Key Points on China: The Bubble That Never Pops – Thomas Orlik

As an Emerging Markets analyst, the issue on China has always been divisive. On one side, the bear points to high household and corporate leverage, alongside local government opaque finance vehicle that masks the true government borrowing. But on the other hand, the bull has gained the higher ground in the past decade as much of the fear that real estate bubble and non-performing loans will bring down the economy failed to materialize.

In the book, Thomas Orlik highlights the argument from both side and argue that Chinese policymaker’ creativity in solving Chinese problem has been underestimated by the bear. Mr. Orlik also points out the increasingly difficult position for China to “grow out of its problem” as leverage is now coming from a much higher base compared to before the GFC and growth rate is slowing down.

Below are some key points I highlighted while reading the book to serve as a reminder to myself and a base for expanding the research on China’s outlook. I highly recommend global macro analyst to read the book and understand the two side of arguments on China.

That borrowing has kept the wheels of the economy turning, paying for an investment boom that offset the export bust from the 2008 financial crisis. Now it has run too far, leaving banks overexposed, state-owned enterprises and local government borrowers overstretched. Close to 4 out of every 10 yuan in national income are required for debt servicing. Even in the US on the cusp of the great financial crisis, debt costs didn’t rise that high.
In the years ahead of the great financial crisis—the Lehman shock that pushed the world’s major economies into recession—China was already running off-balance. The combination of the one-child policy (which reduced the requirement for spending on children and increased the need for saving for old age) and an inadequate welfare state (which pushed families to self-insure against risk of unemployment and illness) drove the savings rate higher. A high savings rate meant consumption was weak. The economy leaned heavily on investment and exports as drivers of growth. As the crisis hammered global demand, exports evaporated and reliance on investment increased. A state-dominated banking system and industrial sector, combined with creaking government controls on how credit was allocated, meant lending and investment were groaningly inefficient. In the years before the 2008 crisis, 100 yuan of new lending generated almost 90 yuan of additional GDP. In the years after, that number fell below 30 yuan. More and more credit was required to produce less and less growth.
  Bottom-up estimates—based on parsing the balance sheets of listed companies—suggested that more than 10 percent of loans were already at risk of default. China’s decades of double-digit growth, which had enabled it to outrun past financial problems, were receding into memory. Far-reaching reform of creaking state firms might shift the economy back onto an accelerated growth trajectory, and increase efficiency of credit allocation. The Xi administration, however, appeared more focused on strengthening the ramparts of the state than on tearing them down.
  Xi’s deleveraging campaign wouldn’t be easy, but China still had important points in its favor: A high domestic savings rate, combined with controls on households taking their funds offshore, meant the banks could count on a steady inflow of cheap domestic funding. Financial crises typically start when banks’ funding dries up. In China, that was unlikely to happen. Average incomes were scarcely a third of the level in the United States—meaning there was abundant space still to grow. No one expected a return to 10 percent annual GDP growth. Expansion at 6 to 7 percent was attainable, and would mean more profits for business, income for households, and tax revenue for government—all money that could be used to pay down debt. A decade of reforms had shifted China from government-set to market-set interest rates, under-valued to market-priced currency, financial autarky to managed cross-border capital flows, and crude loan limits to a modern price-based monetary policy. All of those transitions promised to increase the efficiency of credit allocation, breaking the spiral of ever-increasing lending to pay for ever-decreasing growth. In the real economy, rapid gains in household income, and the rise of the labor-intensive and capital-light services sector, held out the promise of a virtuous circle of rising consumption, higher employment, and less dependence on debt-fueled investment. China’s policymakers are not all-knowing or all-powerful. They do have an unusually extensive and powerful set of tools they can use to manage the economy and financial system, and experience dragging major banks back from the brink of crisis.
  Starting around 2012, China’s banks began aggressively moving loans off the balance sheet. Reclassifying loans as investment products enabled them to dodge regulatory controls on loan-to-capital ratios, as well as policy campaigns aimed at cutting off funds to firms operating with too much debt, or producing too much pollution. Poring through 2016 financial reports from 237 lenders, analysts at Swiss investment bank UBS found some 14.1 trillion yuan in shadow loans (equal to about 18.9% of GDP), up from less than a trillion yuan in 2011.2 Tighter credit conditions have pushed cash-strapped firms into slower settlement of accounts—repaying loans from banks ahead of bills from suppliers. Accounts receivable for China’s big industrial firms rose to about 12.7 trillion yuan in 2016 (17% of GDP), up from 7.1 trillion yuan in 2011.3
  Based on National Bureau of Statistics data, as of 2016 total borrowing for state industrial firms was about 67 percent of GDP.4 The International Monetary Fund put it at 74 percent of GDP.5 The real total might be higher still. As the China experts at research firm Gavekal Dragonomics note, the bulk of accounts payable represents bills owed by state firms to their private-sector suppliers—a hidden debt pile for the state sector (and a hidden tax on private firms waiting to be paid for their work).
