Will China eventually crash?
Something is going wrong in China.
The suspect evidence is plentiful: strange movements in the stock market, worrying industrial and profits data and loads of official statements claiming that everything is OK. But what is the problem? We all know that China might not be a reference for human rights, but it has been an example of economic growth for a long time. We had been told that China would become the biggest world economy in some years’ time. As of today, China’s growth rate is still 7% (in contrast, Italy hasn’t seen a growth rate above 5% since 1980), and it has also started to play the role of the world superpower quite effectively, taking control of many companies and natural resources in developing countries.
Besides, its economy is moving away from its traditional status of low-paid factory for the rest of the world. The service sector is growing quite steadily and household consumption has been increasing. Despite the many social tensions, it looks like a reasonable middle class is starting to form – a fact that, incidentally, threatens the political system of the country, but apparently they have this under control for now. China’s currency, which once had been a textbook example of strategic undervaluation, has been slowly appreciating without making China lose competitiveness. The picture I have painted so far looks extraordinary. And in fact it is: the Chinese economic success is unprecedented in many aspects. But then, why did investors panic this August as shares in the Chinese stock market were plummeting? Why did the Chinese government intervene to stabilise the markets? The first answer is that China is not growing as fast as before. Sure, it is still growing a lot, but sometimes life is about changes – 80 kph feels very slow when you are coming from a highway. An economy like the Chinese, which grew at more than 10% for many years, can easily become what we economists call “overheated” (without entering into details, imagine a guy who wins the lottery and ends up so excited that he spends more than what he actually won).
In China, companies and individuals have been running into large amounts of debt. This is normal when an economy grows that much: there are many profitable investment opportunities out there, and people want to take advantage of them. However, as soon as things start to go not wrong, but just not so well, many of them will have trouble to repay all that money. This is no news for anyone who lived the recent financial crisis in Europe or the US. However, there is a significant difference. In the West, many of the unpaid loans were held by banks, which in turn had access to large amounts of liquid money coming from the central bank or were rescued with taxpayers’ money.
Furthermore, the banks had to fulfill some (insufficient) levels of regulation that ensured that they would not engage in any extremely risky behaviour. In China, a great amount of the debt that we are talking about is held on what is called “shadow banking” – companies that lend money but do not have bank status. This is due to the fact that Chinese banks have been closely monitored for a long time by the State, and sometimes they didn’t provide the financing many small Chinese companies needed. What is the problem with that? An important part of this shadow banking system is extremely unstable. Data about how much debt we are actually talking about is not easily available (this is a common problem in China) and nobody knows if the Chinese government would be willing to bail this system out when the moment arrives (or what the conditions of that bailout could eventually be). Potentially, many financial products sold in China might be affected by a cascade of defaults. In a similar line, many Chinese have been investing their newly found fortunes and savings in the stock market – and lost good money in August – or in housing – and a price crash is likely to be coming.
Therefore, we have a potentially dangerous cocktail which sounds quite familiar (lots of debt, potential bubbles in housing and/or the stock market). How this will eventuate will depend by a large amount on which cards Xi Jinping has on his hand – of which the fact that he doesn’t need to act with complete transparency is not the least important. The worst case scenario shows a 2007-style crisis translated in Chinese terms. However, I wouldn’t expect something like this to happen. The Chinese economy, as argued earlier, is transitioning with relative success; at worst, the current situation will only cause a couple of years of problems, but I don’t think it will translate into an economic depression.
Who should worry about this? I don’t think the US or Europe will be extremely affected (beyond the possible effects in the stock markets and certain particular companies who depend on China or on basic commodities that might be affected by a reduction in Chinese demand) – but probably emerging and developing countries should. Economic contagion is fast and sometimes happens even without a rational reason. For countries that have already got their own (serious) problems, like Brazil, a crash in the Chinese stock market is really bad news that might scare foreign (and local) investors away. Still, and even though I think contagion would not reach the western countries, we are very aware that China is now more important than ever. Have no doubt – when the Federal Reserve takes decisions on the monetary policy of the US, even though they are sitting in Washington D.C., they have their eyes well fixed on the other side of the Pacific.