China Takes The Road To Serfdom

by: Kevin Wilson


China's recovery has stalled due to the failure of both speculative finance and central planning, much as Minsky and von Hayek would have predicted.

Massive malinvestment since 2008 and a bursting credit bubble have generated huge downside risk for the Chinese banking system, and prudent investors should prepare for a financial shock.

The myth of Chinese exceptionalism will end up on the ash heap of history, and its people will inadvertently take Friedrich von Hayek's "Road to Serfdom.".

Many observers have noted the role played by China's strong growth in aiding the recovery from the Global Financial Crisis. China rebounded from the global recession in 2008 with apparent strength, generating official GDP growth of about 12% in 2010, 9% in 2011, 7.5% in 2012-2014, and 7% in 2015. Official Chinese GDP data however are almost universally considered to be suspect, even by the top leadership in the Communist Party. An alternative measure is an empirical index used by the Premier of China, Li Keqiang, based on the less manipulated combined data from electricity production, rail carloads, and bank lending. This alternative index recorded GDP as about 16% in 2010, 13% in 2011, 7% in 2012-2013, 6% in 2014, and 3% in 2015. The sharp differences between these data series are a problem, but if we just assume for the moment that the Premier of China has been using an approximation of GDP that is more accurate than the obviously wrong data (based on correlations to electricity consumption) compiled from his regional governments, then what we see is a steady and drastic decline over a relatively short time. Because China's economy is so big, and because the Chinese growth miracle has been so important as a narrative in the markets for many years, this decline is a very serious thing. Indeed, if I could paraphrase what a CNBC commentator said last week, the loss of 4% in China's GDP growth between 2013 and 2015 (on a $10.34 trillion base) is equivalent to a cumulative $413 billion loss for the global economy. Throw in the knock-on effects in other emerging markets and we are talking real money, quite possibly in excess of $1 trillion.

Click to enlargeSource: Business Insider

China's rebound from the global recession was supposedly brought about mainly through the effects of a truly massive stimulus program that was put into effect back in 2009. The Chinese government injected about $585 billion very rapidly, a level of spending equivalent to 14% of 2008 GDP, which is much larger than the nearly simultaneous U.S. stimulus package. However, China also began a huge credit binge in 2009 that in retrospect was at least as important as the stimulus, and also looks just like the credit binge that took the US down in the first place. China also grew the balance sheet of the PBOC by more than even the US Federal Reserve did with its QE programs, to the tune of about $3.4 trillion. Right after the Chinese stimulus plan began, China's government debt only represented about 20% of GDP compared to 53% for the U.S. corporate debt in China was already at a sustainable but high level of about 115% of GDP in 2009. Now, however, after years of easy money, a real estate bubble, a stock bubble, and an explosion of shadow banking in China, corporate debt has risen to 180% of GDP, and total debt excluding the financial sector has reached 255% of 2014's GDP. If you do the math, that's about $26+ trillion in debt. The sustainability of an economy carrying that much debt, similar in percentage terms to what Greece has been carrying, depends on several things: 1) the banking system must remain trusted and reliable in investors' eyes; 2) debt service must be feasible under projected conditions; 3) government must be seen to back the stability of the system; and 4) no major shocks to the system can occur. But some of these at least, and possibly all, are now in doubt. Let's examine each of these factors in the sustainability of the Chinese economy.

The banking system in China is really two systems, as it is in the U.S. as well: a fairly reliable government-backed and highly regulated formal banking system, and an informal, unregulated shadow banking system that is prone to speculative finance. I have seen estimates that the shadow banking system has as much as $1 trillion in bad loans right now. Other estimates indicate another possible $1 trillion in leveraged loans within the formal banking system, and these would soon be in trouble if a hard landing occurs. The official figures indicate about 1.5% of formal bank loans are now non-performing, but hedge fund manager Kyle Bass thinks the actual number might be 20%. That is equivalent to $3 trillion, which, if true, according to Bank of America, would require a massive debt write-off, a major recapitalization of the banking system, and a major currency devaluation (the latter of which is already in process). If China gets rid of just 20% of its overcapacity in iron and coal through reforms, SocGen analysts suggest there could be an increase in bad loans of another $152 billion.

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China's currency has devalued by about 6% since July, but if that devaluation continues to the level predicted by some, i.e., a 20% decline, the $900 billion in foreign debt owed by Chinese companies, as discussed recently by Shareholders United, would actually increase by about that amount ($180 billion). Real estate in China is in crisis at least regionally, and there are bound to be many more bad loans generated by the downturn in this sector. Many of these loan assets are owned by formal banks, but many more are owned by shadow banks. A financial crisis in China, with the risk of global contagion, is not out of the realm of possibility in the coming months. Global markets have just awakened to this idea, although many (myself included) have been writing about this potential scenario for years. So the fragility of the Chinese financial system's two-headed dragon is now on the table, and incoming data on its relative health will be important to markets.