  China’s firms used their borrowing to fund investment in the capital stock—infrastructure and industrial capacity—expanding the economy’s growth potential. China’s capital stock in 2008 was about the same level as the United States in the 1950s.7 Starting from a low base, China’s corporates had a decent shot at making productive investments, generating returns that could be used to repay borrowing.
  The cycle is a familiar one. Cheap credit drives aggressive investment. Aggressive investment results in excess capacity. Excess capacity means that prices and profits fall. Chief executives who enjoyed spending borrowed funds on the way up find that repayment is difficult on the way down. The problem of moral hazard—the assumption that deep-pocketed government backers will always repay loans to state-owned firms—compounds the difficulty. With the chances of default low, credit is priced too cheaply and allocated too carelessly.
  The question is, does 37 percent represent an accurate picture of China’s government debt burden? It doesn’t. The Ministry of Finance adopted a narrow definition of official borrowing including only central government debt, and the fraction of local government debt for which the central government has accepted responsibility. A complete accounting would include off-balance-sheet borrowing by local governments, and bond issuance by the government-owned policy banks that finance major infrastructure projects. Adding in borrowing by Dongbei Special and China’s 19,272 other big state-owned enterprises, unfunded liabilities in the public pension system, and the potential cost of recapitalizing the banks would push the number higher still.
  Central to that struggle between the center and the provinces: control of the budget. In 1994, fearing that China’s reforms had stripped central government of the funds it needed to exercise effective control, then–vice premier Zhu Rongji realigned responsibility for taxing and spending. Local governments were left carrying the burden of paying for social services. Beijing grabbed the lion’s share of the tax take. Caught between diminished revenue streams and expanding spending obligations, local cadres had to find a way to make ends meet. The beginning of a real estate boom, combined with a state monopoly on ownership of land, provided an ugly but effective solution. Land sales by the government to property developers became a major source of funds. At the same time, the creation of off-balance-sheet financing vehicles allowed local governments to evade controls on direct borrowing, tapping the banks for credit.
  Given that both bond issuance by local financing vehicles and infrastructure spending financed by them had continued unabated, a drop in debt appears implausible. The likely explanation: under pressure to contain the problem without denting growth, officials had resorted to an accounting trick—reclassifying a chunk of local government debt as corporate debt. How high had debt actually risen? Diving into the balance sheets of local financing vehicles, a team of academics led by People’s Bank of China advisor Bai Chong’en has a stab at the answer.13 They estimate the stock of local government debt in 2015 at about 45 trillion yuan (64 percent of GDP).
  At end 2016, China’s three policy banks had liabilities of 21.7 trillion yuan, or 29 percent of GDP. Adding up central government debt, local government debt, and borrowing by the policy banks puts China’s public debt at 130 percent of GDP in 2016.
  The official data put the 2016 budget deficit at 3.7 percent of GDP. As with the Ministry of Finance’s take on the debt level, that reflects a strict definition of government borrowing. Taking account of off-balance-sheet borrowing, funds for infrastructure spending, and land sales, the International Monetary Fund calculated the “augmented deficit” at 10.4 percent of GDP.
  Based on data from the National Bureau of Statistics, total debt for real estate developers came in at about 48.9 trillion yuan at the end of 2016, up from 10.5 trillion in 2008. Mortgage lending—including loans from a government fund for homebuyers—rose fast as well, climbing to 27.9 trillion yuan in 2016, up from about 4.5 trillion yuan in 2008. Putting those numbers together, total lending to the real estate sector rose to 76.8 trillion yuan (103 percent of GDP) in 2016 from 15 trillion yuan (47 percent of GDP) in 2008.
  China’s stimulus was overdone. The alternative—inadequate stimulus and recession—would have been worse.
  In particular, three forces began eroding the stability of banks’ funding base and eating into net interest margins—the gap between the deposit and loan rates, which is the main source of profitability. Wealth management products (WMPs)—a new type of retail savings product—forced banks to compete for funds by offering higher returns to investors. Technology giants Alibaba (Amazon with Chinese characteristics) and Tencent (an online behemoth combining the features of WhatsApp, Twitter, and PayPal) launched massive online money market funds, sucking cash away from deposits. And the People’s Bank of China (PBOC) made steady progress on liberalizing interest rates—taking banks from the cozy world of low-government set deposit rates and high-government set loan rates into a more competitive world where the cost of funds rose and interest margins narrowed.
