Monday, December 19, 2011

No Hard Landing for China, Just an Old Fashioned Crash

About a year ago I began compiling a slide deck on the short case against China in an effort to formalize my thought and form an actionable thesis.  This proved to be fairly all-consuming endeavor and led to a substantial amount of highly enjoyable work that I summarized in a rather long-winded, sometimes polemical (and now slightly out of date) PowerPoint presentation.  My focus is towards the most misunderstood elements of the modern Chinese economy and reflects a perspective sharply at odds with the Western consensus.  Of the ‘soft landing’ camp I am not. 

In my first of what will hopefully be many, if irregularly published, pieces I’d like to briefly touch on my perspective of the Chinese slowdown and its prospects for 2012.

To bring readers up to speed, the situation has recently taken a turn for the worse. The Chinese debt cancer has continued to metastasize. Loathe to loosen in the face of vast demand from local government clients for stimulus, the center has been forced into action by the potential of a looming global slowdown; the Chinese economy, and especially the property markets, however, had already been showing signs of strain.  T
he domestic outlook has been increasingly poor with even the heavily massaged official domestic data looking worse and worse. However, the Chinese policy elite remain trapped between a very real economic (and increasingly pressing social) need to cool inflation driven by unchecked credit growth and the demands of Ponzi growth targets (to be achieved by the aforementioned credit growth).  Absent genuine reform and liberalization, the inherently inflationary tilt of China's managed economy will continue to plague policymakers even as economic activity slows; it is endemic to the model.  Unfortunately, such a fundamental change requires an autocratic oligopoly of the ruling elite to voluntarily relinquish their total control of a massive wealth-generating machine. 

Increasing cognizance of the fact that the $3+ trn of dollars of spoils from mass economic manipulation and top-to-bottom accounting fraud may already be largely spoken for has begun to percolate in the western media. The scale, opacity, and complexity of China's closely held financial system will limit comprehension of the full extent of the problems for most Western observers before it is already well underway.

Gone is the fawning wonder of the potential of unending urbanization and consumerization and in are discussions of ‘soft landing’ and the government’s ability to deftly manage any emerging problems. From this viewpoint, slow down is a necessary, temporary and welcomed respite before a resumption of  continuous growth.   However, while i
n the past powerful core leaders like Zhu and Deng may have been able to force the fiscal and monetary tightening necessary to arrest spiraling inflation, it was not without plenty of pain and suffering to go around.  The strong hand is not precise.  

Today's Party  lacks such dominant personalities, reflecting an increasingly bureaucratic hierarchy that has permeated the highest levels of the party organization.  As power has diffused, so has the ability to direct the vast wealth on tap via the state banking system.  The most powerful ministries, state agencies, and local governments, not to mention the majority of the country's largest enterprises have gorged themselves on cheap and ready financing from their captive banks and sit a top of a mountain of debt that has been stashed away in every possible corner of the economy.  With its tight control of an almost entirely closed system, economic losses could be papered over in accounting-based restructuring and life could go on.  Such has been the story for much of the past 30 years in Chinese finance.   

This time, however, is different.  Several magnitudes of order larger than during the late '90s crises, the mammoth scale of the financial system (with assets growing since 149% since the end of '06 alone) and its growing international integration raise serious doubts about the core’s ability to aggressively manage (and perhaps even survive) an emerging crisis this time around.  That the directives of the center must be transmitted through an enormous apparatus of local and regional leadership, many of whom have a vested economic interest in continued growth, makes the task at hand all the more daunting.

While the US Congress may make it easy to get down on the legislative abilities of democratic government and raise the appeal of the seemingly all-powerful, all-knowing mandarins of China, it is my belief that the magnitude and momentum of the problems at hand are already beyond the control of the central elite. Undoubtedly more aware of the real problems at the root of their economy than their European counterparts, the tools available to the central leadership in China are likely to be similarly limited and ineffectual in practice.  A process of cognitive economization driven by the demands of maintaining financial repression and its aggressive but decentralized management of the economy is already visible.  Policy actions remain wedded to statist solutions,  which raises further doubts about the possibilities for a 'soft landing'.

