China Invented the Printing Press

Economic history says China is due for a rough patch. The real estate sector is not only a threat to itself because of high prices. The real estate sector was a core sector in the Chinese growth model. Local governments spent heavily on infrastructure development, this created a need for the new housing built by developers. Local governments paid for this spending with land sales, post-2008 they borrowed heavily and then used land sales to back the debt. This all fueled continually strong GDP growth. If the housing sector swings into reverse, this whole system swings into reverse. Local governments will be unable to spend, GDP will contract and bad debts will litter the financial system. In the end, this is a good thing because it rebalances the economy away from overreliance on property and infrastructure, but in the short-term it can be a very messy affair.

It need not be a collapse, but it is going to be painful for some segments of the Chinese economy and some foreign companies/industries/countries.

This editorial by Yu Yongding (you might know him from his comments regarding the central bank's need to diversify into gold) in the South China Morning Post does nothing to assuage those of us who see a downturn.

Rumours of a Chinese crash are greatly exaggerated

The market is always in search of a story and investors, it seems, think they have found a new one this year in China. The country's growth slowdown and mounting financial risks have spurred a growing wave of pessimism, with economists worldwide warning of an impending crash.

But dire predictions for China have abounded for the past 30 years, and not one has materialised. Are today's really so different?

The short answer is no. Like the predictions of the past, today's warnings are based on historical precedents and universal indicators against which China, with its unique economic features, simply cannot be judged accurately.

The bottom line is that the complexity and distinctiveness of China's economy mean that assessing its current state and performance requires a detail-oriented analysis that accounts for as many off- setting factors as possible. Predictions are largely pointless, given that the assumptions underpinning them will invariably change.

The Chinese economy is in fact the least complex of the major economies, aside from oil dependent Russia: a huge portion of growth comes from government directed infrastructure investment. The part about historical precedents is true, up to a point. Eventually, every economy runs into the hard laws of economics.

Consider China's high leverage ratio, which many argue will be a key factor in causing a crisis. After all, they contend, developing countries that have experienced a large-scale credit boom have all ended up facing a credit crisis and a hard economic landing.

But several factors must be accounted for in assessing whether this is China's fate. While China's debt-GDP ratio is very high, the same is true in many successful East Asian economies, such as Taiwan, Singapore, South Korea, Thailand and Malaysia. And China's saving rate is much higher. Ceteris paribus, the higher the saving rate, the less likely it is that a high debt-GDP ratio will trigger a financial crisis.

In fact, China's high debt-GDP ratio is, to a large extent, a result of its simultaneously high saving and investment rates. And, while the inability to repay loans can contribute to a high debt burden, the nonperforming-loan ratio for China's major banks stands at less than 1 per cent.

None of those nations is at the same stage of development as China.

As for debt and savings. China has a modern banking system. The deposits in the Chinese banking system come from loans created by the banks. If the debts fail, then the banking system is impaired. Either depositors lose their money (already seen in the trust sector, possibly with WMPs as well), the government issues new debt to bail out the banks raising the nation's leverage, or the central bank prints money and everyone loses through inflation and/or currency depreciation.

China's NPLs are 1 percent now. They are always lowest right before a crisis erupts and we've already seen banks taking steps to hide their NPLs, such as Bank of China selling bad loans to its investment banking division. Conversely, when NPLs are a large number, some bear will be saying this signals trouble for the Chinese economy.

If, based on these considerations, one concludes that China's debt-GDP ratio does constitute a substantial threat to its financial stability, there remains the question of whether a crisis is likely to occur. Only when all of the specific linkages between a high debt burden and the onset of a financial crisis have been identified can one draw even a tentative conclusion about that.

China's real-estate price bubble is often named as a likely catalyst for a crisis. But how such a downturn would unfold is far from certain.

Let us assume that the real-estate bubble has burst. In China, there are no subprime mortgages, and the down payment on the purchase price required to qualify for financing can exceed 50 per cent. Given that property prices are unlikely to fall by such a large margin, the bubble's collapse would not bring down China's banks. Even if real estate prices fell by more than 50 per cent, commercial banks could survive - not least because mortgages account for only about 20 per cent of banks' total assets.

There are no subprime mortgages, but there sure are subprime developers. The losers may not be homeowners with a mortgage, but instead savers whose money has been lent to subprime developers. The local governments fund their operations through land sales. If the flow of credit slows and home prices tumble, land prices will collapse too. Home buyers may come off well, but the local economies will be hit hard.

Let us assume that the real-estate bubble has burst. In China, there are no subprime mortgages, and the down payment on the purchase price required to qualify for financing can exceed 50 per cent. Given that property prices are unlikely to fall by such a large margin, the bubble's collapse would not bring down China's banks. Even if real estate prices fell by more than 50 per cent, commercial banks could survive - not least because mortgages account for only about 20 per cent of banks' total assets.

At the same time, plummeting prices would attract new homebuyers in major cities, causing the market to stabilise. And China's recently announced urbanisation strategy should ensure that cities' demographic structure supports intrinsic demand. If that were not enough to ward off disaster, the government could purchase unsold properties and use them for social housing.

Giving away free homes is a good use of an empty house, but it does not help housing demand.

Moreover, if necessary, banks could recover funds by selling collateral. As a last resort, the government could step in, as it did in the late 1990s and early 2000s, to remove non-performing loans from banks' balance sheets. Indeed, China has a massive war chest of foreign-exchange reserves that it would not hesitate to use to inject capital into commercial banks.

This would lead to a major depreciation of the renminbi. For foreign investors, it would look exactly the same as a cash if asset prices fall only 10-20%, but there is another 10-20% of currency depreciation on top of it.

A more salient threat would arise if the government pursued too much capital-account liberalisation too fast. If China eases restrictions on cross-border capital flows, an unexpected shock could trigger large-scale capital flight, bringing down the entire financial system. Given this, it is vital that China maintains controls over short-term cross-border capital flows in the foreseeable future.

Likewise, the Chinese government must address a fundamental contradiction. Monetary interest rates have risen steadily, owing to rampant regulatory arbitrage (whereby banks find loopholes that enable them to avoid unfavourable rules) and the fragmentation of the credit market, while return on capital has fallen rapidly because of overcapacity.

If the Chinese government fails to reverse this trend, a financial crisis - in one form or another - will become inevitable. But, given the authorities' broad scope for policy intervention, the crash will not come any time soon - if it comes at all.

The Chinese government needs to reverse this trend......by money printing. They can't make overcapacity disappear, but they can force interest rates down. The essay would have been much shorter if he just said, "The Chinese government has a technology, called a printing press, that allows it to produce as many renminbi as it wishes at essentially no cost."

I saw this article in Chinese that adds some numbers to his points about return on capital and interest rates.

Tsinghua's Bai Chongen said in 2012 that the return on capital was 2.7%, while the benchmark one-year lending rate of 6.7%. If the Chinese government can not reverse this trend, some form of financial crisis will inevitably erupt in the future.

Here is a paper from Bai Chongen in 2013: China’s Structural Adjustment from the Income Distribution Perspective

In 2010, the average after tax and after depreciation real rate of return was as low as 5.1%.

The return on capital collapsed from 5.1% in 2010 to 2.7% in 2012. Where is it today?