  For the big state-owned banks, exposure was limited. ICBC, China Construction Bank, Agricultural Bank of China, and Bank of China—collectively known as the big four—had already achieved sufficient scale, and could count on a too-big-to-fail national brand, and an extensive branch network, to continue soaking up deposits. WMPs accounted for just 9% of total liabilities. For the next tier down—banks like China Merchants and China Minsheng, known as the joint stock commercial banks—it was a different story. China’s second-tier banks combined commercial orientation, aggressive expansion plans, and a more limited branch footprint than their big-four rivals. That pushed a greater reliance on WMPs to fund expansion. For the group as a whole, WMPs at the end of 2016 equaled about 27 percent of total funding. For the most exposed, the total was above 40 percent
  Banks are forced to provide higher returns to household savers, boosting their income and speeding China’s transition to a consumer-driven economy. Given the difference in returns between WMPs and one-year deposits, in 2016 investors earned about an extra 870 billion yuan on their savings—equal to more than 1 percent of GDP. Over time, higher household income will catalyze China’s rebalancing, reducing dependence on investment and exports as drivers of growth. When banks pay competitive rates for funds, they have to charge competitive rates to borrowers. Efficient, productive firms will be able to pay; others will not. The result should be a process of creative destruction, where the strong survive and the weak are winnowed out. For the reformers at the PBOC, the hope is that interest rate liberalization will be the ratchet that engineers improvements in efficiency across the economy.
  A typical WMP promised to invest funds in a combination of bank deposits (completely safe), the money market (very safe), and bonds and loans (some safe, some less so). In 2017, three-year fixed-term deposits paid just 2.75 percent, money market instruments 4.7 percent, and three-year government bonds 3.6 percent. None of those would get returns up to the 4.9 percent return promised by products like Sunflower, let alone give banks a margin on top of it. To get to the required level of returns, asset managers would have to invest in high-yield corporate bonds and loans to low quality borrowers. Those investments certainly juice returns. Five-year corporate bonds with an A+ credit rating yielded 8.1 percent in the third quarter of 2017. Shadow loans could pay even more. The trouble is, they are long-term and illiquid, and carry a higher risk of default.
  There have, undoubtedly, been multiple defaults on loans from the WMP pool. Banks absorb those losses in lower profitability, rather than passing them on to investors in lower returns. The benefit is that confidence remains high and funds continue to roll in. The cost is that the entire system is underpinned by moral hazard—the false belief that deep-pocketed, government-backed banks will always make investors whole.
  The parallels between the S&Ls and China’s joint stock commercial banks are clear. Both responded to the deregulation of the financial sector by dashing for growth. Both expanded fast by turning away from safe, stable deposits toward higher-cost, more volatile sources of funds. Both tried to offset a higher cost of funds by reaching for higher returns with loans to risky projects. Both operated in an atmosphere steeped in moral hazard. The S&Ls had their federal deposit guarantee. Chinese households assumed that any funds invested in a product issued by a state-owned bank were backed by the government.
  The term “shadow loans” evokes images of pawnbrokers, peer-to-peer lending platforms, and other shady operations. In fact, most of China’s shadow loans originate with the banks. Here’s how a typical loan is put together: The bank has extended credit to a low-quality borrower, often an ailing industrial firm like Dongbei Steel, or local government financing vehicle borrowing to pay for an infrastructure project. Regulatory requirements make it too expensive for the bank to maintain the front-door lending relationship. The borrower might be in danger of defaulting on its existing loans, and the bank loath to report an increase in nonperforming loans. Or they might be the target of a government campaign against high pollution or some other evil. Cutting the borrower off entirely might push it into bankruptcy and trigger a default—not a desirable outcome. Instead of breaking the relationship, the bank finds a back-door workaround by inserting a shadow lender into the transaction. The shadow lender—typically a trust or asset manager— acts as a shell company, masking the true nature of the transaction. The shadow lender provides a loan to the low-quality borrower. The loan is then securitized, with the bank buying a security from the shadow lender giving it a claim on the borrowers’ repayment of interest and principal.
  In effect, the bank has made a loan. On the balance sheet, it appears as an investment in a security issued by the shadow lender. In some cases, in a final step, the shadow loan is included in the pool of WMP assets sold to the bank’s retail investors.
  Subprime mortgage origination in the United States rose from about $100 billion in 2000 to about $600 billion in 2006, taking the total over that period to about $2.4 trillion, or 17 percent of GDP.5 In China, shadow bank lending rose from 420 billion yuan ($62.5 billion) in 2010 to 8.8 trillion yuan ($1.3 trillion) in 2016. The amount outstanding was 27.2 trillion yuan ($4 trillion), or about 36 percent of GDP. The US subprime crisis shook the world economy. A Chinese shadow banking crisis could break it.
  “My father,” said Deng’s son Deng Zhifang, speaking in late 1990, “thinks that Gorbachev is an idiot.”7 What had Mikhail Gorbachev, the General Secretary of the Soviet Union and the man who presided over its collapse, done to earn Deng’s contempt? Gorbachev’s mistake: attempting political and economic reform—glasnost and perestroika—at the same time. As a result, he lost control of the levers of power, losing both political control and his ability to fix the economy. For China, Deng had chosen a different road, ensuring that the Communist Party maintained its monopoly on power and using that power to steer a path to a more efficient economy.
  conservatives had always feared that economic reform would prove the thin end of the wedge, with rising wealth driving demand for increased political freedom, and an expanding role for the market eroding the legitimacy of Communist rule. The events of 1989, when economic instability and political discontent fused into social upheaval, appeared to confirm their darkest imaginings.