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The notion that debt service must be feasible for the system to be sustainable is a common sense sort of observation. Unfortunately, there is lots of evidence that the existing debt is way too large to be serviced under present conditions. For one thing, debt growth is still exceeding GDP growth, and has been doing so for years. For another thing, the huge overcapacity China has in many industries effectively guarantees bad loans and defaults on a large scale, simply because the money was never going to be there to service new business loans whose purpose was to generate even more overcapacity. Stories of empty housing developments, empty giant malls, and even empty metropolises are legion in China, and they are symbolic of the irrational way growth has been managed in the country over the last two decades. Electricity demand figures suggested a year ago that there were 64 million unoccupied apartments and condos in China. An entire city (Ordos) was built in northwest China to accommodate about 1 million people, and yet is still almost entirely empty. Barron's has reported that capital spending has averaged a whopping 40% of GDP over the last decade, an unprecedented number in economic history that is clearly unsustainable. To its credit, the Chinese government has initiated reforms to rein in the overcapacity problem, allow private investment in government-owned business sectors, manage SOEs to improve efficiency, and begin other adjustments intended to rationalize the system. Reforms take time however, and time may be running out.

In theory, all these empty edifices and infrastructure projects built since 2008 were built "on spec" and could have been occupied or used based on future growth. In practice, there was no economic purpose for many of the projects except either higher employment rates (a goal of the central government) or speculative finance (in the sense that economist Hyman Minsky meant, i.e. the asset was bought under conditions that preclude paying back either the interest or the principal), and paying off the debt could never have been even considered as part of the deal for many of these abandoned structures. To get an idea of the scale of Chinese building projects, consider the fact that the Chinese poured more cement in the three years to 2013 than was used by the U.S. in the last 100 years. Malinvestment has in my opinion been the driving force behind much of China's growth in the past decade. That means that there is no way that the airports, highways, bridges, malls, and office towers built in such profusion were going to be able to generate an income stream (in the short term) that would allow the debt to be paid off. Because the explosive growth in China has been a miracle of credit and government planning rather than a miracle of sustainable capitalism, a credit collapse and ensuing Fisherian debt-deflation cycle is highly likely, as indeed has always been the case when Minsky-style speculative finance takes over a major part of an economy. If we need examples, we can look to the U.S. in 2008, the emerging Asian markets in 1998, or Japan in 1990.

The Chinese government does favor stability and attempts always to support it. Unfortunately, central planning is its method, and this approach has historically been (and inherently is) prone to failure. The market's narrative has been that the Chinese are smarter than everyone else and have more tools than everyone else, and therefore have gotten away with it. But recent events indicate that the Chinese are really no exception. The great economist and Nobel Laureate Friedrich von Hayek published a book in 1944 about this very problem, entitled "The Road to Serfdom" (University of Chicago Press, 1994). In it, he detailed the failures of Communist and Fascist central planners, and the resulting loss of freedom, growth of tyranny, and decline into serfdom of individuals. Because China created a credit bubble after 2008 for national political purposes, and because corruption was at epic levels, and because the competition of a free market was completely excluded from the largest projects, the nation inadvertently took the road to serfdom, and now there is no going back. If Minsky and von Hayek are right, the price will be paid with economic decline and human suffering.

There are unfortunate signs that the government's support of stability is theoretical or political, rather than prudent or capitalistic. The recent turmoil in the Chinese stock exchanges and the massive capital outflows that have accelerated in spite of forced currency interventions are signs that Chinese central planners are somewhat at a loss with respect to certain aspects of capitalism. They are on a steep learning curve however, and some lessons have probably been learned after the market fiasco last week. Still, Western markets reacted violently to the fear that the Chinese growth miracle is over, and that debts are unsustainable. The Chinese reputation for competence has been seriously damaged. I would submit however that much of that reputation has been based on the myth of central planning superiority which grew during the early part of the recovery. Credit bubbles take a long time to burst, and until that point, things look pretty good to many market participants. Now that growth is slowing late in the cycle, and China faces a bank crisis and a currency devaluation, the economic price for all that cheap money and malinvestment is coming due, as it always eventually does.

