A while back I was on a panel discussing the Chinese credit market and restructuring and the moderator opened by saying something that I think captured my sentiments perfectly. While as economists and investors we are obligated to discuss our concerns about the Chinese debt markets, restructuring, and what many believe to be frothy asset prices, I sincerely hope China is able to avoid a hard landing or crisis. Having seen 2008 up close, I do not wish that on China or my many friends and colleagues. As an economist, we sometimes forget that people are much more than data points.
One of the hottest areas for academic finance research is something called market microstructure. As the Wikipedia page so aptly summarizes it “microstructure research examines the ways in which the working processes of a market affects determinants in transaction costs, prices, quotes, volume, and trading behavior.” Basically, how do all the rules made by exchanges (think rules of the game) impact trading and pricing. This is similar to the economics research into the impact of quality of governance on growth but with much more granular and precise data. The reason that I use big numbers when looking at China only when necessary is that this omits all the real important data and processes. GDP, leaving aside whether it is accurate or not, overlooks the cash flow that firms and households have. Debt to GDP is helpful but it is much more important to understand who owes that debt, what type of debt guarantees, who holds the debt, and other issues which drive, similar to what the market microstructure guys focus on, the pricing, volume, and trading behavior.
One thing I think we need to do away with is the mechanistic view of how risk works. The biggest argument that China bulls continue to rely on is because China has not had a serious problem in a long time, people that point out risk just don’t understand China. Even many pessimists have a flawed understanding of risk. Many have pointed to China’s debt to GDP as proof that China will have a financial crisis. It does not mean that, it does mean China has an elevated risk. Let me give you an example on how better to think about this risk. Assume a roulette wheel with 38 ball slots. If we spin the wheel 38 times are we guaranteed to have the ball land on the number 5 given that there is a 1/38 probability of landing on 5 when spinning the wheel? No, it does not anymore than having a high debt to GDP ratio guarantees having a financial crisis. A drunk driver does not always get in a car accident and kill people but it definitely increases the risk. A better way to think of what is happening in China is this: the risk factors continue to accumulate. Using the roulette wheel example, rather than just the probability of landing on 5, as risks accumulate we now run the risk of landing on a number between 5 and 10. Now what is important to note is that these higher risks still do not guarantee a financial crisis but the risk is elevated. The more risks we continue to accumulate and the more we spin the wheel, the greater the cumulative probability that at some point there will be a real problem.
The thing I am watching is that the fundamental risk metrics continue to move in the wrong direction. For instance, after all the talk of deleveraging heading into 2016, debt to GDP is probably going to jump another almost 20% in 2016. We could go example by example but all the risk factors continue to rapidly expand. The risk factors continue to diffuse throughout the economy. Shadow banking is no longer a small financial sector that if something went wrong could be easily contained. The real estate market, probably the most important asset price in China, remains worrying. Off balance sheet debt holdings and investment receivables remain ever increasing cause for concern that expand the risks well beyond the focused risks. This continues to increase the risk that they will not be as easily containable.
It is also worth noting that the longer this pattern continues the fewer options policy makers have to address these concerns. The larger these pressures become and the greater the imbalances become the fewer the options that remain to address it without large dislocations.
Despite my concern, I remain thankful for the opportunity to live and work in China. Merry Christmas and looking forward to 2017.