  Even as banks moved closer to commercial operation and—a few years down the line—full-blown initial public offerings, nothing would dent the Party’s control of their operations. Banks’ role in managing China’s development strategy, and smoothing the ups and downs of the growth cycle, was too important to allow them to become fully privately owned or market-oriented. “Like the People’s Liberation Army,” said one cadre during the 1998 reforms, “the banking system would remain a preserve of the Party and subject only to its control.”
  For China’s leaders, the experience of the first half of the 1990s confirmed the lesson they had learned at the end of the 1980s. The Chinese people must be provided with a soft landing; an overheated economy cooled slowly. The experience of the second half shows that they knew not to waste a good crisis. Asia’s meltdown would provide the catalyst for root-and-branch reforms of state-owned enterprises, a recapitalization of the banks, and entry into the WTO. Those reforms, recalling the dynamism of the Deng era, would propel China’s growth into the twenty-first century.
  As a rule of thumb, loan rates should be roughly in line with the pace of nominal GDP growth—a proxy for the expected return on investment. If they’re too much higher, no one will borrow, hitting growth and employment. Too much lower and demand for credit will be too great, fueling inflation and asset bubbles. Deposit rates should be at least above the rate of inflation—otherwise, household savers don’t get a fair return and consumption suffers. In China, the decision to manage the yuan meant that both of these rules were violated. Borrowers could tap funds at way below their expected return. Savers were penalized with below-inflation rates. China’s economic structure was thrown off-balance, constantly at risk of runaway inflation and asset price bubbles, and with a worrying tilt away from consumption toward investment and exports.
    Speculators had multiple routes to bring funds into the country, from overinvoicing for exports to disguising portfolio flows as investment in factories and other bricks-and-mortar assets. Hot money inflows made it harder to manage the exchange rate and supercharged growth in the money supply—adding a fresh source of inflationary pressure.
  To support demand, preventing a slump in growth and employment, saving has to be recycled into spending. That can happen through investment. Or it can happen through exports—with savings loaned overseas and ending up as foreign demand. Expressed in the formal language of the economics textbook, savings minus investment equals the current account balance. Expressed in more straightforward terms, savings have to show up as either capital spending or overseas sales.
  In a developing economy, there are abundant opportunities for investment. China needed housing, office blocks, shopping malls, roads, railways, airports, power transmission, a telecom network, water treatment plants, steel smelters, and shipyards. Even after funding all of these projects, saving at 51 percent of GDP meant there were too many yuan chasing too few investment opportunities. A major consequence of that was a housing bubble, with the price of property rising at a torrid pace. With developers scrambling to grab a share of the profits, and local governments hungry for land sales revenue, real estate construction rose from 450 million square meters in 1997 to 2,363 million square meters in 2007.
  In the years ahead of the crisis, Bernanke pointed out, the Federal Reserve had raised rates. It had done so cautiously, reflecting uncertainty about underlying economic conditions, but even incrementally executed the move from 1 percent in 2004 to 5.25 percent in 2006 was significant. Strangely, however, even as the Federal Reserve had moved short-term interest rates progressively higher, long-term rates—the price everyone from the government to homebuyers paid to borrow for major projects—stayed low. The yield on ten-year government bonds rose from about 4.7 percent at the start of the tightening process to 5.2 percent at the end. The reason, Bernanke said, was a “global savings glut,” with most of the saving coming from China.2
  The consequence in the United States was bargain basement borrowing rates that fueled the real estate boom. With mortgage rates low, homebuyers took on more debt than they could manage. Investment banks, taking advantage of cheap funding, loaded their balance sheets with mortgage-backed securities. The increase in household wealth, or at least the illusion of it, reduced the US savings rate from low to nothing. Investment was channeled into equities and real estate rather than expanding productive capacity-capping growth in exports. With China in a self-reinforcing cycle of saving and trade surplus, and the United States in a self-reinforcing cycle of borrowing and trade deficit, the foundations of the financial crisis were laid. When the mortgage defaults began, the system toppled and then fell.
  In theory, local governments were barred from borrowing—a common-sense rule aimed at preventing local chiefs dashing for growth at the expense of blowing up the public debt. In practice, a workaround already existed, allowing local governments to set up off-balance-sheet vehicles to borrow. A shift in the rules made it easier for them to do so—a fateful move that solved the stimulus funding problem at the expense of opening a Pandora’s box of financial risks.
