China faced a 1929 moment in 2008. Since then, it has only grown its credit bubble. Instead of reforming the economy in the direction expected by China bulls, opening up its currency to the world, it instead closed its capital account. The risk of a major financial crisis has been increasing over time.
China relied on investment driven growth to get wealthy. Going back to the 1980s and into today, officials made imports more expensive than exports. Most banking is done by state-owned companies, most loans go to state-owned entities. The government used financial repression to drive up savings and made loans cheap. There was a devaluation of the yuan in the mid-1990s as this system caused inflation, followed by a credit bubble in the late 1990s. The government could easily take this debt onto its balance sheet and reset the financial system.
In the 2000s, China was allowed into the WTO. It kept on with the same investment model, drive up savings, make lots of cheap loans, build infrastrucure, and added flooding the world with subsidized exports. Real estate investment also took off and became the main pillar of the economy.
China experienced its own housing bubble burst in the mid-2000s. China was not unlike the United States in 1929, with real estate, credit and stock market bubbles. Their response was a monster stimulus program: China’s 4 trillion yuan stimulus to boost economy, domestic demand
By 2011, it was obvious they’d blown a bigger bubbles. They did get a high-speed rail network out of it though, not a total waste like some countries I know…
Starting around this time, China was transitioning to Xi Jinping’s rule. The incoming officials were saying no more big stimulus was coming. They know it threatens to sink the economy. Yet every time growth slowed again, they opened the spigots. In 2014, the industrial northeast was tipping into a recession. The government blew a stock market bubble that popped in 2015. Instead of cutting zombie steel mills, China kept hitting new records of steel production (into 2020, which everyone misinterpreted as growth). Finally, it turned back to real estate investment. Here’s astory from 2016, the year after the stock market bubble burst: Ministry of Finance Owned Cinda Real Estate Becomes Land King
Instead of reforms, Chinese officials were still promoted in part based on their local GDP growth. It is easy to manufacture GDP with debt and construction. As credit restrictions tightened, local officials started selling more land to finance invetment. They also sold debt against land to finance investment. The system hinges on land prices and home prices going up.
China was an economic miracle into the 2000s. Since then, there was a bait-and-switch. What’s been going on in China is a better looking version of what’s going on across the developed world: ever more debt for ever less return. They should have broken from the West and reformed away from their development model starting around 2005. Back then there was talk of opening the stock market to foreign investors and “internationalizing” the yuan, making it a fully convertible currency. There was some push in that direction. I recommend reading Red Capitalism for a fuller understanding of what went wrong. Instead, they took the easy route of doing more of the same and here we are, about once every three years asking if this is the event that starts the Chinese economic crisis.
About Those Treasuries
Why does China have huge reserves of U.S. Treasuries? To prevent their currency from rising and killing their export markets and ending the housing bubble. The banks sterilize incoming U.S. dollars (this also keeps them from flowing back out of China in unapproved channels) and swaps them for yuan.
Back in 2012 I posted this: PBOC can’t buy a buck; talk of depleted reserves is not alarmist. An economist warned their reserves could disappear within 5 years because of the 2008 stimulus fallout. Most of China’s reserves are “spoken for” in the financial system, because China ostensibly backs the yuan with U.S. dollars and now other foreign currencies and gold. In August 2015, to the shock of everyone who hadn’t closely studied China’s economy, they allowed the yuan to depreciate. It was a small amount, a move that wouldn’t cause much concern in the dollar, euro or yen, but it caused a minor global financial panic because most people were shocked.
Since then they’ve implemented strict capital controls. It’s difficult to take U.S. dollars out of China. They escalated their war on cryptocurrency mining to a total ban. Only a few years ago, people were saying the yuan would become an international currency and challenge the dollar. They have implemented 180 degree opposite reforms, making the currency less useful and less convertible. Chinese reserves have barely grown over the past few years, but money supply growth has continued. When they let the yuan depreciate in 2015 (it wasn’t a devaluation because they had been defending the currency), reserves covered 16.5 percent of M2 money supply. Today, reserves are down to 9 percent of M2. The market doesn’t care about this number, so everyone ignores it. I don’t.
