Saturday, July 20, 2013

The Danger of China's Debt and Finance Crisis

The Chinese government is a net creditor, by a large proportion. It holds reserves in Treasury Bonds (or equivalents) of many countries, including $1.3T of the United States (less than you probably thought--China doesn't "own the US" yet and probably never will).

I have, for a long time, been advocating that the Chinese economic rise is highly unsustainable. Not because it had staggeringly high growth, as any relatively laissez-faire developing economy should be able to do this consistently. The unsustainability came from the policies used to drive this growth: both their fundamental flaws (one) and the changing economic conditions (two) that led to them being no longer effective.

Data about the Chinese fiscal  is being exposed that was previously opaque

Why we even care
Surely many Americans, in reading this news, will celebrate. The Chinese aren't going to conquer the world after all! Sadly, that is because most folks have a badly skewed understanding of the international economy and tend to be what the US President calls "economic patriots," the most dangerous kind of economist.

Railing my opponents aside, this is bad. Chinese growth is, to a large extent, fueling the recovery of the Western Hemisphere, and is lifting up the previously-impoverished countries of Southeast Asia. Growth in China means a middle class, an ability to spend money. It also means a more skilled labor workforce.

Together, these mean importing consumer goods (from Levi's jeans to Coke to Hollywood films, etc) and importing precision manufacturing equipment (made almost exclusively in the US and Germany). Side-note: China wants our precision manufacturing equipment and it would mean a lot to American manufacturing, but we don't allow the export because it's considered "dual-use" technology and could be used to build weapons. So, instead, China may develop its own industry for this. Again, I digress.

So in short, growth for China means growth in particular for the United States, among anyone else that China might want to buy from, and growth for the Southeast Asian and African countries that will take over the more low-skill manufacturing roles from China (labor-heavy mass production, dirty stuff like smelting, "cheap" plastic stuff you might think of, etc). It's good.

If it falls apart? Bad for American growth and jobs, bad for Southeast Asia and Africa.

This has happened before in Japan:
If you watch Sci-Fi movies from the 1980's (think Bladerunner) or follow any "Cyberpunk" themed stuff from that time period, you'll notice that Japanese culture is everywhere. At this time, the "Japanese Miracle" seemed unstoppable and we believed Japan would take over the world, as we believe for China now.

But Japan has been in a 2-decade period of essentially zero growth. There are many reasons for this--some of them demographic--but much of it was due to fundamentally self-destructive economic policy that was heavy on tariffs (driving "import substitution"), cheap government loans, currency devaluation, and low domestic consumption.

These policies couldn't last and set the Japanese up to fail. The Japanese were completely export-dependent, which meant the Yen had to stay cheap. To do this meant inflation of prices, and Japan got to the point that further currency devaluation would mean too much erosion of personal savings and wages in Japan--it was fundamentally unsustainable. So the currency had to stabilize, and in the meantime, other currencies dropped in value, making exports harder, and stopping the growth dead. This was combined with a high percentage of non-performing loans, unprofitable businesses being kept afloat (due in part to a somewhat nepotistic practice of business that in the United States would be considered corrupt), and spiraling government debt (currently Japan's external debt is a mind-boggling 230% of its GDP, compared to Greece's "crisis" 175%).

The two decades of non-growth were essentially the necessary economic "hangover" of relatively artificial growth. Eventually, a liberal market would adjust to reality and then move on, but Japan is resistant to the pain of this change (companies would fall and new industries would have to pop up to respond to the reality of economic conditions) Abe is currently trying to re-spur Japan's growth through government spending and currency devaluation again. I strongly believe that this growth will be equally artificial, but the siren song of seeing the GDP numbers go up is hard to resist.

(Just to note: much of Japan's growth was indeed driven by an incredibly industrious people, open to rapid modernization, spurred by a Bushido style work ethic, and able to come up with extremely efficient manufacturing processes [they invented what we now know as Lean manufacturing] that would have competed well in a free market.)

In China, it's much, much worse (the fundamentals):
China has only one advantage over Japan: its official central government debt is only 30% and it is, of course, a net creditor.

But besides that, things are looking quite bad.

The first problem is this: the Chinese government is quite certain that its powerful economic growth is the main reason that the Chinese people remain fairly content with the government. They're consistently worried that a major slowdown in growth would mean increased unrest. So China must keep powering ahead with this growth until, hopefully, it reaches the level of wealth that Japan had when its economy pleateaued.

So government debt is on the rise. Much of this is funding infrastructure development (as stimulus) of which even local Chinese papers are questioning the efficacy and payoff. China's banks are (illegally) funding these projects through loans to local governments (their debt seems to be in the 27% of GDP range) and these off-book loans are probably non-performing.

