China’s Shaky Foundations: A World at Risk

Update: Undercover investigation reveals that despite government claims, China is digging a deeper hole for itself

China Debt Exponential Growth Danger

The world is watching China’s credit explosion, wondering how it will all end. It is a cold comfort that some of the same institutions that denied the subprime crisis of 2007-2008 are now denying a crisis of Chinese debt.

Speculative Frenzy Built on Exponential Debt Rise

much of the lending appears to represent a speculative frenzy, often involving residential real estate, that has become of increasing concern to some Chinese officials, bankers and economists.

… Shadow banking, or lending that takes place outside official banking channels, plays a major role in the Chinese economy, where big government-controlled banks are often slow to lend to private businesses and entrepreneurs. But experts worry that untrammeled shadow lending could lead to ticking time bombs that could threaten the financial system of the world’s second-largest economy. __ NYT

It is not only residential real estate that has been experiencing a frenzied, near mindless speculation in China. Debt accumulating beneath the behemoths of Chinese state owned enterprises represents an out of control risk to China’s economic future.

Not all speculative frenzies are created equal. If large numbers of savvy investors are free to invest in enterprises that offer high payoffs, a significant number of successes are likely — possibly lifting entire economies to a higher plateau of well-functioning and self-reinforcing capital systems. A number of countries have undergone “investment-led” financial booms over the past 100 years “including Germany in the 1930s, the Soviet Union in the early Cold War period, Brazil during the Brazilian miracle, South Korea after the Korean War, Japan before 1990, and China today—to name just the most important and obvious cases.” source

The US remains the most famous and enduring of the investment-led national economic booms:

the American financial system in the nineteenth century… was chaotic, prone to crises, mismanaged, and often fraudulent; yet the United States grew very rapidly during that time.

___ Michael Pettis

Indeed, the US in the 19th century grew from being an impoverished hodge-podge of conflicted ex-colonies to become the most wealthy nation on the planet. At the beginning of the 19th century, the US was little more than a mismatched set of raggedy former colonies, huddled along the Eastern seaboard of North America. By the end of the 19th century — despite a catastrophic mid-century civil war — the US had become a coast-to-coast commercial, financial, and industrial juggernaut.

The “wild west” nature of American finance throughout the explosive growth of the 19th century is part of the reason why the US grew so far, so quickly. But American finance incorporated an openness and a discipline — simultaneously — that the Chinese system lacks.

In the 19th century high-growth American financial system, private investment in high risk technology and infrastructure typically led government investment — often by a wide margin of time and dollar quantities. This is in contrast to the Chinese system, where government banks drive investment in infrastructure based upon political reasons.

In 19th century America, when ventures failed bad loans were written down almost immediately, and liquidated. That way the pain of failure was borne by investors quickly, and written off. This rapid casting off of the chains of past failures allowed 19th century America to move on from failed enterprises to future inventions, innovations, and enterprise. But China cannot do this, since so much of the failed and unnecessary industrial and infrastructure investment is tied up with the personal wealth of party officials at all levels of government.

… the American financial system then (and now) has been very good at providing money to risky new ventures. It provides capital on the basis not only of asset value but, more importantly, on future growth expectations, and risk-taking has been actively rewarded. In China, it isn’t clear that this is the case at all. Chinese banks favor large, well-connected, and often inefficient giants at the expense of risk-takers. ___ Source

The Consolidation of Power and Wealth by Xi Jinping

Long before the reign of Xi, Chinese wealth had become consolidated in the hands of high level government and military officials. But thanks to Xi’s “reforms,” final control of virtually all wealth and power now flows through the central party offices in Beijing.

So after five years of Xi, his main accomplishments seem to have been to consolidate his power while satisfying people’s desire for social change through crackdowns and promoting traditionalism. The problem is that these efforts come at the expense of actual reforms…

… The complete failure to reform the economy means that the government’s argument about low growth—that China’s economy has slowed only temporarily while the economy restructures—appears less and less plausible. Instead, what could be happening is that the country’s inability to reform further is sending it into the feared middle-income trap—a country that cannot take the next step to become a truly prosperous society. __ NYBooks

China economic specialist Michael Pettis has begun a series of essays looking at historical examples of “rapid-growth” economies over the past few centuries, and what ultimately became of them. His informed approach to economic history allows us to speculate in a more intelligent way regarding the fate of China’s ongoing drive for global prominence.

Looking at government-driven infrastructure spending, for example:

… there is a natural limit to infrastructure spending, and this limit is often imposed by institutional distortions in the market economy. When this natural limit is reached, more investment in infrastructure can be wealth-destroying, not wealth-enhancing, in which case it is far better to cut back on investment and to focus on reducing the institutional constraints to more productive use of capital, such as weak corporate governance and a weak legal framework. The pace of infrastructure investment cannot exceed the pace of institutional reform for very long without itself becoming a problem. __ Michael Pettis

When China Was Forced From an Export-Driven Economy to an Internal Stimulus Economy

After the 2007-2009 global deleveraging crisis, China’s economy was forced to rely far too much on financial stimulus from internal infrastructure investment. Massive misallocation and overproduction followed from the tangled political influences which guided this ongoing monstrous infrastructure stimulus. As a result, ghost cities were built alongside bridges and railways to nowhere. Huge wind and solar developments were built but never connected to the grid, left to rust. More on China bubble

Real Estate Oversupply

David Stockman: China’s Monumental Ponzi Scheme

China’s economy has a certain resilience due to its massive size, and the incredible intelligence and energy of the Chinese worker and entrepreneur. Unfortunately, the rigid top-heavy Chinese system does not allow Chinese workers and entrepreneurs the investment capital and the freedom to produce and trade, which would allow the Chinese people as a whole to achieve the type of regional and global dominance of which they are capable.

Thus the very shaky foundations that underlie the system built by the Communist Party of China. No one knows when the fatal nudge will come, but the further Xi pushes his agenda of consolidation of power, the more brittle the Chinese system becomes in the face of inevitable external and internal chaos.


China’s economic boom was loosely based upon the investment model of 20th century Japan, which itself copied the economically successful 19th century US investment-based model. As discussed in Michael Pettis’ clear essay linked below, China (and Japan) left out a number of critical features of the US investment model, which allowed 19th century America to leapfrog the economic powers of Europe to become the world’s greatest industrial, commercial, and financial power. A deeper look.

Full reading recommended to better understand what China would need to do to avoid falling into its own trap.

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