I have been wandering through the fascinating nation of China of late, so I haven't had much time to peruse the blogosphere - I guess this means that for a month I had a life. I was fortunate enough to spend a few days in the beautiful city of Lijiang in Yun'nan province. This mid-sized Chinese town is famed for its wonderfully restored 'old city', a cobbled and confusing maze of shops, traditional inns with gorgeous courtyards and a grid of small canals filled with luminous fish and gushing clean water. A beautiful place to while away a few days, but Lijiang isn't really known for its nightlife. So on the evening of the 25th of December, I got trawling through some of the past articles on Samizdata. Reading through the comments section on this post, I noticed that an article I wrote early in 2005 got a mention. It was a pity I was not around a computer regularly, because a debate raged in the comments section that I would have very much liked to have been a part of. For all my appreciation of China, I am one of the few Sino sceptics.
I should explain. I am not a sceptic of the aspirations of the billions of Chinese people who sense greatness in the Chinese identity. After all, I'm mentioning a deeply rich culture backed up by a vast talent pool on the mainland and in the diaspora that has the capacity to change the world radically in the future. I am, however, deeply pessimistic about China in its current nominally Communist incarnation, for reasons I have outlined in a previous post. I won't go into specifics; if you're curious, please read my rationale here.
Some interesting developments have taken place between now and then, however. These merit further analysis. One or two of the commenters in the mentioned Samizdata piece stated that they were keeping abreast of banking developments in the Middle Kingdom. In 2002, Chinese officials admitted that 25% of the loans written by the state owned banks were non-performing. Standard and Poors and a number of others said it was closer to 50%, and possibly more. Within the space of four years, the Chinese administration has revised its estimation of the rate of non-performing loans down to an average of about 12%. How can this be done so fast? I'm not really sure. We are, of course, talking about the writing down or otherwise accounting for of many hundreds of billions of dollars of bad loans. I assume that it's due to the fact that most or all of the bad loans have been transferred to special "asset management" companies set up by the government. I suspect that the banks have been able to revise their non-performing loans (NPL) ratio down so quickly by performing a debt-to-equity swap with these holding companies. The article linked to immediately above believes the asset management companies have taken a chunk of the banks' loans and issued them with 10 year bonds in return.
This solution is clearly economic sophistry. At the end of the day, someone has to pay the tab - at some stage depositors are going to want their money. The equity in these holding companies is effectively (if not nominally for the time being) worthless - after all, their assets consist of a bunch of loans that will never be repaid. What is being done about the essentially state-owned industrial sector, which was - and most likely still is - the major recipient of these loans? There's a saying in China that goes something like "The mountains are high and the Emperor is far away". I have no doubt that this thinking pervades China's provincial administration and its state-owned industrial sector, and it explains the pervasive corruption that is, contrary to official publications, as rampant as ever. For every high-profile trial and execution of an apparently "senior" official on corruption charges, there are hundreds of thousands more who not only escape undetected, but are also politically untouchable into the bargain. Quite simply, the central government cannot be everywhere at once, and its reach is frequently limited by local powerbrokers. Consider this case in Guangdong, one of China's more prosperous provinces, where the central government couldn't exercise its will due to local political considerations, even though humiliating international media attention was beaming down. And who's to say that the central government isn't as corrupt as its provincial counterparts? It's hardly unreasonable to say that corruption probes have a definite glass ceiling when it comes to the powers that be in Beijing.
I believe that the Chinese banking sector's dire straits constitute the gravest threat to global stability in the coming years. The Chinese government is always harping on about its "deepening" banking and state-owned industrial enterprise reforms, and this is a mantra is being repeated across the world. Unfortunately, the Chinese state is so opaque that it's impossible to verify the veracity of such claims, and the unrealistic numbers being thrown at us by the Communist party (like the drop of NPLs from 25% to 12% in less than five years) and the shonky juggling of bad debt from one insolvent bank to another woefully undercapitalised holding company do not inspire much confidence in the nature of the reforms. Frankly, I believe the banking sector is too far gone to reform without collapse. In international terms, the crisis in the Chinese banks and SOEs is an elephant that stands in the middle of the room, but everyone is either perceiving it as a mouse or trying to pass it off as a mouse. I believe the Australian government is in the latter category, as are a great many others around the world.
I speculate that governments like Australia's are acting as they are because they realise the Chinese state is very brittle and unlikely to withstand economic collapse. The massively stimulating US$50 billion or thereabouts annual injection of foreign direct investment is holding the Chinese state together for the time being. Thus, a number of states such as Australia have an interest in talking up Chinese economic reforms - and concealing the parlous nature of the Chinese economy - in the hope that investor confidence will not flag and the Chinese will trade and consume their way out of their problems. Our current economic health is due to huge demand in booming and resource-hungry China. Thus we see documents like this (pdf) that echo the "deepening reforms" mantra consistently spouted by the Chinese administration. Puff pieces like this create and sustain the irrational exuberance that swirls around the legend of the Chinese economic miracle, and inevitably amplifies economic pain when the collapse eventuates. The strategy of our governments may work, but it's an extremely high-risk gamble. The more investment in and commercial intertwinement with China increases, the more outsiders will suffer if the system unravels.
And perhaps the cracks are already becoming evident even to the man on the street. When I was in China in late 2005, ATMs were frequently out of order. I work in the banking sector in Australia, and when an ATM is out of order this nearly always means the machine has dispensed all its money. This was not a problem in late 2004 during my previous Chinese visit - ATM operations at that time were indiscernible to those in Australia. I am speculating here, because I'm not really an expert on this kind of money velocity issue, but perhaps the sudden patchiness of the ATM network is a sentinel of a solvency crisis.
