In the latest sign that China is pressing forward in it’s efforts to revamp the country’s financial system, Chinese regulators have begun experimenting with allowing several debt defaults to occur in an effort to reduce reckless lending and introduce market forces into the system of capital allocation. Following the several cooperate bond defaults and a rare bank run at Jiansu Sheyang Rural Commercial Bank, the China Securities Regulatory Commission is planning for a new division to regulate the fast growing corporate bond market with a goal of creating default rules and allowing market forces to decide who fails and who doesn’t.
A Peoples Bank Of China official commented, “As long as there is no systemic risk, some defaults resulting from market forces will be allowed. This will encourage market discipline and correct the behavior of the issuers and the investors.” The Chinese credit market has been criticized as being outdated, with the government playing too large a role in preventing defaults. These characteristics have encouraged the reckless lending practices that may begin to cause real issues in the Chinese economy as the economy slows, returns begin to dwindle, and the high risk loans begin to fall.
In place of the previous implicit government guarantee that the government would step in if bankruptcy occurred, the Chinese government is expected to introduce a deposit-insurance program this year. While allowing these defaults to occur may be painful, it seems to be a necessary step in China’s attempt to liberalize and modernize it’s economy to allow for continued growth.
Source: Lingling Wei, China Tries Allowing Defaults, The Wall Street Journal, 3/26/2014