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China’s Hidden Leverage

eijing’s desire to pump up the Chinese economy is leading it into dangerous territory.
Although China has piled on debt, the country has been relatively cautious about one of the big areas that led to the U.S. financial crisis: leverage. It was the slicing and dicing of mortgages into digestible bite­sized chunks called derivatives that was a key contributor to the U.S. financial meltdown in 2007. Once they unwound, they threatened the banking system itself. Until recently, China has avoided complicated derivatives and other forms of leverage. However, desperate to keep the economy from slumping, the Chinese reluctance to wander down the leverage path seems to have faded.

China’s Fire Sale of the Century

A decade ago, when China was struggling to clean up its banking system, regulators pulled a rabbit out of a hat. They set up a series of “bad banks” – called Asset Management Companies (AMC) – and took Rmb 1.4tn ($125bn) of debt off the hands of the four State Banks in Beijing. It was a big success, leading to the listing of the “Big Four” banks in Hong Kong and a healthier financial system. Now, they’re trying to pull the same trick again – this time across the country.

Can China Bail Itself Out?

Chinese economists are quick to point out that the country has plenty of money to pay off its debts and could easily avert a financial collapse. The government, they say, could function as lender of last resort. How does one confirm whether there are sufficient resources in China to provide adequate capital for a massive collapse in economic activity, including a popping of China’s property bubble?