Wrapping It Up
This post is getting a bit long because it’s a big topic, and I’m sure I’ve missed a few things. The main takeaway is that China is in a credit bubble, as is Europe, Japan and the U.S. Many China bulls interpret Chinese money printing as bullish, but horrible when done by the developed nations. It’s the same policy. Which nation has a crisis first will determine which nation’s currency rapidly devalues first. Since the U.S. dollar is the reserve currency, it is the least likely to start the crisis because a crisis anywhere else will trigger deflationary forces, i.e. repayment of debt, and the dollar underpins the global credit system. Only if the dollar is in its end game crisis of losing reserve currency status will it fall first. (That crisis is probably about 10 years away.) Or if all currencies implode simultaneously against commodities. In a sequential devaluation scenario similar to the 1930s, the dollar will most likely devalue last.
Many people think China being an export powerhouse makes it strong. The U.S. was the export powerhouse in 1929. Many people intuitively undertsand that the U.S. has lost the trade war, but they don’t think through the implications. The U.S. is going to build factories and bring jobs home in the next crisis. China is going to have closed factories and idle workers. Europe is talking about making semiconductors domestically, as is the U.S. In terms of trade, China is at a peak. It will have the hardest time adjusting. Addtionally, if I’m wrong about how the currencies move and the dollar tumbles against the yuan, the U.S. won’t need tariffs or industrial policies to ban Chinese exports. The falling dollar will destroy China’s exports markets.
Many bulls will also point to various growth markets, but consider all the technology and development coming to the USA in the 1930s. Florida saw its first land boom in the 1920s. California was going to become an economic power in its own right. Autos, TV, air travel and electrification were all coming. Yet the country still suffered a massive depression and eventually devalued the dollar from $20 per ounce of gold to $35 per ounce. This was caused by the credit bubble that preceded it.
China’s ultimate weapon against a bursting of the credit bubble is money printing. As crises popped up in the past decade, it blew more credit. At some point, more credit won’t work and it will have to print money. Or as people seem to have an easier time understanding with the U.S., people inside and outside of China will lose faith in that credit. Either way, the currency will experience a major depreciation or devaluation. Back in the early 1990s, they did a huge one-off devaluation and then defended the new fixed exchange rate. I expect a similar “surprise” move will come again because it was succesful. I have no idea what number they might settle on, but USDCNY 10 is probably a conservative number for a major devaluation.
I recommend reading Michael Pettis and Anne Stevenson-Yang for honest takes on China’s economy. The latter wrote this in 2017: «China is going to hit a wall» It’s a great article that makes similar arguments to ones I’ve made above. Here’s what she said back then about Evergrande, the developer with US$300 billion in debt that is finanlly going bust in 2021:
And how are such ghost towns financed?
There is probably no company that is more representative of the investment bubble than Evergrande. It’s the biggest pyramid scheme the world has yet seen. Evergrande is highly leveraged and has like 270 projects all over the country. I have been easily to 40 of them yet I have only seen one that was fully occupied. Many of these projects are megalomaniac visions and totally empty. Yet you go to these places and you see their sales room filled with young buyers. When I open my eyes I see crumbling stone and empty jungles or deserts. What they see is a future with wealthy Europeanized people strolling on modern paths. It’s just amazing. It’s a mass illusion and Evergrande more than any of these developers plays to this illusion by building developments that are specifically positioned for the investor, not to live there but to buy for some future appreciation in price.
None of the above is to say China’s future isn’t bright. The USA of 1929 was on the cusp of greatness. Still, the U.S. experienced a deep depression and currency devaluation. Currency devlauation is the fastest way out of a credit bubble because it immediately resets everyone’s balance sheets. Most countries exited the depression quickly in the 1930s because they devalued against gold quickly. The U.S. waited until 1933. Had it stopped there it would have come out of the depression quickly too, but the country decided to try authoritarian socialism. Similarly, the big risk in China isn’t currency devaluation, which should be expected, but a similar policy error that derails what would otherwise be a quick (for a depression) recovery. Or worse, the unfolding crisis leads nations into another destructive global war.