  The resumption of yuan appreciation—with the crisis-era peg to the dollar broken in June 2010—was a contractionary policy (denting exports), but it also added to price pressure (attracting hot money inflows). Inflation was moving out of the government’s comfort zone. It was time to move from targeted controls toward a comprehensive tightening of policy.
  The one-child policy represented an intrusion of the state into the most intimate realm of the family, often brutally enforced. Apart from the initial boost from reducing working time lost to child care, the economics didn’t make sense. Families with only one child spent less (fewer mouths to feed) and saved more (fewer children to take care of them in old age). That was a significant contributor to China’s high savings rate—the original sin in its unbalanced growth model. As demographic destiny played out, China faced a shrinking working-age population and a burgeoning old-age dependency ratio, with every young person working to support two retired parents.
  With compensation from the government, slum residents could afford to move into one of the new skyscrapers. To lock in that process, compensation—typically about 3,000 yuan per square meter—wasn’t paid directly to the residents. Instead it was placed in an escrow account, then paid directly to the developer once residents decided which apartment they wanted to occupy. That wasn’t the end of efforts to boost demand. Anyone who bought a house got a local hukou—guaranteeing access to local welfare benefits and increasing the incentive for out-of-towners to buy.
  There’s a “helicopter money” feeling to the process: the central bank printing money to cover the losses of real estate developers. At the same time, even if slum clearance started with the whirring of the PBOC’s printing press, it ended with repayment of the borrowed funds. Local governments clear away slum houses, paying the former residents with borrowed funds and gaining ownership of the land. Residents whose slum homes are cleared use the funds toward the purchase of a new apartment. That absorbs excess inventory, pushing real estate developers’ profits higher. With stronger profits and anticipating higher demand, developers buy more land from local governments. With the revenue they get from land sales, local governments repay the money they’ve borrowed, closing the loop.
  The macro-prudential assessment solved two critical problems for the PBOC. First, it got the bank past Benjamin Strong’s dilemma about spanking all the children when only one had misbehaved. As the PBOC had learned back in the June 2013 money market shock, pushing up borrowing costs enough to deter shadow banks also chokes off funds for responsible lenders, and deals a blow to the real economy. Using macro-prudential tools, the PBOC could separate financial regulation from monetary policy. Interest rates could be used to manage growth and inflation. Macro-prudential tools could be used to manage risks to stability. The system the PBOC put in place allowed for management on a bank-by-bank basis.
  There are various ways of tracking growth in China’s credit. The PBOC publishes a series on “aggregate finance,” which includes bank loans, bond issuance, equity fundraising, and shadow bank activity. Netting out equity finance provides a high-frequency read on the pace of credit growth.
  The slowdown in lending came almost entirely from the riskiest parts of China’s financial system: shadow bank loans. Bank claims on other financial sectors—a series from the PBOC that captures bank loans to shadow banks—peaked at 73.7 percent annual growth in February 2016. By mid-2018 it was contracting. On the liability side, too, there was a shift away from risky short-term funding from the issuance of wealth management products back toward safe and boring deposits. At the end of 2015 bank funding from wealth management products was up 56.5 percent from a year earlier. In 2017, it didn’t expand at all. Focusing the slowdown on shadow banking didn’t just lower financial risks, it also preserved growth in the real economy. Bank loans and bond issuance fund real activity: investment in factories, infrastructure, and real estate. Shadow banks—providing the equivalent of payday loans for cash-strapped private businesses, or funds for speculation in the property or equity markets—do not. Put simply: bank loans make the economy grow, shadow bank loans don’t. By keeping the former turned on, and turning the latter off, China’s policymakers could partially square the deleveraging–growth circle, slowing lending without cratering growth.
  A transition from heavy industry to advanced manufacturing and services would help tackle China’s structural woes. In particular, a more innovative economy would be less dependent on debt. Capital intensity levels across China 2025 sectors vary. Building ships and airplanes is far more capital-intensive than researching new medicines. In general, however, China’s industries of the future are less capital-intensive than its industries of the past. As a result, borrowing needs are reduced. If the China 2025 plan succeeds, corporations would be less dependent on debt and deleveraging will be easier to do.
  The risk from China’s 2025 agenda is that even as advances in technology continue to expand supply, by reducing households’ share of total income and tilting what is left even more toward the richest households, the same advances in technology will reduce demand. The result will be a Chinese economy that looms even larger as a share of global GDP—rising from 16 percent of the total in 2018 to a projected 20 percent in 2025—but is an even bigger source of imbalance and instability. With consumption insufficient to fuel the economic engine, China would have to continue relying on debt-financed investment at home and protectionism-inducing exports abroad to keep growth on track. Trade partners would lose jobs—this time not to Chinese workers, but to Chinese robots.
