China not immune to zombie borrowers and insolvent banking system

While I have been traveling over the last two weeks, there have been several articles on China that discuss how it has not been immune to zombie borrowers and that like the EU, Japan, UK and US it too has an insolvent banking system. [Examples of articles include excellent Reuters article and Economist article.]

This raises the interesting question of how will China or any other country transition from policies designed to mask an insolvent banking system to policies designed to restore growth to their economy.

Regular readers know China, like the other countries, is pursuing the Japanese Model for handling a bank solvency led financial crisis.

Under this model, bank book capital levels and banker bonuses are protected at all costs.  This shifts the burden of the excess debt in the financial system onto the real economy.  As a result, growth in the real economy slows substantially as capital needed for reinvestment and growth is instead consumed by the excess debt.

Regular readers also know the way for China and the other countries to escape the negative consequences of pursuing the Japanese Model is to adopt the Swedish Model.

Under the Swedish Model, banks are required to recognize upfront their losses on the excess debt in the financial system.  This protects the real economy and insures that capital needed for growth and reinvestment is used for growth and reinvestment.

But what happens to the banks when they recognize these losses.

Those banks that have a franchise that is able to generate earnings after recognition of their losses will continue to operate and will rebuild their book capital levels through retained earnings.

Those banks which don't have the ability to generate earnings after recognition of their losses will be closed down.

But what happens to depositors if there is not enough capital or unsecured bank debt to absorb the losses?

Depositors can and should be protected.  One way to protect them is to transfer their deposits to a bank that is capable of generating earnings.  [For accounting purposes, the "loss" that these depositors would have suffered is also transferred.  This simply increases the amount of retained earnings needed to rebuild book capital levels.]