Analysis | China can deflate the world’s largest credit bubble in an orderly fashion

China’s authorities are committed to orchestrating an orderly unwind of US$3 trillion worth of excess credit and the resultant distressed debt on banks’ balance sheets by employing a multi-pronged, market-based approach.

In our view, there are essentially three alternative paths for resolution. Firstly, let’s consider a government bailout.

Today’s situation is very different from the period 2002 to 2004 when Beijing launched an earlier government bailout of the state-owned banking system. Many of the financial institutions that received support at that time are now publicly listed.

Recently authorities have been deliberate in saying that they do not want to bail out private equity holders. They also recognise that a bailout embeds moral hazard, as it can send the impression of a “sovereign put” that promotes reckless risk behaviour and which also produces poor quality GDP growth.

Secondly, is the concept of “extend and pretend”. After witnessing the lack of restructuring in Japan after their credit bubble in the early 1990’s, and the ensuing 20-plus years of deflation, Chinese authorities have been vocal that this is not a viable path.

Thirdly, is a market based approach similar to the one used by the US in 2008 to 2010. Reducing unproductive debt is necessary to realign the economy and restore longer-term growth.