Now that long-predicted problems have finally arisen, we can see that in many respects Minsky-style finance (pure speculation) was what really kept it all going in recent years, and not necessarily a mythical Chinese brand of super-competence. This is not in any way to diminish the major achievements and economic progress made over the last 25 years. Rather, it is an attempt to go beyond a simple, complacent consensus that nothing can go wrong. Many are now saying that China can weather this storm of bad economic data, wild markets, huge capital outflows, and currency devaluation. Maybe it can, since it has so many tools at hand. But similar beliefs have been expressed for decades at a time about other (failed) centralized systems such as those run by the Italian fascists, the German fascists, the Soviet communists, the Cuban communists, the North Korean communists, etc. But one by one, they have all failed economically and politically because of the inherent problems associated with central planning and the resultant tyranny. I would suggest in light of these historical precedents that continued belief in the exceptionalism of China's central planners might be the same thing as basic human denial. When this denial is eventually replaced by the despair that generally follows denial, watch out below.

There are many other signs of problems. Shadow banks and trust companies have remained mainly unregulated to my knowledge, and just as in the U.S. subprime debacle, that has led to extremes in speculative finance in the real estate sector. Much of the problem has been exacerbated by the role that regional governments have played in propping up the real estate bubble. Now that these regional government-backed entities have built many billions of dollars of overcapacity, with income insufficient to service the debt, many of their loans have been put in "extend-and-pretend" mode, kept alive by leveraging already extent loans. The central government has supported this in the name of stability, but as Minsky has noted, too much artificial stability breeds instability. Keeping bad projects alive steals growth from other areas and drives down the productivity of the system. Years of this have led to unprecedented levels of overcapacity, and bleeding that out of the system will take time.

Layoffs and factory closings have become a common feature in daily Chinese life over the last two years in spite of government's goals of higher employment and urbanization. Because there is little transparency required in employer business dealings, most of these events are surprises, which has led to ever increasing social unrest. The government has tried to crack down on corruption as a tactic to combat social unrest, but that will be interesting to watch since over 60 members of the Politburo are billionaires, who in turn owe their fortunes to state-supported finance and/or corruption. As George Friedman (formerly of Stratfor) has recently written, the Chinese have a huge problem with respect to the distribution of wealth. Almost the entire middle class, around 300 million people, lives in coastal regions while the average wage in the interior remains abysmal. Chinese per capita income is around $8,000/year, but about 650 million households live on less than $1,460/year. Household consumption comprises only about 39% of GDP, compared to 55% in Germany and 68% in the U.S. In spite of the best efforts of China's ruling elite to raise up a middle class, the road to serfdom has already been taken by most of the population. Such is the actual result of political (one-party) stability and central planning.

The final factor to consider in this discussion is that major shocks to the system must be avoided in order for what is essentially a stable disequilibrium to remain balanced in the near term (although we know that such a system will eventually break down). The Chinese have until recently been lucky, but now that luck may have run out. Housing prices are coming down fast in certain regions, bad debts are increasing rapidly, and corporate debt defaults are happening increasingly but at too slow a pace to actually clear the market. Collateral for billions of dollars in loans was ingeniously provided by warehousing huge volumes of copper, but copper prices are down over 40%. Demand for coal has dropped by the biggest amount in 15 years, demand for steel dropped the largest in 20 years, and demand for cement dropped by the largest in 25 years, according to Financial Times. Retail sales have plummeted all the way down to just 4.5% growth according to unofficial sources, and containerized rail traffic has dropped 38% in two years. Deflation may be taking hold, as the latest PPI rate fell to -5.9%. Capital flight is so huge that the government spent $513 billion of its currency reserves fighting it in 2015, and contrary to popular belief, most of its remaining $3.4 trillion in reserves already is committed to trade-related rebalancing according to analyst Charlene Chu, so the amount of reserves remaining for use in 2016 may not be enough to make it.

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The notion that China will avoid a hard landing through further monetary easing in spite of two years of failure to stem the tide suggests that a shock to the system is in fact on its way. The currency problem is the most likely source for a shock right now, and if Charlene Chu is right, the Chinese monetary authorities will be unable to control the fall of the renminbi. If that fall is disorderly, the shock to the system might be sufficient to produce a market crash, a credit market meltdown, and a financial crisis. This Minsky Moment would have obvious contagion effects, especially in other emerging markets and in Europe, where much of China's foreign debt is held. The resulting economic collapse and replay of 2008 in China would potentially have a different outcome this time since social unrest is already prevalent and the financial system is already in far worse shape than it was in 2008. The ability of the government to fight an economic downturn may be much more limited this time. Central planners will not find that things go according to plan, and since they can't really choose free market capitalism as an option, they have in effect chosen to take the road to serfdom.

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