What Alan Greenspan thinks of China's ills

Alan Greenspan, the longest serving chairman of the US Federal Reserve, was considered the greatest central banker who ever lived until the spectacular meltdown of the American housing market three years after his 2005 retirement.  

Bob Woodward, the famous Washington Post journalist who brought Richard Nixon down, described Greenspan as the maestro in his hagiography. Mervyn King, the former governor of the Bank of England, said Greenspan’s "departure from the central banking scene will deprive us of a source of wisdom, inspiration, and leadership", according to Neil Irwin’s The Alchemists: Inside the Secret World of Central Bankers.  

Under his watch, the US experienced one of its longest uninterrupted periods of growth during the 1990s and early 2000s, known as the Great Moderation. But he failed to foresee one of the biggest financial events in his long career -- the great crash of 2008.  

Many commentators and analysts are increasingly drawing parallels between the US before the meltdown and the current economic woes in China. It has become quite fashionable to use doomsday terms from the great crash -- like "Minsky moment" or "Lehman moment" -- to describe the Chinese economy.

So what does Greenspan make of the debt problem in China now? The humbled former maestro admitted to Chinese media that something was fundamentally wrong with his conceptual framework of the way the economy works. Then he went on to provide his diagnosis of China's ills.

Greenspan on Chinese debt

"The problem with the Chinese economy is, as I see it, that you had a very major expansion in debt in the so-called shadow banking system that has been well beyond anything which is stable and continuing," Greenspan told Sina Finance.

He explains that the greatest problem is the implicit guarantee that the government and the central bank will bail out banks and other institutions if they are in trouble -- even though they are making commercial loans and engaging in off-balance sheets lending.

"Indeed, if you hold that view then the risk involved in taking on these types of credits is minimal. Why? Because in fact you have this near $4 trillion in reserves and that is readily available and very liquid. And a large chunk of it is in US dollars and euro," he said.

However, that implicit 'too big or too small to fail' policy is under challenge. Beijing is trying to juggle a delicate balance of teaching a much-needed lesson in moral hazard as well as maintaining confidence in the overall financial system. And trust is in short supply at the moment.    

The country had its first corporate debt default in March since the market first developed in the 1990s. "The Premier has said effectively that the government is going to be in a position where failures are going to be allowed to happen," said Greenspan.  

Greenspan on creative destruction in China

The former Fed chairman applauds the decision by Beijing to allow corporate defaults to happen and argues it is healthy for a quickly expanding market economy, which will encourage the process of creative destruction.

"I think he [Premier Li] understands that if you want to have a vibrant and growing economy you have to allow inefficient firms to be liquidated and phased out of the system.

"It is called creative destruction in the sense that you can only gain in productivity if you have the savings of the society being invested in cutting-edge technologies. And that you allow those obsolete elements of the economy to be gradually phased out."

A lot of Chinese companies and especially state-owned enterprises from industries that suffer from chronic excess capacity issues are essentially on life support from state-owned banks. Local governments also often use their administrative power and political sway to keep loss-making companies humming along to maintain employment.

"And there is no future in that," Greenspan forcefully points out.

Greenspan, who has befriended many leading Chinese policymakers including former premier Zhu Rongji and the current central bank governor, said he believed there was increasing awareness among China’s political elites about the need to allow market forces to play a more important role in the economy.

He speaks highly of two Chinese policymakers: Zhu RongJi, the former economic tsar who implemented bold, state-owned enterprises reforms as well as China’s ascension to the World Trade Organisation; and Zhou Xiaochuan, the governor of the Chinese central bank, who has been leading the charge for reform in the financial sector including through the liberalisation of interest rates.

"He [Zhu Rongji] was not a fan of state-owned enterprises," Greenspan said. "He said we have to change, and he understood that."

Under Zhu’s watch, thousands of inefficient state-owned companies were shut down and tens of millions of government employees were laid off.