Zhou Xiaochuan, the long-serving and respected governor of the People's Bank of China, raised eyebrows last week when he cautioned that the country could have a “Minsky Moment” if “we are too optimistic when things go smoothly”.
Zhou Xiaochuan, the long-serving and respected governor of the People’s Bank of China, raised eyebrows last week when he cautioned that the country could have a “Minsky Moment” if “we are too optimistic when things go smoothly”. Although he was right to warn against policy complacency and general economic overconfidence, particularly in the context of a growth model that still relies too heavily on credit and debt, the Minsky threat of a financial crisis per se is lower than the risk of generalised downward pressures on economic growth should the policy effort falter. The “Minsky Moment”, a term coined by my former colleague Paul McCulley at Pacific Investment Management Co., refers to a tipping point when a prolonged period of stability leads to unsettling financial volatility. It is the culmination of what the economist Hyman Minsky labelled a period of “Ponzi finance”, as risk-taking and economic activity are financed overwhelmingly by credit and higher leverage. It is fuelled by booming debt encouraged by both lender and borrower overconfidence in continued financial stability.
Coming at the end of the multistage Minsky cycle, it engenders dislocations, including a sudden destabilising collapse in asset prices and markets. In the past decades, the notion has been used to shed further light on the debt cycles experienced by developing countries whose weaker institutional structures left them more vulnerable to alternating periods of financial feast and famine. This includes the financial and economic “sudden stops” that characterised the 1997 Asia crisis and the Russian default of 1998.
The concept was also applied to the 2008 global crisis that originated in the developed world and disrupted the financial system’s sophisticated payments and settlement system (once thought improbable if not unthinkable), and took the global economy to the edge of a multi-year depression. Zhou is right to point to the growing risks associated with the rapid rise in total debt in China and, more generally, financial risk-taking by Chinese households, corporations and local governments. Indeed, some of the numbers are truly striking, including a near doubling in debt to gross domestic product in the last 10 years during a period of declining, albeit still high, economic growth.
As notable as growing indebtedness and financial risk-taking are in China, they do not automatically translate into a near-threat of a typical Minsky Moment for a simple reason: Forced deleveraging, the main driver of the traditional Minsky Moment, is unlikely in the Chinese context. One way to illustrate this central point is to ask who would force the deleveraging that, accompanied by plummeting asset prices, would fuel indiscriminate panic sales, credit freezes, and cascading breakdown in payments, settlement and general financial confidence. The usual culprits in the developing world are jittery foreign investors, undercapitalised banks, overstretched non-bank financial actors, overvalued exchange rates and low international reserves.
The amount of foreign portfolio money invested in China is relatively low and difficult to move rapidly. Banks are subject to heavy regulation and moral suasion. The government has ample local and foreign exchange resources to use to stabilize the financial system. The exchange rate is not overvalued in a fundamental sense. And the authorities have also already shown a willingness and ability to manage capital outflows in an orderly fashion through the use of a range of instruments.
But this is not to say there are no risks. There are, and they relate mainly to the ongoing transition in the growth model. Simply put, it takes China too many units of debt to generate a unit of growth. The longer this continues, the greater the doubts as to whether the incremental income generated in the future will prove sufficient to meet the ballooning debt service obligations. Should such circumstances prevail, both actual and potential growth would be negatively affected over the longer-term, also undermining the political legitimacy of the governing Communist Party.
Rather than shine a spotlight on a fragile financial system, Zhou’s warning should be seen as emphasising the need to accelerate—and render more effective—the broader middle-income economic development transition that China is currently undergoing. It is a message that the politicians, rather than financial market participants, need to hear, internalise and respond to.