China is in the greatest financial bubble in history. Yet, calling China a bubble does not do justice to the situation. This story has been touched on periodically over the last year.
China has multiple bubbles, and they’re all getting ready to burst. If you make the right moves now, you could be well positioned even as Chinese credit and currency crash and burn.
The first and most obvious bubble is credit. The combined Chinese government and corporate debt-to-equity ratio is over 300-to-1 after hidden liabilities, such as provincial guarantees and shadow banking system liabilities, are taken into account.
Paying off that debt requires growth, but the growth itself is fueled by more debt. China is now at the point where enormous new debt is required to achieve only modest new growth. This is clearly non-sustainable.
Picture this. You’re a middle-class Chinese saver and you walk into a bank. They offer you two investment options. The first is a bank deposit that pays about 2%. The other is a WMP that pays about 7%. Which do you choose?
In the past ten years, bank customers have chosen almost $12 trillion of WMPs. That might be fine if WMPs were like high-quality corporate or municipal bonds. They’re not. They’re more like the biggest Ponzi scheme in history.
Here’s how they work. Proceeds from sales of WMPs are loaned to speculative real estate developers and unprofitable state owned enterprises (SOEs) at attractive yields in the form of notes.
So, WMPs resemble collateralized debt obligations, CDOs, the same product that sank Lehman Brothers in the panic of 2008.
The problem is that the borrowers behind the WMPs can’t pay their debts. They’re relying on further bubbles in real estate or easy credit from the government to meet their interest obligations.
What happens when a WMP matures? Usually the bank customer is encouraged to rollover the investment into a new WMP. What happens if the customer wants her money back? The bank sells a new WMP to another customer, then uses those sales proceeds to redeem the first customer. The new customer now steps into the shoes of the first customer with the same pile of bad debt. That’s where the Ponzi dynamic comes in.
Simply put, most of the debts backing up the WMPs cannot be repaid, which means it’s just a matter of time before the WMP market goes into a full meltdown and triggers a banking panic.
Finally, there is an infrastructure bubble. As explained in more detail below, China has kept its growth engine humming mostly with investment instead of aggregate demand from consumers.
Investment is fine if it is directed at long-term growth projects that produce a positive expected return and help the broader economy grow as well. But, that’s not what China has done.
About half of China’s investment in the past ten years has been wasted on “ghost cities,” white elephant transportation facilities, and prestige projects that look good superficially, but that don’t produce enough revenue or efficiencies to pay for themselves.
Much of this investment was financed with debt. If the project itself is not revenue producing then the associated debt cannot be repaid, and will go into default.
The toxic combination of government debt, corporate debt, WMPs, and unrealistic growth expectations have set up China for the greatest market crash in history. But, not yet. As analysis will continue to prove, political forces will put off a day of reckoning until early 2018.
The Middle-Income Trap
Most of the debt statistics noted above are well known. Analysts are relaxed about it. They acknowledge that debt levels are high, but point to the fact that China has the second largest economy in the world, and is by far the fastest growing major economy in the world.
Even though growth rates have fallen from 10% to 6.5% in recent years, that 6.5% growth is still enviable compared to 2% growth in the U.S., and less than 1% growth in Europe. China’s debt burdens are manageable as long as the growth is there to support the debt.
This rosy scenario ignores two harsh realities. The first is known as the “middle-income trap.” The second is a death spiral of rising debt and rising interest rates that choke off growth just when it is needed most.
When I studied development economics in graduate school in the 1970s, it was widely believed that the most difficult part of moving countries from poverty to wealth was the initial stage. Societies seemed stuck in a permanent rut of primitive agrarian culture and simple resource extraction.
What was needed was a “takeoff” that would move citizens to cities, improve productivity on the land (the “green revolution”), and employ newly urbanized workers with foreign direct investment, foreign aid, and national savings. From there the expectation was that growth would be self-sustaining and economies would grow rich over time — just as Japan and Germany had achieved high-income status from the ruins of World War II.
It turned out that the first part of this model was true, but the second part was not.
In broad terms, the IMF and OECD define a “low-income” country as one with per capital income of less than $5,000 per year. A “middle-income” country lies between $5,000 and $20,000 annual per capita income. Above $20,000 per year of per capita income is generally considered “high income.”
Obviously such measures are somewhat arbitrary. Also, because they are averages they mask a lot of relevant information about income distribution. In the case of China, per capita income is about $8,000 per year, but extreme income inequality means that the median income if far less.
These figures also do not take into account government benefits and social safety nets than can produce a decent quality of life even at lower income levels. China has no robust social safety net (one reason the personal savings rate is so high). This means the $8,000 per year income figure overstates the income security of Chinese workers compared to some other countries.
Even adjusting for income inequality and no social safety net, the Chinese per capital income figure puts it solidly in the middle-income ranks. By way of contrast, India today is stuck in poverty at $1,600 per year. In the high-income ranks, Switzerland’s per capital income is $81,000, almost 50% greater than the United States.
In 1960, per capita GDP for China was $90 in constant dollars. The Chinese Miracle is that per capita income has risen 10,000% in less than 60 years, with most of that coming in the past 35 years since the death of Mao Zedong.
All of this is consistent with the 1960s takeoff theory I studied in the 1970s. The problem is that this growth is not self-sustaining. It turns out that the path from poverty to middle-income is straightforward, but the path from middle-income to high-income is far more difficult.
Moving from poverty to middle-income is just a matter of mobilizing factor inputs of labor and capital. The labor comes from hundreds of millions of citizens moving from subsistence level farms to cities and taking manufacturing jobs. Finance capital comes from export-related savings and foreign direct investment.
The result is an explosion of income through simple assembly-type manufacturing and cheap exports. This process is helped by a cheap currency, which China manipulated from 1995 to 2008.
Moving from middle income to high-income is a different challenge. It cannot be done with more of the same urbanization and manufacturing. It requires high-value added products that come from education, technological innovation, and entrepreneurship.
Germany and Japan managed this after World War II because they had huge reservoirs of human capital in the form of an educated workforce despite the destruction of physical capital.
Since then, only three major countries (other than oil exporters) have moved from middle-income to high income. Those three are Taiwan ($22,000), South Korea ($27,500), and Singapore ($53,000). (Macau and Bahamas also made the leap, but those are special cases based on tourism and gambling that cannot be applied to major industrializing economies).
China is not alone in the middle-income trap. It is stuck there with Malaysia ($9,300), Mexico ($8,500), Turkey ($11,000), and several others.
All of these countries have grown through some combination of assembly-type manufacturing, tourism, energy exports, and commodity exports. None has generated the kind of self-sustaining technological innovation seen in Taiwan, South Korea, and Singapore.
The prospects for China to break out of the middle-income trap are poor. China’s theft of intellectual property and weak rule of law make it an unattractive venue for technology development. Its Communist Party dictatorship also does not allow the free exchange of ideas, social media connections, and entrepreneurship needed to generate high-value added processes.
At the same time, China’s advantages in assembly-type manufacturing are being siphoned away by low-income countries such as Vietnam ($2,100), Philippines ($3,000), Indonesia ($3,600), and others in Central and South America.
Of course, the greatest threat to Chinese output in the manufacturing sector in India. There, one billion people are ready to make the same transition from farm to city that China made in the 1980s and 1990s.
In short, Chinese growth is in severe jeopardy. Its manufacturing base is being taken over by competitors and its high-tech future has yet to emerge, and may never emerge in time to avert a debt crisis.
The Chinese Miracle is no miracle at all, it’s just simple development economics. China is now out of time and out of good options.