China's corporate debt has swelled massively. At 220% of GDP, these corporations are over-leveraged due to artificially cheap money from the central bank and huge shadow-banking loans. At that level of leverage, the best hope of crawling out without major bailouts is continued astronomical growth... but that growth would have to happen without more corporate debt being taken out, and it seems that this debt has been fueling the monetary activity that translates into "GDP." In short, you need GDP growth to pay off this debt, but since growth has been driven by expansion of this debt, it may be a bit of a death-spiral. (A bailout is possible but it would either increase Beijing's debt significantly or deplete reserves, which would increase the value of the Yuan, drive down exports, and again squish economic growth).

Because of these non-performing projects and high debt, corporations and local governments are taking out short-term loans to pay off maturing loans at staggering annual rates like 17-20%. This is going to drain liquid assets and unless growth picks up to levels where they can pay off their debts with profits, this will signal a death-spin of interest payments similar to what is causing the Eurozone crisis.

With numbers like that, the reported non-performing loan rate of 1% (it's probably higher, due to a huge deal of off-book loans and China's notorious reputation for flat-out lying about bad numbers) is set to rise. If it does, the banks that hold the credit will start to crumble. To keep them from crumbling, China would have to expand credit further and essentially bail out these banks with printed money or reserves. As we discussed above, this will hurt growth in its own way.

Changing economic conditions:
Much less responsible than dangerous economic policy, but China's middle class is growing. This means that public savings are going to decrease among this group (meaning there is less liquidity for banks to use to support high leverage) as consumer spending starts to increase, but there may be enough upward mobility left in China that the very-poor will become the new high-savings generation these bank reserves will not deplete entirely.

Second, this consumption means that China's imports will (or at least should) rise. This means its domestic cash reserves will grow at a slower rate--again, less investment.

Generally, higher consumption  means less investment, period (if you produce $100 and spend $80, you only have $20 to invest or save). With excessive corporate and government debt, higher domestic consumption might put the final nail on the coffin of high Chinese infrastructure and economic development.

The bottom line: No matter how you look at it, it's bad
I will admit that I am an Austrian in the realm of economic policy, meaning I think (among other things) that significant stimulus by government through spending and currency devaluation generally leads to mal-investment, perverted prices of labor and goods, and generally creates an artificial recovery that will at some point bite the economy in the rear end.

But even my Keynsian friends will agree that such stimuli are a recipe for disaster if they're used as the primary mechanism for growth. Keyenes said that such spending should be counter-cyclical and if you're expanding debt (at corporate or public levels) and devaluing currencies during periods of growth (rather than recession), you're setting yourself up for disaster.

In order for China to not crash and burn completely, it must find some path towards real growth, rather than artificial growth driven by excessive corporate debt, currency devaluation, and government spending. This is going to be a very long, hard path--China is very far from it. Japan still has not made it, more than 20 years after its plateau began.

But China may ultimately be doomed by politics. As we stated before, significantly slowing growth risks major unrest in China, which still has hundreds of millions living in poverty that might be "behaving" purely on the hope that life will get better. For the Communist party, this means they are juggling between continuing growth and trying desperately to reduce debt... but in a debt- and government spending-driven economy, I don't know how it's possible.

The lesson here is that the party has to end at some point when you're fueling it with debt and artificially cheap money.

Either China will find some sort of "soft" landing of low growth or the house of cards may start to fall apart. If it does, it will have huge consequences.

The foreign policy consequences:
First, unrest in China would totally change its foreign outlook. Rather than being aggressive in the South China sea, China would turn its focus inwards until it could get a lid on its own population. This could take a very, very long time.

The US and other economies would reel if China's economy started to shrink. Those exporting to China (a significant number) would face massive shortfalls in orders, where importers from China (in particular of building materials like steel) might go bankrupt before domestic industries could pop up to replace them.

In the long-term, countries like the US would drop their imports and become dependent instead on more expensive domestic production. There are arguments that this might be good but I generally always believe that a country's labor is best spent on its comparative advantage industries, not those which could be supplied cheaper elsewhere. Whether good or bad, it would mean a huge long-term change to the American economic landscape.

Oil prices would fall dramatically on reduced Chinese demand, with all the consequences: CPI deflation, potentially even-higher Middle East unrest, decreasing competitiveness of green alternative energies and at the same time a potential dent in exploration of shale LPG/oil.

Japan's more militaristic tendencies would likely subside as China became less of a risk in the medium-term.

Southeast Asian and African economies would falter and frustrate in the short-term. I can say little about their long-term growth prospects at this point.

And a whole lot else that is very hard to predict.
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