Bears are circling bulls in the China shop

As long as the Chinese economy continues to outgrow its fully industrialised counterparts, the debate between China bulls and bears will rage on. In my view, they both are right and wrong. But I’m not sitting on the fence because there is some nuance required here. Here’s why bulls don’t know why they’re right, and bears don’t know why they’re wrong. 

Bulls insist 40 years of rapid growth, interrupted only by a couple of mediocre years after the 1989 countrywide riots, prove that China can adapt to almost any situation. It is, after all, still at a low base with GDP per capital less than $US7000. There is still a lot of room to grow, and grow it will. After all, China is such a large potential market in and of itself, and this can sustain economic growth for a long time.

Look at Alibaba.com as an example. Its success is based on a service that largely matches Chinese buyers with Chinese sellers -- a Chinese company created for China. Its profit margins are way superior to that of Amazon, Yahoo or any other Western dot.com company. For bulls, this is what China is capable of.      

Bears have plenty of ammunition to point to as well. So much scorned and mocked by bulls when China seemingly sailed through the Global Financial Crisis, bears point to China’s response to the GFC as the primary reason why they are China bears.

To wit, China responded with the largest ever stimulus in economic history. Formal bank lending more than doubled in one year from 2009-10. The outstanding loan-book of banks expanded by almost 60 per cent in the two years from 2009 onwards. If one includes the shadow banking sector, debt to GDP levels are well above 200 per cent. The fact that local government financing vehicles (local government state-owned enterprises that eagerly accepted the cheap credit and wasted much of it on ghost cities and other foolish property ventures) possibly have distressed debts of somewhere between $US1.5-$US2 trillion is not reassuring. Throw in corruption and other institutional failings, and one can see why bears are now probably in the ascendancy.

In the interest of full disclosure, I have been a short-term China bull but medium- to long-term China bear since around 2007, as the release of a book I authored, Will China Fail?, would suggest. I have also been consistently sceptical that China’s leaders can implement the reforms that they continually promise (China can’t beat economic laws, August 20, 2013).

For the sake of this article, one can agree that a major (if not the major) battleground is the Chinese financial and banking system. Sure, China is still growing at about 7 per cent. But exporting to advanced economies is no longer a viable driver of growth, domestic consumption is not growing fast enough to pick up the slack, and China has become even more reliant on fixed investment to drive rapid growth.

The problem is that there has been so much capital investment that the country is running out of profitable things to build. Hence the problems with chronic over-capacity, empty cities, and empty houses fuelling what many believe to be a residential property bubble. For many bears, it only takes a couple of high-profile defaults to bring down the financial house of cards since the drying up of credit will lead to a cascading series of defaults and loss of confidence that will expose the true state of bad loans lurking in the Chinese financial system.

Indeed, it appeared a close shave in September-October 2013 when interest rates spiked dramatically on China’s overnight interbank market (what financial institutions borrow from each other to meet short-term liquidity needs). In the past, when it seemed like a spike was becoming serious, the People’s Bank of China had stepped in to inject more liquidity in the system. This came on the back of warnings by agencies such as Fitch Ratings downgrading the country’s sovereign debt ratings on account of these concealed financial frailties.

As panic between financial institutions ensued, interbank lending rates momentarily reached an astounding 30 per cent, up from rates of about 2.5 per cent. Finally, the People’s bank responded, announcing that it would ensure liquidity in the system.

As expected, bulls and bears learnt different lessons from the episode. Bears believed that this was a dress rehearsal for China’s impending ‘Lehman moment’, referring to when the American investment bank’s collapse triggered the GFC in 2008. The spike in interbank rates was proof that China’s financial institutions were spooked by the systemic problems caused by easy money and indebtedness rampant throughout the economy.

For bulls, the opposite conclusion was reached. China didn’t have its ‘Lehman moment’. Things stabilised quickly. Besides, growth will cure China’s debt ills and the boom continued despite a few wobbles here and there. The fact that a ‘Lehman moment’ was avoided with minimum fuss proves the resilience of the Chinese economy, and perhaps the policy skill and execution of its authoritarian leaders.

This now gets me to the point of the article. If we use the absence of a ‘Lehman moment’ as the litmus test for China’s economy, then the bulls appear to have won the day. Furthermore, China is unlikely to have a ‘Lehman moment’ simply because its political economy more broadly, and banking system more particularly, is very different to that of America’s, or from the rest of the advanced economies for that matter.

In 2008 -- and after the collapse of Lehman Brothers -- commercial banks, having lost confidence in the solvency of other banks (and therefore that other bank’s capacity to pay back their short-term debts), panicked and stopped lending to each other. The lifeblood of liquidity in the whole financial system, credit, dried up immediately as banks treated each other like institutions about to fail -- almost fuelling a self-sustaining prophecy. This was the beginning of the GFC from which America and the industrialised world is only just beginning to recover.

China’s banking system is very different. It is dominated by state-owned banks that ultimately do what Beijing tells them to do. The evidence: the massive expansion of loans and credits from 2009 onwards. This arose from government directive, not from commercial decision. Even when interbank rates spiked in September-October last year, the People’s Bank intervention was followed by political directives that the banks must lend to each other again at normal rates -- which they duly did. The point is that along with a still-closed capital system which minimises capital flight out of the country, China’s banks won’t stop lending to each other or external clients because Beijing will force them to do so to keep the economy ostensibly humming along.

So the bulls are right in that China can avoid its ‘Lehman moment’. But they miss the point that a closed and command system capable of perpetuating and exacerbating the serious misallocation of capital will have little motivation to genuinely fix these capital misallocation problems.

In other words, the Chinese banking system is not resilient because it is lean, efficient and rational, but because it suppresses the emergence of genuine market and price signals (e.g. a spike in interbank and retail interest rates resulting from a rise in non-performing loans) that would lead to the slowing of investment activity.

By the way, such a system is not cost-free, even if GDP continues to grow rapidly. The great beneficiaries of such a system are inefficient SOEs nurtured and protected by the government, and which need more and more capital to prevent them from defaulting on their debt obligations. The losers are more deserving private sector firms starved of capital and opportunity, and households whose savings, in returning meagre interest, are effectively used to subsidise inefficient investment activity by SOEs.

Conversely, the bears predicting a ‘Lehman moment’ collapse are likely to be waiting for some time. But they are nevertheless correct about the serious flaws in the Chinese political-economic and financial system. They are also correct that these problems are getting worse and worse, even if they are wrong about an imminent collapse.

To sum up: bulls don’t know why they’re right (and are actually wrong in many respects) while bears don’t know why they are wrong (but are actually right in many respects) -- if that makes sense. So should we be long or short on China? That depends on whether one can tell when an economy with chronic problems deteriorates into an economy with a terminal one. But that’s for another time.  

Dr John Lee is the Michael Hintze Fellow and Adjunct Associate Professor at the University of Sydney, non-resident senior scholar at the Hudson Institute in Washington DC, and a Director of the Kokoda Foundation.