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Friday, July 7, 2017

Will a Financial Crisis undo China’s Superpower Ambitions?

By Roy C. Smith

The media has been focused lately on the rising influence of China and the confrontational bi-polar superpower world that lies ahead.[1] But before we acknowledge China as a superpower, it needs to demonstrate that it can maintain the long-term economic power that enables its geopolitical rise: a challenge that past superpower aspirants failed to manage successfully.

China has to deal with a slowing growth rate that may be worse than it seems and carries the risk that a disgruntled citizenry will begin to question the legitimacy of the Communist Party to rule the country without either Communism or any sort of popular consent. For years, both Chinese and other observers have noted that, defacto, consent to rule was exchanged for economic growth and prosperity provided by the Party. No one was ever sure of what the minimum growth rate to retain consent was, but many suggested 7%-8%. This year, China is forecasting growth in the 6.5% – 7% range – high everywhere else, but low for China.

But even this target may be tough to meet without fudging. China’s export customers are growing at less than 2% and shifting economic resources to the consumer sector has continued to lag. Much of the growth that is occurring is from the agricultural sector and overproduction of basic materials and manufactures, which global trade scrutiny is making harder to dump in overseas markets. Some of the growth, too, is from costly roads and bridges being undertaken well in advance of demand for them, and from large-scale demonstration projects (e.g., the Asian Infrastructure Investment Bank, and the One Belt One Road project). Meanwhile, Chinese profit margins are weak and wealthy Chinese investors have been shipping capital out of the country. The Chinese stock market has been lackluster since the Shanghai index soared to 5,100 and then plunged back to 3,000 in 2015.

Importantly, in its efforts to support a sagging growth rate, China may have pulled back too far from the necessary economic and financial reforms needed to transform the country into a mature market-driven economic system, and increased the chances of a financial crisis that could halt or seriously slow growth rates, exacerbating the legitimacy-to-rule issue.

Under the Xi Jinping government, some reforms have been undertaken, but these have been offset or undermined by blunt-force efforts to increase growth through easy credit and government spending. Indeed, there seems to be significant competition between the financial regulators fearing systemic risks and those more politically minded officials who fear unemployment and labor unrest more. Balancing the two concerns, in an economy the size of China’s with many decentralized vested interests, and limited policy tools is a very difficult task.

Last year the Bank for International Settlements said China was three years away from a financial crisis.  How likely is this to happen?

Based on historical precedent for rapid growth Asian economies (Japan, Korea, Taiwan, Thailand, Indonesia), a debt-based financial crisis seems inevitable. China’s total debt has soared in recent years to $28 trillion, 277% of GDP, with non-government debt ($17 trillion) representing 170% of GDP, twice what it was in 2011. Moody’s recently downgraded China’s sovereign debt to A1.

Most of the increased lending has been to weak state owned or other government supported entities experiencing growth constraints, which has raised concerns about bad debts. Chinese bank loans have increased by 15-30% annually since 2008%, though Chinese estimates of non-performing loans increased only to 1.75% of outstanding loans, though this is the highest ratio in eleven years. Few foreign observers take this non-performing number seriously; indeed, in September 2016 Fitch estimated the ratio to be ten times larger, representing as much as $2 trillion.

Bank regulators have made some significant efforts to contain credit risk. Whether these will be sufficient in a crisis in which market values could be decimated, threatening systemic failure is hard to know. But, the efforts to reduce bank exposures are in conflict with central and regional governments’ and the central bank’s efforts to support credit for growth that began in 2014.  This has inspired borrowings by “local government financing vehicles” and several other makeshift off-the-books ways to get around the regulator’s controls that have sprung up in recent years. S&P has recently downgraded several LGFVs, which, together with other “shadow banking” entities, now represent $9 trillion of assets. Two-thirds of these are considered bank loans in disguise, as they were arranged and presumably are backed by banks.

The four largest Chinese banks (assets of $12 trillion, 40% of total bank assets) are captive to government demands. China has a high savings rate and the government has $3 trillion of foreign exchange assets that might be used to shore things up in the event of a crisis. Indeed, the government tapped into these reserves in 2006 to clean up the balance sheets of the big banks that were going public then. The banks are assumed to be backed by unspoken government guarantees, with risks containable within a closed-loop government credit mechanism that is insulated from foreigners and private capital markets.

But this closed-loop assumption that many foreign observers have used to shrug off fears of credit collapse in China, may be different from what it was. The many new initiatives to spread credit beyond the banking system, and a bond market now with $10 trillion of capitalization, have transferred substantial market risk to private institutions and investors, including international investors. This exposure is now huge and vulnerable to price and liquidity changes that could sink many institutions unless aided by the government. If this should happen, and today it seems likely despite China’s increasing global eminence, it could invoke consequences similar to those of other recent financial crises.

Japan learned in 1989, that its relatively closed-loop financial system was highly vulnerable to a credit crisis following the bursting of a stock market and real estate bubble. The financial crisis that ensued was crippling to the Japanese economy and ended the superpower ambitions Japan then had once and for all.

Similar crises affected the high-growth Asian economies in 1997-1998 as credit losses threatened banks that had to be assisted by their governments and the IMF. The rapid growth rates of these countries have been sharply curtailed ever since

And of course, we in the West also learned in 2007 and 2008 that a relatively modest market segment (subprime mortgages worth $600 billion, in a $5.5 trillion mortgage backed securities market in a combined US bond market of $30 trillion) could be subject to severe pricing shocks as some investors, fearing credit losses, ran for the exits and created a global liquidity crisis that contaminated most other asset classes, including corporate bonds, commercial paper, bank CDs, real estate and equity markets, and, a bit later, sovereign debt. This extraordinary crisis, unexpected and largely unprecedented, was significantly enhanced by global market linkages that required substantial governmental intervention to resolve, and has sapped growth rates for nearly a decade.

China has considerable power and resources to deal with a crisis, including its lack of need for parliamentary approval to do whatever it wants. But it lacks experience in managing an increasingly market-oriented financial system, and in making the internal political trade-offs to serve both growth and regulatory control simultaneously. Indeed Japan, and the US and the EU had resources also, and used them to fight their crises. But crises, particularly in countries accustomed to the government closely managing the economies, can destroy confidence necessary for the economies to maintain investment, consumption, and – most important, especially in China --confidence in the future of growth, employment and well-being for all the citizenry, not just the urban well-to-do constituting 12% of the population.

A financial crisis could end China’s hopes for superpower status, but if the crisis is deflected or skillfully managed, it could fortify superpower claims for a long time.

[1] See Graham Allison, Destined for War, Gideon Rachman’s Easternization, and Amitai Erzioni’s Avoiding War with China, among others.

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