All financial crises occur for one reason: too much debt. We are seeing the endless drama with this issue in regard to Greece. Investors and banks lent Greece a lot of money based on the assumption that it was Germany. This assumption is rather silly in retrospect, but the result is that Greece, not being Germany, can't pay its creditors back the full amount that it owes. This causes a problem.
In the US we experienced a similar issue. Lenders lent money to home owners based on the assumption that house prices would go one way: up. Worse through the magic of modern finance, the debts multiplied beyond either reason or even sanity and then were sold, not just in the US, but around the world. In retrospect this also turned out to be a bad idea.
Still the issue was not the form of the loans. Whether the debts were sovereign, as in the case of Greece, or collateralized debt obligations (CDOs), as in the case of US mortgages, in the end made little difference. They are both debts. The point was that an awful lot of lot of money was lent to debtors who could not pay the money back.
What is really interesting about financial crises though is not the cause. It is the trigger. The problems of Greece were not a secret. Perhaps the extent of the problem was, but the issue itself did not become obvious until the world went into recession and creditors decided that they wanted their money back. The same is true with the US housing mess.
The savage lending that led to the bubble could have gone on much longer than it did. If the creditors had never started to doubt the safety of their investments the lending would have certainly continued. If the creditors just assumed that everything was fine and did not try to collect, not much would have happened. Panics start when everyone tries to be the first out the door.
Now let us consider China. The Chinese government required its state owned banks to flood the country with loans, in excess of 4 trillion dollars since the beginning of 2009. Most of these loans went to either state owned companies or local governments. It was not only the banks that lent the money. The provinces and cities also created scads of finance vehicles to get around the lending limits. This lending binge was encouraged by the central government in Beijing to the extent that the loans were considered almost a patriotic duty, until now.
It should hardly surprise anyone that many of these loans went bad. When this amount of money goes out the door, much of it will end up in the wrong place. This is especially true of China where loans are made for political and not financial considerations.
But investors need not worry. This particular pile of toxic lending waste will not melt down. Why? Simple, the creditors are not rushing to the door. The great thing about the state controlled lenders is that they do what they are told. In this case they have been told not to try and collect the loans, just roll them over. If there is no panic and no one actually tries to collect the loans, then there is no reason to believe that their value has declined.
Is this a problem? Many commentators dismiss it. After all unlike Greece, Europe or the US, the Chinese economy is rapidly growing at a projected 8%, so it can easily absorb these bad debts. But one wonders that if the Chinese economy were not flooded with cheap loans whether it would be growing as fast.
It has also been suggested that the problem is nothing more than a flawed national financial system that needs to be reformed. If the provinces and cities could have issued bonds rather than borrowing from banks all would be well. The problem is now being resolved because a handful of cities are being allowed to issue bonds.
Exactly why bonds would be better than bank loans is not exactly clear, at least to me. It seems both are debts and both can go bad. But bad loans are not the problem. According to a Chinese investment banker, calling in the loans would be the "surest route to trouble"
But of course this entire assumption is just as absurd as the assumption that Greece is Germany or that housing prices won't go down. No matter the form, a bad debt is a bad debt. It is money that could have been used more efficiently elsewhere. It prevents further stimulus and stymies growth. So maybe the Chinese have avoided a crash, but don't expect growth either. Over time quick dramatic pain might have been the better option.