Setting aside my personal conviction that economic adjustment and contraction cannot be accomplished without some amount of pain and suffering for some participants (I'm increasingly a minority here), I think these arguments belie a lack of understanding of Chinese finance and its history since liberalization. While I urge those with time to take a look at my presentation (and to check out some of the referenced works, especially the particularly diligent and relevant work of Victor Shih and Yasheng Huang), I will briefly sum up my perspective on the potential outlook for China.  This is the apocalypse scenario which I view as now being more likely than any 'soft-landing', although a significant shift in leadership/policy could yet possibly avert the worst:

  • The still-born tightening of the past 6 months and the subseuqent loosening will lead to a final inflationary upsurge culminating in massive social unrest and an eventual collapse of the property markets and the already insolvent banking system. I believe this is already underway and is likely to continue to unfold over the next 18 months or so. 
  • Capital flight, led by the political-economic elite, who have been among the sole beneficiaries of the last 15+ years of growth, will accelerate and drain much of the country’s real wealth. 
  • Combining these two factors, the Chinese macro-economic outlook has the potential to rapidly deteriorate into a Greek-like debt morass, with the best option in the end likely to be the printing press. Whether the Communist Party is capable of navigating this scenario intact remains to be seen.
The Chinese state is at its most vulnerable since Tiananmen and faces a crisis dynamic that, while similar to the overall cyclical template in post-Mao China, is unprecedented in its potential severity.  With the aftermath of the last significant crisis in the late '90s still lingering on bank balance sheets, the prospects of avoiding a systemic event within China are bleak.

While available data is limited and lacking in consistency, by most estimates the Chinese property bubble is among the largest and most extravagant in documented economic history, if not the preeminent example. Setting aside the other looming issues (horrifically inefficient capital allocation, enormous corruption, uncompetitive industry, demographic shifts, a broken education system, and so on…) history would generally suggest that this will not end well. This Chinese system of today, like a man-eating shark, cannot survive for long without forward motion and was likely never capable of surviving a world of low-to-no growth for very long. With a huge number of vested interests at the local level clamoring for continued credit expansion and further unsustainable growth, I think we are already past the point of no return and the final, crushing down stroke is at hand. 

With that in mind, here are some interesting China tidbits that have emerged as of late:

Predictions of rising unrest seem to have been well founded. The FT has some pretty cool footage on the fairly unprecedented, still emerging Wukan 'incident'. The state's paranoia visible in its increasing budget allocation to domestic ‘public security’ seems to be well founded.

The Journalism & Media Studies Centre at the University of Hong Kong offers some perspective on the media coverage of the outright rebellion of villagers in Wukan in Guangdong province. While the story, prominently covered in the foreign press, is unsurprisingly absent from mainland media outlets, it has increasingly been a topic of discussion in social media.

As one might expect, currency outflows strengthened for the second month. I would highly recommend taking a spin through this compelling thought exercise from Victor Shih at Northwestern, which discusses the potential for capital flight in China in light of its startling inequality:
“Even in the conservative case, where the top 1% owned 30% of all financial wealth and 20% of all real estate assets, they would own about 3 trillion USD in assets. If those ratios shifted up by 10%, the wealthiest 1% would own assets worth 4 trillion USD. Finally, if those ratios shifted up by 20%, the super rich would own assets worth 5 trillion USD.”
As he goes on to state, these estimates are if anything likely to understate the actual magnitudes of the elite's wealth.  He continues by making some assumptions about the potential for capital flight, the implications of which should be concerning to those who see safety in China’s large reserve position:

Recalling that Chinese nationals have reportedly been aggressive buyers of real estate in a number of developed world markets and the 30%+ compound growth of Macau in recent years, it seems that this is not solely a theoretical phenomenon. The piece referenced above from the Economist contains an interesting little nugget to this end:

"According to the Hurun Report, a wealth researcher, some 14% of rich Chinese say that they have already left the country or are filling out paperwork to obtain a foreign passport. Another 46% are considering one of these steps. A recent report by Bank of America Merrill Lynch warned about the destabilizing effects of "hot money" speeding out of China this year."
To say that the implications for the rest of the world, not least the US, are potentially worrisome is perhaps an understatement.

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