  As Chinese firms gain market share in new-energy vehicles, industrial robots, and batteries, that will come at the expense of losses for foreign firms. A look at exports of China 2025 products on a country-by-country basis shows who has the most at stake. Germany, South Korea, and Taiwan stand out as the most exposed. German automobiles; South Korean electronics, autos, and shipping; and Taiwan’s semiconductors all face a new competitive threat. Strangely, given how President Donald Trump led the charge in opposing China’s industrial ambitions, the United States has less to lose—at least in terms of export market share. That’s a reflection of the low share of exports in GDP, and relatively limited presence in advanced manufacturing.
  Finally, if increased automation boosts production capacity at the expense of greater inequality, a China tilted further toward saving and away from spending, and toward exporting and away from importing, would be a drag on demand and a source of imbalance for the rest of the world.
  Lower exports would be a direct blow to demand (though the impact would be partially diffused among Japan, Korea, Taiwan, and other suppliers of components snapped together in China’s electronics assembly shops). With exports weaker, there would be less incentive to expand manufacturing capacity, so investment would fall. Higher costs for imported goods—the result of reciprocal tariffs imposed on US imports—would dent household’s spending power. As the same dynamic played out in the United States, growth there would slow and demand fall, triggering a second-round impact on China’s exports. Plunging equity markets could compound the blow, denting business and household confidence.
  The common refrain from the market bulls, and the title of Carmen Reinhart and Kenneth Rogoff’s classic treatment of financial crises: “this time is different.” Sure, past booms have been followed by an inevitable bust. This time, the innovation is genuine, the price gains sustainable, and wise investors set to enjoy outsized returns.
  In China, information asymmetries are not an unfortunate bug in an otherwise transparent system, they are a pervasive feature. “They have no idea what they’re buying,” said one of the financial engineers behind the 29-trillion-yuan wealth management product market, referring to retail investors ignorant of the risks they were taking on. The quality of assets on banks’ 27-trillion-yuan shadow loan book is invisible to everybody but the banks.
  In China the problem of moral hazard is even more entrenched. State ownership of the banks and borrowers fosters the belief that default is a distant prospect. Even in parts of the economy that operate more on market principles, China’s stability-focused policymakers frequently intervene to put a floor under losses. The “national team” of state-backed investors buys into the stock market to prevent sharp drops. The central bank intervenes in the currency market to steady the yuan. At the economy-wide level, the government’s commitment to its annual growth target acts like a giant put option—assuring investors that if things get really bad, stimulus support won’t be long in arriving.
  The pro-cyclicality of credit works on the way down as well as the way up. In the financial markets, as asset prices fall, speculators who had borrowed to fund their investments face margin calls, forcing them to liquidate their positions. With the number of sellers increasing, asset prices fall further. In the real economy, lenders pull back and credit conditions tighten. That results in weaker demand, pushing businesses from profit to loss and turning households from confident to cautious. Seeing the deterioration in economic conditions they anticipated, lenders double down on caution and the supply of credit shrinks again.
  The modern banking system, with its unlimited ability to create credit, is a different beast from the gold-hobbled lenders of the seventeenth and eighteenth centuries. A United States where the Federal Reserve can act as lender of last resort—preventing the failure of systemically important firms—is different from the United States of the nineteenth and early twentieth centuries, before the Federal Reserve existed or had realized the extent of its powers. A crisis in the United States, which can fund borrowing in its own currency, is different from a crisis in a Latin American or Asian country, where foreign funds exit at the first sign of trouble.
  First, continued belief in the no-bank-failure guarantee of the Ministry of Finance’s convoy system, close relations between bank lenders and corporate borrowers, and accounting rules that permitted the banks to exaggerate their capital buffer and conceal their losses all allowed the wounded banking system to limp on. The day of reckoning on bad loans was delayed, at a cost to the vitality of the economy. Banks were locked into unproductive lending to zombie firms with little hope of a return to profitability. Second, with land and equity prices collapsing, even viable firms found themselves technically insolvent, saddled with liabilities worth more than assets. The result was what Nomura Research Institute economist Richard Koo called a “balance sheet recession.”11 As a result, instead of investing in new machinery or workers, businesses used any profits they had to pay down their debt. That might have made sense for individual firms, but with everyone doing it at the same time, the result was a disaster, triggering a downward spiral of inadequate demand, falling prices, shrinking profits and wages, and further erosion of demand.
  The parallels between Japan’s bubble economy and lost decade, and China in the post–financial crisis period, are striking. That’s not a surprise. China consciously followed Japan’s development model, paving its path to prosperity with a combination of industrial planning, state-directed credit, and an undervalued currency. As a result, China suffered from many of the same distortions. Mercantilist policies aimed at grabbing export market share, stoking protectionist sentiment in the United States: check. Wasteful public investment resulting in a landscape littered with roads to nowhere: check. Government direction of the banks resulting in massive misallocation of credit: check. Pervasive moral hazard, behind-the-scenes deals to stave off bankruptcies, and an industrial landscape stalked by zombie firms: check, check, and check.
