The lead story at Bloomberg is George Soros’ dire warnings about China a speech yesterday. He is talking his book; he’s short the renminbi, and pumped for China to float the Chinese currency against a broader basket of currencies, which would also lead it to decline against the dollar.
Soros made a doomsday call against Europe in 2012 that did not pan out, and he has been aggressive there in trying to influence policy, both on economics and on Ukraine. And he acknowledged that the timing of ugly end games is uncertain. Key sections from the Bloomberg story:
China’s March credit-growth figures should be viewed as a warning sign, Soros said at an Asia Society event in New York on Wednesday. The broadest measure of new credit in the world’s second-biggest economy was 2.34 trillion yuan ($362 billion) last month, far exceeding the median forecast of 1.4 trillion yuan in a Bloomberg survey and signaling the government is prioritizing growth over reining in debt.
What’s happening in China “eerily resembles what happened during the financial crisis in the U.S. in 2007-08, which was similarly fueled by credit growth,” Soros said…
Capital outflows from China are a growing phenomenon driven by the nation’s anti-corruption campaign, which makes people nervous and spurs them to pull money out, Soros said. While China’s reserves swelled by $10.3 billion in March to $3.21 trillion, they’re down by $517 billion from a year earlier.
With over $3 trillion in reserves, China would seem to have tons of firepower to support its currency. Some analysts have argued that IMF metrics suggest that below $1.8 trillion would put China at risk, which on the surface seems hard to fathom. The bigger issue with depleting reserves may actually be political: even though the reserves cannot be spent domestically, Chinese citizens regard them as wealth and have gotten upset at US moves that they perceived reduced the value of those holdings. So actual depletion to defend the currency if it continues could become a hot topic for the government.
The underlying issues with credit growth, however, are that too much easy credit eventually means bad loans. But if you are a fiat currency issuer you can just keep bailing out your banks until inflation becomes an problem of the politics of how the government does the rescues restricts future salvage operations. Soros raised the specter of 2008. But when I saw the signs of trouble in 2007 and 2008, I thought the outcome would be more like the aftermath of Japan’s bubble years: a ratcheting down of markets and the economy over a protracted period, with bad loans written off way too slowly. And the big wave of failure didn’t come until 1997, when the Japanese thought the economy had recovered enough so that they could reduce stimulus.
Mind you, the Chinese government regards producing growth as a prime directive, but bouts of inflation have generated serious unrest, so inflation is a bigger constraint than one might think.
Now Japan had only (IIRC) 11 “city banks” and 3 long-term credit banks that dominated its financial system, so it didn’t have that many moving parts to oversee. One issue that has the potential to cause more disruption is operational: whether China can shore up its various shadow banks quickly enough if they start falling over so as to prevent contagion. There have been some wobbles in the wealth management products market and the government did prop them up. But as we saw in 2008, efforts to reduce risk in a tightly-interconnected system tend to and in fact did backfire. So there’s legitimate reason to keep a worried eye on China.
Bruegel has a fresh article on the Chinese banking system which gives a good overview and discusses the major types of credit providers. Key findings:
…total bad loans reached 1.27 trillion yuan at the end of 2015, the highest since the global financial crisis, on the back of an economic slowdown and a ballooning corporate debt. All in all, one can argue that the banking sector is becoming the Achilles’ heel of the Chinese economy once again, as happened in the past. Chinese public banks are particular hit hard amidst the rise of non-bank financial institutions and rural banks. In fact, Chart 1 shows that the assets managed by large commercial banks have been dropping over years from nearly 60% of total assets in system in 2003 to about 40% in 2014. Yet compared with non-bank financial institutions and rural banks, large commercial banks generally still enjoy the support of the state, which still brings enormous benefits. The latest example can be found in the rumours saying seven listed Chinese banks may have received permission to lower their coverage ratios.
Notwithstanding the slowdown of the Chinese economy, bank credit has continued to expand quite rapidly. This includes both official bank credit but also the shadow banking. Only in the first two months of 2016, bank credit rose a significant 28% to RMB 3351 billion compared with the same period in previous year. When adding corporate bond issuance and shadow banking, total credit expansion in the economy totaled RMB 4200 billion in January and February, a 23% increase from the same period in 2015…
Over all, the outcome of the Annual Party’s congress last month has made it very clear that growth is the key target and that the rest, including excessive leverage, is to subsidiary to that. This was confirmed by the surprising move of the People’s Bank of China (PBoC) cutting the required reserve ratio (RRR) by 50 bps effective from March 1st, 2016…. The high bank loan growth was also amplified by the fact that zombie corporates rushed to get credit before the PBoC announced that banks could not grant loans to unapproved projects taken by zombie corporates, which however seems hard to implement given the overwhelming importance of the growth target.
