End of the Chinese Miracle

In global economics, the title of “Emerging economy” is sought after on both ends of the supply-demand spectrum. Developing nations crave the opportunities that come with injections of foreign investment and investors are often excited by the potential return.

On the list of emerging markets, China has stood out as a superstar. In 1995, China’s GDP was $734bn of which Hong Kong, recently handed off by the British, made up almost 20% ($144bn). Today that number has increased 20-fold to $12tn. The Chinese miracle, like its Japanese-equivalent, has radically changed the fiscal ecosystem within the country. A burgeoning middle class, greater-access to a variety of consumer goods, and massive state-sponsored projects are just a few of the benefits the Chinese hinterlands have experienced over the last two decades.

However, the 2019 domestic economic model of China evokes more significant parallels to pre-crisis Argentina of 1998 than to Japan of 1988. To say nothing of the differences in market models and export goods, China’s economic base is far more leveraged and reliant on politicized local economies.

Massive accumulation of debt across sectors is common, and oftentimes required, to stimulate and encourage growth. Paired with a soaring economy, a large national debt value is hardly a problem on its own. But it’s not just the Chinese government taking loans; gross economic debt, the debt held by all entities in the economy, encompass an alarming 300% of the nation’s GDP. Non-financial corporate debt of this magnitude in a developing nation is unprecedented. Today, China is more leveraged than 1997 Thailand just before it triggered the ASEAN financial crisis.

In recognizing that GDP, while a useful benchmark and barometer of national fiscal health, is a denominator that is not inherently a declaritive metric for imminent financial collapse, it is worthwhile to examine other predictors where China falls short. Notably, the rate at which debt has accumulated over the last decade. In the IMF report on credit booms, there were “43 [identified] cases where the credit-to-GDP ration increased by more than 30 percentage points over a 5-year period.” Among those cases, exactly 5, or 12%, ended without a financial crisis or major growth slowdown. Of those 5 exceptions, only Hong Kong (1983) and Finland (2003) saw stable continued growth, with the latter’s taking place after a significant deleveraging of the Finnish balance sheet in the late 90s.

Moreover, China’s credit boom is both longer and larger than anything in the researcher’s survey. The reasons for this expansion could warrant a text unto itself but the ultimate reasoning amounts to large state-owned banks providing renewing stimulus in the aftermath of the 2008 financial crisis. In reading government press releases, the term “structural deleveraging” comes up frequently enough to suggest that Chinese authorities are aware of the risks behind this policy but it is not altogether apparent if there is political motivation to mitigate these risks.

Lacking in electoral input in the political process, the advancement of local officials in China is intimately tied to certain specific metrics of success. Two specific measures are GDP growth and tax revenue. While these metrics seem innocuous at first, they lead to dangerous and distorted incentives. It is well-known, for example, that local government officials forge outright false economic statistics because of the important of growth to political promotions. In his book, China’s Great Wall of Debt: Shadow Banks, Ghost Cities, Massive Loans, and the End of the Chinese Miracle, Dinny McMahon describes a less well known, but insidious pattern that poses a critical threat to the Chinese economy caused by the politicization of local economies.

In effect, a state employee will artificially boost their numbers by borrowing from a state-owned bank to pay for local projects, generating GDP growth and employee wages. Generally, the state official will deploy the capital into a space that wouldn’t be profitable under typical market conditions. The space usually materializes as a state-owned enterprise, but has also taken the form of local infrastructure projects like housing construction or land clearance.

With the injection of cash the tax revenues from the VAT increase which, in turn, causes local GDP to increase. The state employee receives recognition and praise for their work based on the improvements to the aforementioned metrics. In the short-term, this is a win-win-win. The central government is pleased at the prestige that comes from the project, the state official is promoted because local metrics improved, and the bank secures a government-guaranteed loan for which they’ll earn years of interest payments.

Of course, eventually, the central government has to bail out the local government when the loan comes due. But by that point the consequences have dissipated; the central government can’t punish the local official who initiated the project without acknowledging that the state-owned bank erred in approving the loan. Restructuring the bank loan approval process to account for moral hazards would cause inflows to drop too substantially (which is its own political prerogative), so the bank doesn’t have to modify its behavior. In effect, all investments in China have an implicit guarantee so the local official employs money that doesn’t belong to them, and the de facto ultimate holders of the liability, the Chinese public, have no input on the process. It’s your usual principal-agent problem.

As a result, local government debt has ballooned out of control. On paper, overall government liabilities are only about 50% of GDP, but once Local Government Finance Vehicles (LGFVs) are factored in, the number increases to nearly 90% of reported GDP. The standard prescription for the central government has taken the form of a bailout. A bailout is the fast food of economic planning: the promise of a bailout lowers the quality of investments for the reasons explained above. To central planners, the GDP growth minimum of 6% YoY ensures that the government will continue to have fiscal reserves to cover these domestic misadventures. If that target isn’t met, it’ll drive the state to borrow from abroad which will both expose China’s relatively closed capital account and raise interest rates. Both of which can cause problems, especially in a country so reliant on maintaining strict capital controls.

Additional foreign investment in the form of Chinese bond and equity inclusion within global indexes could well keep China on its minimum 6% YoY growth in GDP but with the state’s rate of debt accumulation, the allocation of that debt, the misallocations of structural capital, and a United States executive administration that isn’t shy about direct economic confrontation, we may well see the end of the Chinese miracle.

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