  When exports crunched down, contracting 16 percent in 2009, China, like Japan, turned to a massive monetary stimulus. Indeed, China’s stimulus was significantly larger. From 1985 to 1989, Japan’s private-sector credit-to-GDP ratio rose 42 percentage points. From 2008 to 2017, China’s rose 96 percentage points. In China, like Japan, that resulted in distortions in two directions: overinvestment in industry and bubbles in stocks and real estate. Overinvestment left China’s firms, like Japan’s firms before them, burdened with excess capacity, falling prices, weak profits, and trouble servicing their debt. The situations are so similar that the models economists use to track zombie firms in China are borrowed from earlier analysis of Japan.
  There are also important differences. Back in 1989, Japan’s GDP per capita was already closing in on that of the United States. Space for catching up with the global leader was all but used up. In 2018 China’s GDP per capita was just 29 percent of that in the United States. It should have decades of rapid growth still to come as it closes the gap. Back in 1989, Japan was 77 percent urbanized. In China in 2017, that number was just 58 percent. Real estate won’t return to its role as all-conquering growth driver, but neither is construction about to grind to a halt. Japan, with its 120 million population, has a big domestic market. China, with its 1.3 billion population, has a vast domestic market, making it more straightforward to transition away from exports as a source of demand, and easier for firms to achieve world-beating economies of scale.
  Korea was behind the curve in responding to its problems. China has been ahead of it. Korea’s chaebol chiefs were allowed to run wild, investing in vanity projects that resulted in massive misallocation of capital. In China, wayward executives have been brought to heel, with some falling into the clutches of the corruption investigators. In Korea, growth in shadow banking ran unchecked until the crisis hit. In China, from 2016, the government moved aggressively against the shadow banks—bringing asset growth for the sector down to zero. Perhaps most important, China is a lender to the rest of the world, not a borrower from it. Learning from Korea’s experience, China allows foreign funds to play only a limited role in the economy.
  China’s combination of advanced-economy debt levels and emerging-market income levels is a unique disadvantage. Along with exports, credit is the fuel that powers the development engine. Borrowing pays for upgrades to industry and to infrastructure. China’s income level should mean it has years of catch-up growth ahead. By maxing out on debt at a middling level of development, China has made it more difficult to close the gap with high-income countries.
  In the decade from 2009 to 2018, debt rose to 254 percent of GDP, an increase of more than 100 percentage points. It’s hard to find examples of other major economies that have taken on debt at a similar pace. It’s easy to find examples of those that have taken on less, and still faced a crisis. In the United States, outstanding borrowing rose to 229 percent of GDP in 2007, from 190 percent in 2001. That 39 percentage point increase came ahead of the biggest financial crisis since the Great Depression. In Greece, debt rose to 244 percent of GDP in 2010 from 171 percent in 2001—a 73 percentage point increase that anticipated the plunge of Greece, and the eurozone, into a rolling five-year crisis. Closer to home, in the eight years ahead of the Asian financial crisis, Korea’s debt-to-GDP ratio rose only 44 percentage points. The International Monetary Fund (IMF) counted forty-three countries where the debt-to-GDP ratio had increased more than 30 percentage points over a five-year period. Among them, only five ended without a major growth slowdown or financial crisis. Narrowing the sample to look only at countries that started with debt above 100 percent of GDP, as China did, reveals that none escaped a crisis.
  It is China’s private-sector firms that show the highest return on assets: 9.5 percent in 2017. Based on the official data, the return on assets for state-sector firms was just 4 percent. Taking account of subsidies state firms receive in the form of cheap access to credit and land, even that overstates actual performance.5 Local government investment vehicles, many of which have no income except from selling their endowments of land, do even worse. By concentrating credit on the least efficient borrowers, China’s banks added to the problems innate in a rapid rise in lending.
  Evidence of stress is not hard to find. The incremental capital output ratio—a measure of how much capital spending is required to buy an additional unit of GDP growth—rose from 3.5 in 2007 to 6.5 in 2017, the highest level in the reform era.6 The additional GDP generated by each new 100 yuan of credit fell to 32 yuan in 2018, down from 95 yuan in 2005. According to the Bank for International Settlements, close to 20 percent of GDP has to be used to service debt—higher than the United States on the eve of the great financial crisis.
  That brief history of national-level near misses and local-level direct hits should convince that China is not crisis-proof. It also provides a checklist of potential triggers. A slump in exports, a plunge in real estate, overly ambitious reform, draconian tightening, market meltdown, capital outflows, or simply the inertial weight of zombie firms all have the potential to push China into crisis.
