Tackling Moral Hazard in China’s Financial System

This striking confidence in the presumed “security” of risky assets has led Chinese households and corporations to take more risks than they fully understand—and to exuberantly push forward the development of China’s banking and shadow banking sectors, its real estate market, and its stock markets.

Excessive debt financed investments, says Zhu, have led to overcapacity and the accumulation of corporate debt. Yet many imprudent investments will eventually turn out to be insolvent, which will yield even more bad debt problems and exacerbate the fragility of China’s banking sector. Zhu is Deputy Director of the National Institute of Financial Research, and Oceanwide Professor of Finance, at the PBC School of Finance at Tsinghua University, on leave from the Shanghai Advanced Institute of Finance, where he is a deputy dean and professor of finance.

Zhu’s short policy memo explores and explains why Beijing’s affection for GDP growth targets, in particular, will inevitably lead to excessive government support and guarantees for unsound investments. He elaborates why he believes that many of China’s current economic problems, not least overcapacity and debt, have their roots in the moral hazard associated with the Chinese government’s implicit guarantee against insolvency. His memo proposes six policy measures that, in his view, could help to eliminate, or at least alleviate, this underlying moral hazard problem in China’s financial system.