The extensive credit expansion in January and February, especially from the banking sector, has several implications. First, it masks the growth of the non-performing loan ratio as the denominator has experienced such a big increase (see Chart 3). Second, such surge in credit granted must have had a surge in demand as well. Whether that new demand reflects an improvement in the economy or simply more financing needs is a key question. If it is the latter then it reflects an increasing demand for new funds to repay outstanding loans…
The question, thus, is how weak are Chinese banks in the current circumstances.
We cannot take banks in the whole China banking sector as homogenous. For the banking sector as a whole, pre-provision profits and cash loan loss reserves are enough to charge off bad loans as the average coverage ratio is 235%. This basically means that large banks should be quite prepared for the current economic downturn…As for the risk of contagion through a liquidity channel, the PBoC has swiftly moved to daily open market operations which lower the risk of a liquidity crisis…
All in all, it seems clear that the Chinese banking sector, which has become massive – even for China’s huge economic size – will have to navigate difficult waters in the next few years. The key risk is coming from corporate borrowing and, to a lesser extent, from the reduction of profitability stemming from financial liberalization and heightened competition.
As much as this analysis is thoughtful and measured, one is left with the similar nagging concerns in the runup to the crisis of a lack of a real grip on the situation, most of all by the authorities. Those who are confident that China can engineer a soft landing are betting on the will and skill of its financial and monetary authorities. We’ll see in due course if they are up to the test.
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I think the point about inflation is a key one – China has lots of capacity to backstop its banks, but only if it accepts the risk of a major increase in inflation. Historically, inflation has been a political disaster for the CCP whenever it has gone out of control (such as in 1989), but the existing domestic economic situation is very different. Not least, there are far more people and institutions in deep debt who might actually welcome a blast of inflation. But riots tend to be associated with the urban working classes and students, and it may be that their incomes are not so flexible. I’ve been surprised at the reluctance of the government to put in place some sort of income guarantees to workers as a way to prevent unrest, but I assume this has become institutionally too difficult. They are caught in a trap whereby the ‘social promise’ is based on plentiful jobs, not on welfare back-ups and so lack the counter-cyclical benefits of a welfare state (Germany) or a social commitment to keeping people in work (Japan).
As the last paragraph suggests, there is a lot of confidence that the CCP have the institutional capacity to handle a financial crisis. There is no doubt they have been very successful in the past, admirably so. And its very clear that the crack down on dissent in the past 2 years has been part of a deliberate policy of ensuring they have a firm grip on the tiller in the face of an inevitable crisis. But my confidence in them was shaken by the gross mishandling of the stock market last summer – it smacked of real panic, and of an attempt to manipulate the system in favour of insiders. For me this was the first clear evidence that they may not really be prepared for a major crisis.
I’ve stated this many times in articles in the past about China, but I think the crucial weakness in the Chinese system is that far too many wealthy and powerful Chinese are not actually committed to the country. Almost without exception, they have ‘boltholes’ set up from London to Sydney to San Francisco to Panama. I have never met a Chinese person of any means whatever (and I don’t mean wealthy, I just mean having a better than average income) who does not have an exit strategy of some type. I can’t think of any precedent in history of a growing and prospering country where so many of its most prominent citizens are so ready to leave in the event of anything going wrong. I think it is this attitude which could result in an unanticipated outflow and collapse of the system. I do agree with writers like Michael Pettis that a long term period of slow growth is more likely, but a major collapse is I think a realistic possibility, and it could be far more uncontrolled than most people expect.
wouldn’t an income guarantee be inflationary?
I don’t see how an income guarantee is inflationary, unless it was paid for with a ‘blank cheque’ of money printing. I was thinking more along the lines of long term subsidies for workers who lose their jobs due to cutting back on excess capacity – in other words, guaranteeing them a percentage of their salary for a reasonable period. I think one problem in China is that the tax base isn’t large enough to support this sort of wealth transfer.
A Job Guarantee, as advocated by MMTers, would do the trick and wouldn’t be inflationary were it done right. An income guarantee as you describe shouldn’t be inflationary, but a JG would be better. This could act as a kind of automatic stabilizer. But many at the top of the tree are vehemently against it.
