In the last piece in this short series, I covered the general macro financial arguments against a bull case primarily focusing on the overall debt dynamics. Essentially, outgrowing its debt problems a second time is risky and unlikely on many levels. However, there are other key arguments that are made by China bulls all of which have significant weaknesses about why China will not have a financial crisis.
As I have previously mentioned, I do not personally believe a financial crisis is likely in the short term, but I believe pessimists on balance have stronger arguments than the bulls. One thing is certain: China’s finances cannot continue to move in the direction and speed they are moving without suffering a significant reversal. That is not a ten year prediction but significantly shortened time frame.
China has a high savings rate. This is one defense of why China cannot have a financial crisis and one that has never made much sense to me as a strong defense. There are two primary reasons this specific argument is not as strong as many people want to believe. First, this confuses the difference between an asset and liability. Domestic savings is being used to fund investment but most of that investment is in the form of a liability. If the debt cannot be repaid to the bank, there will be bank collapses. High savings rate does not in anyway speak to the viability of the liability. Just because China has high savings does not mean it has high capacity to repay that debt. Those are two very distinct problems and solutions.
Second, while it does change the dynamic between the domestic and international capital dependence, it again does nothing to alter the dynamic that this savings has funded a liability that needs to be repaid. If the liability is not repaid, then there will be bank collapses. Part of the problem is that bulls are relying almost exclusively on foreign capital flight to precipitate a financial crisis. However, many financial crises have happened absent foreign capital flight. Especially for a large country like China, we need to ask whether it could have a financial crisis absent rapid foreign capital flight and the answer would be a resounding yes. While domestic savers are easier to oppress than international investors, they are more likely to be unhappy in an authoritarian state if there are bank collapses or similar problems due to firms being unable to repay their debts.
China has a closed financial system. This is another argument that has a grain of truth but significant weakness to it. Bulls are essentially making two separate arguments. First, that foreign capital cannot trigger a financial crisis. As I have already covered this, I will not address it here. Second, in the event of financial stress, China can wall itself of from external influences and control the problems. Let’s examine this argument a bit closer.
This argument makes an implied pre-stress assumption that a closed financial system is less likely to have financial problems than an open system. This is demonstrably false especially given the wealth of empirical data we have not just on China but on other financial systems. While there are very valid policy discussions about whether capital controls are useful policy instruments, having a closed financial system absolutely does not guarantee greater financial stability.
Following this assumption, it further assumes that in the event of financial stress a closed financial system is better prepared to address and prevent financial stress from becoming a crisis. There is some validity to these arguments but also real drawbacks that require additional detail. For instance, this requires us to believe that Chinese technocrats are high quality and will move to prevent any problems by essentially either engaging in never ending bailouts or large asset write downs. Chinese technocrats would not receive high marks from anyone and while they have been willing to engage in never ending bailouts, any form of asset write downs is virtually unheard of. This essentially promotes extreme moral hazard and as we have discussed previously, does nothing but builds up the problems.
Furthermore, this assumption requires great repression and not just financially. We have already seen the lengths China is going to to prevent capital from leaving China. It would not be a leap to think China will pursue increasingly financially and social repressive policies to maintain financial stability should it face financial stress. Add in how Beijing responded during the 2015 stock market collapse and it does not stretch credibility to believe Beijing would respond even more forcefully if faced with serious financial stress. It seems strange that bulls are basing their belief system on Beijing’s ability to oppress and violently suppress panic as a positive.
The other major assumption this makes is that financial stress is contained within China. As a simple example, many people assume that financial stresses of heavy industry will be self contained either within those industries or geographic locations. I find this thinking unsatisfactory. Remember when everyone thought that mortgage default rates in Ft. Lauderdale would be uncorrelated with default rates in Portland and how those risks would not impact broader financial markets?
What both of these primary pillars of faith overlook is the natural consequence for believing them. Assume that there is a period of financial stress (I am purposefully not using the word crisis) that necessitates some type of public action. To prevent the financial stress, the closed Chinese financial system closes even further and China assures savers that their high level of savings will be protected via public action. This prevents or stalls the full onset of a “financial crisis”, but this overlooks the very serious second order repercussions of these actions.
If this scenario unfolds as the bulls predict as the safety net, it is very safe to discuss some combination of the following. First, draconian currency exchange regulations. Second, large, broad based decline in asset prices. Third, fiscal recapitalization of banks. Fourth, debt monetization. Fifth, significant fall in the exchange rate. Any combination of these things, or similar events, in the bull case would at best be nothing less than crisis lite. You simply could not expect the bull scenario of high savings and closed financial markets to hold as a bulwark and not see some combination of these second order events.
Think about it, assume China has to ring capital to prevent a flight abroad. They would impose draconian FX controls meaning the resumption of current account controls. Assume savers get worried about their savings, Beijing would have to formally order the PBOC to buy soured debt or recapitalize the banks from the public purse. (It is worth noting these are already happening to a small degree). These events would undoubtedly lead to a revaluing of assets and a loss of confidence in the RMB placing it under enormous pressure. While China may officially prevent a “crisis”, it will undoubtedly face a “crisis lite” if some such series of events take place. It would be very difficult to tell any fundamental difference between what the bulls argue would happen the impact of their rosy scenario.
It is not that there is no validity to these arguments but China bulls place much too much faith in these supposed unique differences of China. At the end of the day, if borrowers cannot repay their loans, savers won’t be able to access their savings, and there will a domestic financial crisis rather than a foreign capital outflow crisis. While these factors do cushion or lengthen the time available, neither is the supposed bulwark many believe it to be.