And the collapse could come sooner than we think. In 2007, as per the agreement China entered into upon joining the WTO, it must open up its retail banking sector to foreign banks. This is a potential tripwire. Even if only a small number of Chinese are concerned about the health of their local banks (and thus their savings), when Citibank opens up next door the run on Chinese banks could easily spin out of control. I am assuming that the government is trying to spread the notion of confidence and stability in the retail banking sector. If the Chinese don't panic come 2007 or any time in the subsequent 20 years or so, the banks should be able to reduce their NPL rate to a "more manageable 5%". It wouldn't be the first time that people have left their money in a bank that is essentially insolvent because they believe the government will cover any losses incurred. This is a questionable assumption, however, and if I was Chinese I probably wouldn't run the risk.
I am concerned by the consequences of a Chinese economic collapse, and these concerns reach far beyond any short to medium term economic pain. I fear a worldwide economic slump prompted by the collapse of China and its supposedly free market will provoke a popular backlash against globalisation and the liberal market reforms carried out in the 80s in the most successful economies of the West. Capitalism and liberalism will be blamed if people create a nexus between China's collapse, its market reforms and its intertwining with the greater world economy. There is no shortage of people who will quickly jump to the fallacious conclusion that the free market sunk China - those who protested in Hong Kong and other places would grab plenty of (misguided) ammunition from such a catastrophic event. Ask any one of those economic curmudgeons about post communist Russia's economy, and I'll bet you penny to a pound that their standard response would be "capitalism failed Russia". This is about as sensible as saying that modesty failed Paris Hilton, for anyone who knows anything about post-Soviet "free market reforms" will know that they were in fact nothing of the sort. This type of thinking could very well gain traction because it makes sense prima facie. Policy reversals may follow and suddenly we're staring down the barrel of a neo-Keynesian revolution. Consider what the average person knows about China's economy. We're all told about China's free market reforms and its burgeoning capitalist class in the mainstream media - we're not told about the Chinese government's meddling in the economy and its mandating of compulsory totalitarian-style imposts on big private companies like internal "political cells", its retention of control over huge swathes of industry, its equity market (there is currently a ban on IPOs on Mainland bourses) which is stuffed with companies who are controlled by local governments and even the military, rather than shareholder, the board and a CEO. Most importantly, we're not told about the largely intractable problems with China's banking sector. Most people truly think China operates under a free market economic system. If the dog's breakfast that is China Inc fails with all the accompanying pain and fallout, there's a real danger that free market liberalism will be made the scapegoat internationally.
As I speculated above and in my previous article, Chinese economic collapse will probably preface political revolution. This is in itself an interesting, though disturbing proposition. What would post-communist China look like? Firstly, I should mention that a democratic revolution seems fanciful at best. There is no ANC-type shadow opposition waiting in the wings. The Party is the State, and the Party brooks no opposition. Here are what I consider to be the two most likely outcomes:
1) The military will overthrow the Party. If the banking sector collapses, so too will large chunks of the state-owned industrial sector that are afloat solely due to loans from the state-owned banks. Millions upon millions will be out of work - millions more will lose their pensions and benefits. Many tens - perhaps hundreds - of millions of people will pour onto the street to vigorously and violently protest their loss of savings and/or employment. In its death throes, the Communist Party will order a brutal military crackdown. Trouble is, a military is made up by people with aspirations, families, hopes etc. People who would have lost their savings, too. People whose parents, family and friends are suddenly out of work and without benefits. Most of the officers and soldiers will have no end of sympathy for their countrymen under such circumstances, and it's difficult to imagine the chain of command will survive under such conditions. The Communist top brass will lose control of the military, which will regroup under a new command. The old political order will be drawn and quartered, Mao will be evicted from his mausoleum and his portrait ripped down from the gate of the Forbidden City. There is no democratic tradition in China, however the country is steeped in a history of rule-by-decree. Expect this for many years to come. Perhaps the best outcome would be highly imperfect democratic elections in several years time.
2) The country breaks up along the lines of regional powerbrokers. Along with rule-by-decree, China also has a long history of warlordism and disunity. Due to the lack of any credible and widespread opposition movement in China, the possibility of a complete breakdown of central control is high if the Communists depart the scene and the military doesn't fill the vacuum. Hong Kong would almost certainly go its own way. Those provinces with large populations of non-Han citizens like Tibet and Xinjiang may declare their independence - perhaps bloodily ejecting the old order. Inner Mongolia may reunite with Mongolia. There is scope for large-scale dismemberment of the modern Chinese state. That left over will be fractured and ruled perhaps by the old regional party bosses reincarnated as warlords or whoever is able to wrest power from them and maintain it.
Some mention Taiwan as a wildcard that could be used as a distraction by the Central government. I think this unlikely. If the economy collapses, a war with Taiwan isn't likely to distract anyone from their sudden poverty. Militarily, it seems unrealistic, too. The military will be stretched to breaking point in an attempt to reign in the chaos on the Mainland, so a massive invasion or attack on Taiwan looks unfeasible.
I truly hope that I am wrong about my bleak assessment, mainly due to the turmoil and potentially massive loss of life that would undoubtedly accompany such an event. I am also deeply concerned about the potential illiberal and protectionist measures that may be enacted in the West and elsewhere in the wake of a Chinese meltdown. The world has made a grave error of judgement in heavily backing an economy designed, constructed and administered by a group of ostensibly reformed Communists. This fact alone should have cooled the foreigners' ardour. As it stands, the potential for unprecedented economic losses from Chinese investments is enormous. I think we could be facing a very painful depression, which may very well be "cured" with a protectionist, welfarist New Deal-like solution. Scary times ahead.