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72 Deleveraging, What Deleveraging
which typically provides an incentive for explicit defaults. A more likely scenario
for China is a combination of inflation and currency depreciation that indirectly
shifts the burden of the adjustment to foreigners.
In order to contain systemic risk, the Chinese government may choose to
bail out some major players (either financial or non-financial) if high debt and
slowing nominal growth result in some over-leveraged large entities getting in
trouble. However, even if such bailouts stemmed from systemic risk, it would not
be a free ride. Indeed, a combination of public bailouts and the likely burning
of private shareholders would correspond to a diminished propensity to lend in
the private sector and an increased perception of risk that would compound the
slowdown in activity. The consequent deleveraging would be accentuated should
there be, as looks likely, a sequence of relatively ‘small’ defaults by individual
private entities, which the government calculates would not threaten financial
stability. Although not systemic, these defaults could still affect confidence and
thus activity levels.
If rapid leveraging up was indeed the reason why China kept growing at a
slowing, but above potential, rate since 2008, a phase of deleveraging through
slower credit formation would imply a significant slowdown, with growth
possibly falling below potential. Even a Chinese ‘Type 2’ crisis that avoided
severe financial disruption but generated a significant growth slowdown would
still have a global impact. The difference with the post-2008 crisis would be
in the transmission channel: while the financial spillovers were the main
transmission channel to the rest of the world in the advanced-economy crisis,
the international transmission of deleveraging in China would primarily operate
through lower demand for global exports. Given the prominence of China as a
source of export demand in recent years, this would have a material impact on
global growth performance. Furthermore, the combination of a trade slowdown
and a renminbi depreciation could also generate international political economy
tensions by triggering renewed debate about ‘currency wars’.
It is also possible to envisage more adverse scenarios in which the Chinese
authorities decide to fight the ongoing structural slowdown by maintaining the
pace of leveraging up of the economy of recent years. Such a choice would increase
the likelihood of a postponed, but abrupt ‘Type 3’ crisis down the road, as after
another few years of rapid leveraging up even China would be unlikely to have
the resources to achieve a gradual deleveraging process. Chinese policymakers are
likely to remain for some time between the ‘rock’ of slowing nominal growth and
the ‘hard place’ of high and rising leverage.
The ‘fragile eight’
Recent market concerns have focused on the so-called ‘fragile eight’ (Argentina,
Brazil, Chile, India, Indonesia, Russia, South Africa and Turkey) for which various
types of risk indicators have shown significant movement since 2010, even if
the individual circumstances of these countries are quite diverse. Accordingly,
we also examine the behaviour of two subgroups of emerging economies (EM1
and EM2), where EM1 consists of the ‘fragile eight’ and EM2 consists of a second