arguing that China can still grow its way out of its debt pile given its relative poverty, and also that the debt isn't nearly as prone to cascading systemic risk as in the Western financial system in 2007-08 because it's still largely in the form of traditional bank loans, not investment securities (to include exotic leveraged derivatives).

But even beyond this, as I've argued before, the Chinese financial system enjoys a massive guaranteed backstop that its Western counterpart can hardly dream of: it's still essentially an arm of the communist dictatorship.

That is to say, if it ultimately comes down to it, Beijing can relatively easily extinguish vast sums of bad debt by forcing creditors - itself, ultimately - to write it down, eat losses, and accept huge reductions or "haircuts" on what assets are in fact recoverable. Given that all state banks are ultimately under central party control, the top communist leadership effectively dictates just who within the financial system gets a handout and who gets thrown under the bus. If you don't like it, you have little recourse to complain: especially since you can be charged with far worse than mere negligence in managing state funding, you'd probably feel lucky simply to avoid prosecution in any case involving large sums of lost money.

Even more significantly, all this can happen with enough speed and efficiency that it won't have much negative consequence for the country's overall fiscal or credit standing. Debt is, after all, merely paper or electrons: for an autocracy that has a sufficient handle on its social consequences (or regains it if it somehow slips away), it's as easy to make it disappear as it is to create it in the first place.

Of course, there are unavoidable short-term disruptions to any kind or degree of deleveraging. Asset and collateral valuations may be drastically reassessed, triggering volatility in certain market segments. Unproductive "zombie" capital or even whole firms may have to be liquidated with no assurance that the process will be smooth with no unforeseen stumbling blocks. Likewise there may be heavy cleanup costs to dismantling unsound end-product investments, i.e. real estate or infrastructure. All these challenges, however, are to get the real economy on a sounder footing by redirecting labor and capital away from overly saturated sectors and locales to those that warrant more attention as quickly as possible. And in fact it's merely the natural byproduct of solving the real problem of the bad debt settlement: establishing responsibility both for the original misallocation of resources and also for the corrective reallocation.

It should come as little surprise, then, that the anti-corruption campaign has become such a permanent and defining feature of the Xi Jinping administration: China's debt bubble is, at the end of the day, essentially a corruption bubble. Little surprise, too, that the whole effort is led and masterminded by former Beijing party secretary Wang Qishan, a former banker who first rose to national prominence during the Asian crisis in 1998 by fixing the biggest bank failure in mainland China to date (in Guangdong province).

So to conclude: the real focus of those concerned with Chinese financial stability should be the integrity of communist party rule, i.e. just how secure is it? Despite persistent rumors and speculation to the contrary, few in China or outside it can even conceive of a credible challenge to it, let alone organize one. This hardly means the regime's longevity is assured - but it means it hasn't made enough uncorrected mistakes yet for its opponents to capitalize on (even assuming its opponents are just as adept), and if China's history since reform and opening is any guide, don't count on it either.