Why No China Crash? Wrong Question

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About: iShares China Large-Cap ETF (FXI), YINN, FXP, YANG, PGJ, GXC, MCHI, CHN, TDF, XPP, YXI, YAO, CN, FCA, GCH, CXSE, JFC
by: Scott Sumner

Tyler Cowen recently did a post with this title:

Why has it taken so long for a China crash to arrive?

Wrong question! Here are some good questions:

  1. Why hasn't China had a deep slump? (i.e. a depression, or at least Great Recession)
  2. Why hasn't China had a financial crisis?
  3. Why hasn't China had an asset price collapse?

I hope this doesn't sound too pedantic, but I'm honestly not sure what "crash" means (except when I hit another car).

The US had a huge stock market crash in 1987, but no economic slump and no financial crisis. The 1980s S&L crisis was a sort of financial crisis, but no deep slump or asset price crash accompanied that fiasco. And, of course, there have been deep slumps without financial crises or asset price collapses, say in 1921 or 1982. So asset price collapses, financial crises, and deep slumps are three distinct problems.

In 2009, we had all three, and I suppose the same could be said for the East Asia crisis of 1997-98, so I'd guess that's sort of what Tyler had in mind. Nonetheless, I'd like to take them one at a time. Let's start with deep slumps. Here's China's reported RGDP growth rate since 1990:

screen-shot-2016-11-03-at-7-59-39-pm

1. China has a reputation for having a very smooth RGDP time series, but that's a bit misleading. One issue is the high average growth rate. Thus, when growth slows from 14% to 6% during the Global Financial Crisis, China seems to have dodged a bullet, even though that's a bigger growth slowdown than occurred in the US. And the second factor is that growth really has been very smooth for the past three or four years, gradually slowing from 8% to 6.7%. That might be partly because big countries are more diversified, so you see more volatility in say Latvia or Iceland than in the US, or perhaps China is smoothing the data for political purposes. But that smoothness is quite recent. (The growth dip in the late 1990s and early 2000s probably reflects the strong dollar, to which the Chinese yuan was pegged at the time.)

So China already has normal business cycles, just around a higher trend rate of growth. No deep slumps (with the possible exception of the post-Tiananmen slowdown), but that's partly because deep slumps are pretty rare, especially for countries engaged in rapid catch-up growth. AFAIK, South Korea had only one deep slump in 50 years, for instance. The main cause of deep slumps is tight money that produces dramatically slower NGDP growth, not "malinvestment".

2. Why no Chinese financial crises? I suppose because the big banks are publicly owned. They were bailed out in the late 1990s, and will probably be bailed out at some point in the future. Rapid NGDP growth also helps.

3. Why no bursting bubbles? Because bubbles do not exist, the EMH is true. Yes, the US housing "bubble" burst, but not the similar "bubbles" in the UK, Canada, Australia and New Zealand. In all those cases, prices are at "bubble" levels or even higher. There is simply no reason to expect asset prices to crash.

Now, of course, asset prices are volatile - recall the Chinese stock market fell in half a few years back. But that's not something you can predict. If Shenzhen housing prices are up 50% in the past 18 months (or something like that), then there will probably be future periods when housing prices fall in that dynamic city. That's how an efficient market behaves. Just as housing in New York and San Francisco have had their ups and downs, without there ever being a crash that exposed pre-crash prices as a "bubble".

If I'd had to guess, I'd estimate that China will have one Korea-1998 type disaster in the next 30 years, but I have no idea when. It will be impossible to predict. That's because if it could be predicted three years ahead, then the date of the crash would immediately move up by three years!

So don't hold your breath for a China crash. It will probably happen at some point, but no one will be able to predict it. Nonetheless, you can be sure that Jim Chanos and other China bears will take credit for predicting it, even though they were wrong many times before being right.

P.S. In a 30-year window, I think the second most likely number of 1998-type disasters for China is zero. Two is third most likely.