  To its trading partners, China is a combination of competitor, partner in production, and customer. In a crisis, a collapse in exports as factories failed might benefit some competitors. The dominant impact, however, would be a drag on growth as the main link in Asia’s manufacturing supply chain breaks and China’s demand for imports collapses. Asian economies, integrated in the global production chain with China, would be especially hard hit. China’s limited capital market ties with the rest of the world mean the direct impact through financial channels would be small. As the experience of China’s 2015 equity market plunge demonstrates, the indirect impact from a collapse in confidence could be severe. A plummet in China’s stock and bond markets would send tremors across global markets. Commodity prices are the intersection where trade and financial channels meet. With China the swing factor in demand for everything from soybeans to iron ore, a collapse in China’s demand would trigger tumbling prices. Commodity exporters would suffer. Advanced economies that import commodities would benefit as prices fall—but not enough to offset the blow from falling exports and financial market contagion. The Belt and Road Initiative got off to a slow start. Over time, however, China’s investment in the rest of the world can only increase. A crisis in China, causing a sudden pullback of planned projects, would dent capital spending. The impact would be particularly marked for developing countries that rely on Chinese funding to get projects off the ground.
  The combination of space for development, enormous size, access to foreign technology, and a ready-made blueprint for development gave China a major head start. On top of that, add a high savings rate, controlled capital account, and a state-owned banking system. As a nation, China saves almost half of its income; a controlled capital account means it’s difficult to move those savings offshore. As a result, the vast majority ends up in the domestic banking system. That’s important because it guarantees China’s banks a steady flow of cheap funding. And with the banks state-owned, that means government planners have a constantly replenished piggy bank for funding priority projects.
  China’s leaders as stuck between a rock and a hard place, confronted with a series of damned-if-you-do, damned-if-you-don’t dilemmas: Development means creation of a middle class. A middle class will demand political rights. The challenge to the Communist Party’s authority will result in regime collapse. Failure to develop will leave the population in poverty, undermining the legitimacy of a government that promised continued improvements in quality of life, causing regime collapse at an even earlier date. The creaking state sector must be reformed if China is to avoid stagnation. But the state sector is the lynchpin of China’s industrial planning and demand management, as well as the basis of patronage networks for leaders. Without it, the government will lose control. Runaway real estate prices must be curbed, or would-be homeowners will agitate against the political order. But taming prices will prick the property bubble and crater the construction boom that has been the biggest contributor to China’s growth.
  A larger role for services firms, higher income for households, and rebalancing from investment to consumption are mutually reinforcing trends. The services sector is more labor-intensive than industry: a restaurant or hospital has a lot of employees and not much physical capital, while a steel mill or cement kiln has a lot of physical capital but not many employees. More labor-intensive production drives higher demand for workers. The pass-through from higher demand for workers to higher wages isn’t straightforward. Many services jobs are low-skill, and workers have less bargaining power than they did on the factory floor. Still, all else being equal, more demand for workers pushes wages higher. As incomes rise, households consume more, and a larger share of incremental spending goes on services. As demand for services increases, employment rises and the virtuous circle begins again.
  The state sector might be growing as a share of traditional industry, but traditional industry is shrinking as a share of GDP. Private steel mills and coal mines are going under. But steel and coal are China’s past, not its future. In the industries of the future—e-commerce, electric vehicles, robotics, artificial intelligence—private firms are at the fore. Go back to 2007, and China’s top-twenty listed firms were all state-owned, with the biggest banks, oil companies, telecoms, and industrial and infrastructure firms all represented. Fast-forward to 2019, and a number of private firms—Tencent, Alibaba, home appliance maker Gree Electric—have muscled into the top ranks. If they have any sense, Communist Party cells in foreign and private firms will focus on defending the Party’s political bottom line, not calling the shots on business strategy.
  financial crises do not start on the asset side of a bank’s balance sheet; they start on the liability side. In China, the high savings rate and controlled capital account mean a continual buildup of new deposits in the banking system, locking in a cheap and stable source of funding. State ownership of big and small banks means policymakers have unusual resources to manage liquidity within the system. Control of the media is not a positive for China. It does mean they are unlikely to face a downward spiral of market shock, amplifying press reports, and crumbling confidence.
  The end of the one-child policy, aging of the population, buildout of the welfare state, and development of a more sophisticated financial system all pull in the same direction—increasing households’ propensity to spend, reducing their propensity to save. There’s a risk to lower saving; with less deposits flowing in, the funding base for banks will become less secure. But as less saving also means more consumption, there will be a parallel reduction in the need for bank-financed investment. As the imbalances caused by a high savings rate unwind, the need for a high savings rate to guard against the consequences of those imbalances is reduced.

Published by Journeyman

A global macro analyst with over four years experience in the financial market, the author began his career as an equity analyst before transitioning to macro research focusing on Emerging Markets at a well-known independent research firm. He read voraciously, spending most of his free time following The Economist magazine and reading topics on finance and self-improvement. When off duty, he works part-time for Getty Images, taking pictures from all over the globe. To date, he has over 1200 pictures over 35 countries being sold through the company.

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