A renewed introspection is underway amidst debt market participants of the world that goes to the heart of the political economy of the State. The consequences of these deliberations extend beyond the relatively obscure world of bond trading and spill over into economic growth and stability. At its heart, the question is simple: How should China and Europe deal with their large amounts of debt that is overdue?
With regards to Greece, the answer has been, as the economist Paul Krugman calls with a dollop of irony, ‘an "orderly" default'.
Over the past week, a deal of sorts was struck to swap one type of creditor (the private lenders, who have no gunships and army) for another (the European Central Bank, who have gunships and an army). In the past, this used to be a benign form of gunboat diplomacy. Private lenders (who binged out on lending under the tactical assumption that a Greek bond was equal to a German bond) have ‘agreed' to lose nearly ¤100 billion (Dh485 billion) of previously issued Greek debt. This is done to clean up the banking system and pass the burdens onto a more robust player, the ECB, which has presumably a higher threshold for pain (and a much larger balance sheet). Note, all of this has occurred when Greek economy has contracted 15 per cent over the past year.
Fear is liquidity
This morning, the first day after the agreement to swap lenders, the Greek bonds continue to trade anaemically. Investors expect around 15-19 per cent yield (compared to the low single digits that German trades on). The ten-year trades at 18.9 per cent while the 30 year at 13.9 per cent (an inverted yield curve, if there ever was one). The fear is liquidity (with no one to sell back the bond to) and credit (what if the Greeks refuse to honour future payments?) risk.
To make matters worse, in the past the European governments had tried to intervene in the CDS (credit default swaps) market written on the Greek bonds, which are a form of insurance in case the Greeks default, and render those contracts worth less than they originally are. So, for now, the bigger player has tried to absorb the financial cost of Greek debt.
Massive stimulus
In the case of China, however, there is no bigger player around. Except the global financial markets — which can presumably absorb new Chinese debt. But, the question is about the past debt. From last month, the Chinese government has told its banks to roll-over the debt it had issued to state and municipal authorities over the past four years. When the American credit crises hit, the Chinese responded with a massive stimulus — around $1.7 trillion — that drove into a hole their local authorities with virtually no debt and sufficiently mature mechanisms to investigate performance of lendings. The loans from the Chinese banks are due over the next couple of years and the present decision to defer the loans by 2-4 years strikes to many as the kicking-the-can-down-the-road strategy thanks to policy dissension in the Communist Party. Some have argued that most projects for which these loans had been made are at the 80 per cent completion stage, and so the question is simply one of the "last leg". Others have essentially said, until China's approach to the perpetuation of non-performing loans continues, it is a house of cards.
Non-performing assets
Like Greece, in one sense, the Chinese have an all too familiar a problem: The scale and the timing of the debt has forced their hand. Michael Pettis, at the Carnegie Endowment for Peace, argues that the political pressures in China will force it down the Japan route. [Japan has nearly 233 per cent of debt to GDP ratio, largely funded by the savings of its own people and institutions]. In order to facilitate a move into the global debt markets, China had allowed Shanghai to issue debt last year, but it seems too late make any impact at this stage. For now, the Chinese government will increase its share of the GDP by absorbing more of the non-performing assets.
Another unpopular solution would be to sell off its state owned enterprises to the private sector and use the proceeds to clean up these errant institutions.
Keerthik Sasidharan works for a major European investment bank in New York City. All opinions are personal and don't reflect any institutional perspectives.
