China and the chaos theory of finance

April 8, 2013

By John Foley

(The author is a Reuters Breakingviews columnist. The opinions expressed are his own)

Will China have a financial crisis? And if so, would Chinese people be any worse off? The answers are not found in the country’s rapidly rising levels of debt, but in the potential for chaos when things go wrong. China is sliding further along the scale of chaotic financial systems, but is not yet in the danger zone.

Financial chaos might be described as the potential for one event to cause other unforeseeable ones. That might happen because of unexpected linkages. Or it might be because people respond to developments in unpredictable or irrational ways. It’s close to what investor George Soros has called ‘reflexivity’. In Soros’ eyes, thinking actors are fallible, and that makes them prone to inappropriate and destructive actions.

A bit of unpredictability in the financial system is a good thing. Freewheeling promotes innovation, and helps capital to go to where it’s needed, rather than where a centralized authority thinks it belongs. Chinese leaders are deeply troubled by the idea of chaos, or ‘luan’, but have tolerated the financial kind occasionally, say by letting in foreign investors, setting up stock markets and occasionally laying off state-sector employees.

Imagine a Financial Chaos index. It starts at zero – total state control in a country where the government is entirely trusted. The authorities can print money to make problems go away, and there are no foreign creditors or trade partners to complain. Now picture a system with a score of 100. It has no trust at all, and its denizens are driven by fear and ignorance. Only gold has financial value. At the height of its own financial crisis in 2007, the United States was probably around 70.

China used to be close to zero. Until 1978, there was really only one bank, the People’s Bank of China, which dispensed investment funds following government orders. Later, new banks were created, but the state retained its virtual monopoly on credit. In that world, it didn’t really matter whether borrowers paid back loans or not. The mandarins, as owners of the whole banking system, could rewrite accounts and make losses disappear.

Twenty years later, things had got more chaotic. Private lenders and foreign investors proliferated. Claims on China’s borrowers were spread more widely, but the system remained pretty simple – probably a 10 on the Financial Chaos index. Even when a financial institution failed and bad debts spiked, trust in the government to make things whole – at least for Chinese lenders and depositors – was absolute.

Then came the big bang. In 2010, banks stepped up a clever trick of repackaging credit into trusts and wealth management products that don’t appear on their balance sheets. This so-called shadow banking has thrived since. Banks are still at the centre of the spider’s web, but the number of people with claims on Chinese companies has widened to include literally millions of depositors.

That means more room for chaos. Say a small business, whose debts were repackaged as a wealth management product, defaults. Tracking down its thousands of creditors would be a nightmare. Moreover, individuals are unpredictable. They might protest angrily if they don’t get their money back. Or stop buying such products, creating a credit crunch. Or pull their savings from banks that sold failed investments, leading to dreaded bank runs.

Despite that, China is probably only a 30-40 on the Financial Chaos index – more uncertain than in 1978, but less than the United States in 2007. That’s because as long as the state can credibly bury bad debts with new money, the financial system can remain more or less whole. At a push, the government could buy all outstanding “shadow bank” lending, estimated at $3.7 trillion. Trade partners and foreign investors would worry; moral hazard would result. But there wouldn’t be a social collapse.

China isn’t totally immune to self-destructive fear and ignorance. Environmental degradation could provoke chaos; so could corruption. Unproductive lending and too much control could harm the real economy, by giving people too much of what they don’t want, and too little of what they do. But provided the level of financial chaos stays low, a credit crisis, even if it does happen, needn’t be an economic one.

 

Comments

The Financial Chaos Index is a fascinating idea. It seems difficult to know at which position a particular economic entity stands in real time because major players have an interest in making it appear that everything is as it should be.

Position on the index might be considered a functional juxtaposition of previously hidden, ignored or unknown risks and the responses to those risks over time.

Consider the multiple risks mentioned in this recent Reuters article regarding the Eurozone:

http://www.reuters.com/article/2013/04/1 3/us-europe-ministers-esm-idUSBRE93C0972 0130413

It is impossible to know at this moment whether the risks will be adequately resolved in a timely fashion. At this moment, either all is well or the Eurozone is quite high on the Financial Chaos Index… and we will discover which is the case at some point in the future.

Posted by breezinthru | Report as abusive
 

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