If the political effects of inflation are similar to those in Latin America, the issue will not be unrest amongst workers but rather a revolt from the upper classes. From the little I know, in the past the CCP has shown itself willing and able to buffer the effects of inflation with wage increases and safety nets, but this is inevitably opposed by the concentrated capital sectors. Is this what happened in 1989? If so, given the increased power of China’s elite, I would think an anti-inflation revolt would be even more potent now.
I think its fair to say that the political impact depends very much on what investments the middle classes have made. The impression I have is that the latin american ‘monied classes’ tend to have a lot of savings in banks and business loans, and so are very vulnerable to high inflation. I think in general, the more a particular class is indebted, the more they like inflation, and vice versa.
Quoting PlutoniumKun:
China has a high savings rate, low investment rate outside of Shanghai. Inflation won’t be kind to savers. Being aggressive with savings means buying houses. Bad investment deals can be papered-over easily, but a collapsing real estate bubble not so much.
From what I’ve seen, no one bats an eye at people paid to stand around. Especially state-owned companies have an attendance-optional policy in rural provinces. Expect the full employment policy to buttress any collapse.
Largely agree, except for the potential of a real estate collapse.
I’ve seen the bolt-hole behavior first hand (complete with condos, Ferraris, spare wives, children). I think macro-economically, though, it’s not a significant factor between capital controls and an aggressive central bank with lots of dollars in reserve. The anti-corruption drive is in its infancy, but has produced some tangible results: http://dangerousprototypes.com/2016/03/10/how-to-chinese-drivers-license/
In short, I expect China to be a replay of Japan, complete with tit-for-tat tariffs, antitrust investigations of Chinese purchases of US companies, and decades of deflation. The difference being that the Japanese deflation’s proximate cause was the Plaza Accord. Will there be a similar international conspiracy against China, or will it shoot itself in the foot with a real estate collapse?
Also, don’t be surprised to see Chinese management theories becoming vogue a la Kanban, 5S, continuous improvement, et al.
Indeed, China’s is the first ruling class in history that is abandoning its own “miracle” economy en masse — and not only for economic reasons. See my “China’s communist-capitalist ecological apocalypse” in the Real–World Economics Review of last June: http://www.paecon.net/PAEReview/issue71/Smith71.pdf.
I’m only 25 pages in, but want to thank you for the piece, Richard. It’s excellent.
The Chinese used to refer to trains/railroads as the “Iron Rooster” and that phrase popped up recently regarding China’s steel industry. Which I interpret as an indication that China plans to pull its way out of this with the Silk Road for now. “Iron Rooster” sounds derogatory, like an anticipation of much fanfare and little progress. The last thing China wants is to devalue its currency so it has stockpiled zillions of tons of gold and as much in foreign currencies. And it is backing some new security that rolls up bad loans, etc into shiny new bonds backed by the govt. And is waiting to see if the influx of foreign capital offsets the escape of yuan. Their debt sounds yuuge but they have an enormous population… and equally enormous plans.
and speaking of Soros, the Chinese referred to him as the old crocodile when he first started sounding alarms about their inevitable devaluation… and they came up with solutions to foil all the short sellers… but Soros is still after them.
Hi Richard, no criticism of you but I found your article on China one of the most depressing I have read in some time. Your analysis was unrelenting. As I said, this is not a criticism, but a kind of visceral reaction to what you described. You did it so well that I had difficulty finishing the article. I felt the need for a tranquilizer, I was so distressed by what I was reading. I am by no means a China expert, but your analysis was convincing.
I did try to look you up at the IPRD, but was unable to find you. NC can give you my email address if you would be interested in getting in touch. I am also in England.
An observation, I remember back in High School knowing a young man who was from the Philippines. I also knew of several young people from other “backwards” places like South and Central America. These were the sons and daughters of the ‘local’ elites in their respective countries. For whatever reason, these young people were being schooled in America, not their own countries. These young people had to live somewhere while attending school in America. Hence, the existence of American ‘boltholes’ for those families. Any information available about Chinese young people residing in America while going to school here? That would be a sign of a change of allegiance on the part of Chinese elites, and significant.
Money if fungible, children are not.
I believe most every major college in the US has seen a huge run-up in Chinese students. At UW-Madison, Chinese enrollment grew by 350% from 2003-2013 and has continued upward from there. 2015 data show 2,600 Chinese students, roughly half the total number of foreign students and by far the most from one country. The online application is now in Chinese as well as English. My understanding is that virtually all of these students are paying the full out-of-state rate with no financial aid.
