Financial turmoil is intensifying in China, and it will test the Chinese leadership's unity, resolve and effectiveness. Premier Li Keqiang said March 13 that Beijing would press forward with market-oriented reforms after the conclusion of the annual National People's Congress and Chinese People's Political Consultative Congress, known together as the "two sessions." The legislative stamps of approval on fiscal and financial reforms — as well as social and environmental initiatives — were overshadowed in the media by public security concerns. The attack on the Kunming railway station by ethnic Uighur militants took place March 2, the eve of the sessions. This was followed by the mysterious disappearance of Malaysia Airlines flight MH370 between Kuala Lumpur and Beijing on March 8, sparking speculation of foul play. Amid these events, China's decision to target a growth rate of 7.5 percent in 2014 — instead of a lower rate that would have signaled a more ambitious pace of reform — received little attention from the press.
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However, international financial markets have certainly taken note of other worrisome economic signs in China. For example, the country's first-ever onshore corporate bond default occurred when solar panel manufacturer Chaori Solar Energy Science & Technology Co. failed to make an 89.8 million yuan ($14.6 million) payment that was due March 7. In his March 13 remarks, Li felt the need to assure the international community that China's debts remain under control but that the central government had set a schedule for regulating the booming informal banking sector. Beijing is aware of the need to impose discipline on the markets, but it is also aware of the danger of standing on principle and allowing another Lehman Brothers moment. The central government's default mode is to intervene and backstop a financial cascade as long as it remains able to do so.
The bond default is only the latest in a series of indications that China's slowdown is causing turmoil in different areas as companies lose the ability to evergreen their loans. Defaults, bankruptcies, near bankruptcies and bailouts have struck companies in real estate, coal, steel, shipbuilding, property and other sectors with greater frequency since 2012. This trend gained widespread attention in mid-2013 with the technical default of Everbright Bank. China has dealt with failed wealth management products and other issues through localized, ad hoc bailouts. These have involved first the companies affected, then state-owned banks and asset management companies, and finally even local and central government emergency assistance.
The number and frequency of defaults and bankruptcies are increasing, especially as China resolves inefficiencies in coal and steel and as property prices in second- and third-tier cities appear to be falling. Calendars of debt maturities show that 20 billion to 100 billion yuan ($3.3 billion to $16.3 billion) in trust products will come due every month between now and the end of 2015, according to Bank of America. Morgan Stanley estimates that, in a dire scenario, financial contagion arising from failed trust products could cause a 4.6 trillion yuan credit crunch.
In fact, Beijing has anticipated cascading loan and business failures — these were the inevitable consequence of the past year's promises to deepen economic reform, emphasize quality rather than quantity of growth, cut overcapacity and rebalance the economy toward households and consumers. The Communist Party recognizes that it cannot maintain a permanently interventionist posture that drives growth through state-backed investment. It intends to withdraw somewhat, intervene more selectively and strategically, and let market forces and creative destruction resolve some of the nation's imbalances. In light of the vast post-crisis credit expansion, this posture typically entailed defaults, bankruptcies and, to some degree, layoffs.
What is not known is whether Communist Party leaders and the state bureaucracy will have the unity, decisiveness and effectiveness to go through with reforms and manage these consequences. The financial challenge provides an important example of why Chinese President Xi Jinping began his term with a sweeping party rectification campaign: Party unity and chain of command are necessary not only to implement desirable economic reforms in the long run but also to prevent a party split amid immediate and extreme challenges. As the next waves of bad loans come forward and rattle China's banking system and broader confidence, Beijing's ability to reorganize and restructure debts will be put to the test.
Ultimately, Beijing may prove again — as it did in the late 1990s and early 2000s — that its controls on the financial system are sufficient to manage things in an orderly way. But that seems highly unlikely in today's environment, both in China and abroad. As can be seen from the two sessions' emphasis on improving quality of life and public security, along with fighting pollution and corruption, Beijing faces enormous tasks. The nation's banks provide a critical instrument of control, and without financial stability, China's other problems will be magnified.