The China bulls argue that China has lots of FX reserves, can print its own money, high savings, and a strong regulator that will ensure China can contain a crisis. The bears point to a factors like the speed in the increase of the credit to GDP and the level of credit to GDP so support their case.
I find points of validity in both cases but neither one ultimately satisfying. I think the major problem with each is that they find broad headline points of commonality or difference with either 2008 subprime or 1997 East Asia financial crises and claim that China is just like or totally different. This is part of why I find some aspects that are valid in each, but also fundamental shortcomings.
What I am writing here is an attempt to talk through or think out loud about what will happen to China. Let me emphasize that these are not predictions but rather trying to work with a combination of economic theory and Chinese empirics what may happen, teasing out more detail from the two major sides of this debate. Today I will start with the bear case that China will ultimately have a financial crisis or hard landing.
The major reason not to believe the bear case is political: Beijing will not allow a crisis is political due to the potential blowback ramifications. In 2008, the United States and other countries made clear and conscious decisions to not bailout firms and households. We can argue over whether they should have, whether the divergent approach to Fannie and Freddie vs. Lehman, or whether it should have targeted asset levels via home prices for consumers, but the take away is simply that the United States made a clear and conscious decision to not broadly pursue such policies. The United States generally allowed asset prices to fall, firms to fail, and households to be evicted or declare bankruptcy.
I do not believe Beijing is willing to incur the risk of suffering such a financial downturn running the risk of allowing such an event. Assume for one minute a financial crisis hits China. That is literally a once a century event. Probably bigger economic and financial event that the fall of USSR with larger international consequences. Beijing is acutely aware that Moscow made it to the 13th 5 year plan and Beijing is in the middle of its now. Xi has built his entire administration around preventing a weak China and this type of event. If China suffered a financial crisis, this would likely end Communist Party rule in China with major consequences for ruling elites.
This does not mean that Beijing will make good policy in the interim to prevent such an event, in fact quite the opposite and we should expect Beijing to take all steps to avoid a crisis without addressing the fundamental problems. In fact, this matches very closely how we see Beijing behaving. For all the talk of how they intend to deleverage, Beijing has clearly prioritized growth stability above deleveraging. For all the talk of improving risk pricing and allowing defaults, has always in practice resulted in government and SOE bank led bailouts of companies in default. Concerned about how a bankrupt firm with large losses imposed on banks and investors would be perceived in the market place, Beijing acting to avoid a crisis without addressing the fundamental problem.
In fact, this policy path, which I believe broadly fits what we see Beijing doing, delays inevitable adjustments but stores up increasing large amount of risk. Again, this broadly fits what we see happening. Capital is being spent to delay ultimately inevitable reforms but in virtually every case, it is merely storing up risks. This makes the financial position increasingly tenuous and risky as we move forward in time. Now we have a point in the bears favor, there may come a time at which the risks become simply unmanageable provoking a crisis, but currently it seems unlikely we will have a Chinese crisis in the near future. There are clear signs of stress across a variety of sectors in the economy, however, I do not believe these signs are so dire that Beijing cannot prevent a crisis for the forseeable future.
There are however, a host of smaller reasons that the bears could be wrong. In real order, they could be:
- Estimates of Chinese non-performing loans are overstated. Even Chinese securities firms have come up with estimates of 10%, which I would personally use to establish the baseline estimate. In reality, we simply have opaque ways of estimating what might the true number of NPLs be. Could they be the higher range estimates of 20%+? Sure but do we really know for sure? No, we don’t and we need to leave open the possibility that many are wrong on this.
- The structure of debt within the economy matters and may signal less risk of crisis than is understood. Many analysts focus on the total debt level but omit more commonly that most of this is corporate with relatively small levels of government and household debt. What if corporate debt as a percentage of GDP stagnated but household and government continued to rise over the next 5-10 years? That would imply that total debt as a percentage of GDP could continue to rise for some time. This would also allow investment and consumption to rise as a percentage of GDP if the public sector assumes greater responsibility in investment and household consumption increases. The problem with this story is that it implies enormous debt levels in say 5-10 years with very high levels of financial fragility.
- Real estate is less of a financial risk and more of a social risk than is appreciated. While implied marginal leverage rates on new purchases of housing in China is rising rapidly, the overall debt associated with housing in China, especially when placed against the current estimated value, is minimal. Financially, this would seem to imply that there is little actual risk of a crisis being caused by a downturn in the real estate market. However, it is a poor analysis to conclude there is no risk from a real estate price decline. There are two specific factors. First, real estate prices might be the most concerning trigger for social instability. If for instance, there was a 30% decline in real estate prices in China, I have little doubt that there would be wide spread social urban instability. That presents a wide range of risks that the Party is simply not willing to tolerate and consequently will do everything to prevent. Second, depending on the exact estimate you believe an astounding amount of Chinese economic activity is tied to real estate. On average over the past few years, probably almost 50% of government revenue, 20-30% of GDP, and tied to a grossly disproportionate share of lending in different ways. Consequently, while real estate does not represent the first order financial risk that the 2008 subprime crisis did, it absolutely represents second order or indirect impact on potential downturn in real estate development, lending, and potential defaults from colleateralization drops.
- The transition to a service and consumer driven economy is better than presumed. I find this argument unsatisfying. Empirically, there appears strikingly little growth in consumption service focused industries. For instance, travel and hospitality within China, which represents approximately 98% of Chinese travel, flat to low single digit growth. Virtually the only service sectors enjoying demonstrable real and nominal growth are financial services (for very concerning reasons) and logistics/supply chain/postal services. However, while it is wonderful for the Chinese consumer, the growth in logistics/postal services are doing little more than cannibalizing activity from brick and mortar retailers. The marginal boost to growth, after accounting for the cannibalization, is minimal. There is no evidence of double digit or near double digit wage growth that would drive the consumption/retail sales growth Beijing touts.
The picture we are left with, seems to be an economy that has a wealth of problems, is driven by credit, but one that is not as of January 2017 on the verge of eminent collapse. Furthermore, each of the supposed arguments of why China will continue to thrive have major problems. Additionally, if we carry forward the counter argument of the bulls to counter the bear crisis argument, we left within 1-3 years of astoundingly perverse outcomes.
China may be able to prevent a financial crisis through capital controls but that would require hard draconian capital controls. China may be able to prevent a financial crisis by having the PBOC intervene but that would require widespread debt monetization which brings a whole host of problems on its own and assumes as “soft” or “semi-controlled” debt crisis. Absolutely neither of these should be considered positive outcomes. That would be like saying someone had a quadruple bypass and is bedridden for 6 months but didn’t die.
Next week I’ll consider the argument, this is all overblown and China will continue to grow rapidly for the next 10-25 years.