Buckle in, it’s going to be a wild ride:
http://www.rollingstone.com/politics/news/welcome-to-maternity-hotel-california-20150819
The quotation melange from previous comments captures pretty well what I find so interesting and confounding about China. The CCP, to the extent that it can resolve on a crisis approach, has at its disposal an inventory of economy management measures that seem to offer great leeway in handling a crisis. Capital outflows can be blocked, devaluations on investments imposed, investments can be directed into boom technology, etc. It seems very naive to then think that they can work around or through any crisis without a real system lockup, but I just dunno. And, although we hear much about expatriation of wealth, this is most clearly a threat only if it represents the development of a ripoff and run psychology, of the sort that is pandemic here, that undermines central planning coherence. The recency of extended suffering due to national weakness suggests that’s unlikely. Finally, even if they are unable to limit and resolve environmental degradation without significant cutbacks in growth, I don’t think we should assume that this could not be handled politically, especially if elites realized that sacrifice of some of their wealth would help maintain legitimacy. ?
The wealthy are all similar. This statement here: ” I think the crucial weakness in the Chinese system is that far too many wealthy and powerful Chinese are not actually committed to the country” is applicable to any wealthy people, not just Chinese.
Wouldn’t it be ironic if there’s a crisis in China but it’s actually precipitated by a crisis in the US/Europe first?
I have a completely contrarian view. So much so that I’d bet with China against Soros.
China has a huge balance of payment surplus. Thus it is completely independent of any dollar peg on its currency. Only if a country need dollars is there any pressure to maintain currency value.
The elites can go and hide, but they are as irrelevant as fleas on a dog. The professional (managerial) class are those who make a country work. The 1% can leave and everything will still be managed and still work.
Because of China’s dollar holding and its balance of payments surplus I believe Soros wrong. He’s not dealing with a Britain struggling with its balance of payments and necessary dollar link.
If the plies of Dollars starts to evaporate the Chinese ruling party will just impose capital controls, and execute a few of those breaking the rules, and the problem will end.
As for a Banking collapse, again the ruling party will just seize the banks and the professional class will just continue to manage the enterprises under state control, and the state will create the liquidity necessary to keep the economy going: aka MMT on steroids.
If the Chinese 1% want to bolt, I’d invite them to go, because they are useless parasites. China still has 900 Million (some of whom are very smart) citizens willing to step forward and pick up the reins.
Pollution and Climate Change are greater threats.
Soros seems to have lost his touch or perhaps people are becoming better aware of what he stands for.
He squeezed the population of UK for billions under John Major’s government which brought him to global attention. He tried to shake-down the people of HK but lost his shirt. He did the same in Ukraine and lost another fortune. Now he’s doubling-down on a biggie – ransoming China – and he really needs help.
So do as he says good people. We don’t want him to starve, eh?
Why would Soros think ‘talking his book’ would be of any value to him now if China’s control over its currency is as fixed in the firmament as is suggested? And does his book belong to him, or is working with/for others?
If it was Chinese drawing down reserves (later explained away by Chinese authorities as if a fairly long chain of transactions taking the reserves numbers back to where they started as nothing remarkable) that caused so much angst in markets earlier this year, enough for Soros to put on whatever bet he made suggests to me that ‘reserves’ aren’t nearly as liquid as might be believed or that some other undesirable effect issued from the procedure. Suppose reserves are for practical purposes unavailable as a short-term fix?
I think China is in a much worse position than is conveyed here, certainly for purely ecological reasons alone, as per Richard Smith above, and certainly for financial reasons – and I’m sure that a very substantial portion of new debt is used to pay off old debt, but also for the practical reasons of what to do with a giant urban construction economy and workforce no longer required, meaning everything from materials, to energy, to engineers, equipment, machines, having reached the end of this one-time, massive building boom?
The point being that even with a command economy and a purportedly clear goal, i.e., transition to a ‘service’ economy, the scale and scope of what is involved in order to accomplish this at all, let alone in a timely, orderly manner, requires recourse to almost magical thinking.
It’s not as if the US ‘service economy’ model works – it demonstrably doesn’t, and not just because the 1% have run amok. The whole set of relationships between income, work, talent, obligations, etc., desperately need fundamental re-ordering, and so far, nobody is up to it.
The US is a firm believer in “markets.” Aka Chaos.