by Roger Bourke White Jr., copyright June 2016
China has been booming. For the last ten years this boom has been financed in part with steadily increasing debt. Sometime soon the boom will end and the debt burden will look much more ominous than it does today.
This essay is Roger's forecasting how this upcoming bust is likely to unfold.
This China boom fits a pattern. It looks like the US boom did in the years preceding 2007.
The year 2007 was the beginning of the crash that started the US Great Recession -- the crisis that ended a decade-long boom during which housing debt became overextended. The crisis hit in 2007 because that was the year US housing prices stopped steadily rising. Housing prices had been rising constantly for twenty years prior and by the mid-2000's this was being treated as a given of the economic environment.
In a similar way China has now experienced a decade-long debt expansion; the business, government and finance people are treating this expanding as a given; and that means the country is likely to experience its next bust as a debt bubble crash.
What will it look like? How will it evolve? Crashes have their own unique signatures, so it won't be the same as 2007 in the US. Instead it will bring on its own signature forms of financial pain, grief and scariness.
One thing these two booms have in common (and with many other booms) is that some new financial innovations have been created and are growing and spreading as part of the boom. Part of the reason for the crashes is lesson learning about the boom's financial innovations -- how do they work well, and how can they be abused?
This 6 Jun 16 WSJ article, Long Shadow Hangs Over China’s Banks The growth of off-balance sheet wealth-management products is exploding by Anjani Trivedi, is one of many about China's growing debt that have been in the Wall Street Journal over the past few months. And its main topic is a financial innovation.
From the article, "Chinese banks collectively have an enormous balance sheet, enough of a worry for investors on its own. Then there is the off-the-books shadow of a balance sheet, which is looming increasingly large.
The shadow is cast by the surge in issuance of so-called wealth-management products, or WMPs, high-yielding investments sold to bank customers looking for yields higher than what China’s low deposit rates offer. This may sound familiar. A similar surge in shadow-banking products in the early part of the decade caught investors and regulators unaware.
This time the sequel is scarier than the original."
In sum, it's boom time, and late in the boom cycle. The scary question is when will the bust start and how will it evolve when it does?
This debt growing started in 2008 as China, like the rest of the world, took action to fend off the spread and deepening of what started as the Sub-Prime Mortgage Crash in the US. This started in the US and evolved into The Great Recession that spread world-wide.
China's intervention by increasing its debt worked, China got through it without much pain, but over the years the rising debt has not stopped. Instead, for China, the rising debt has transitioned into creating a "soft landing" as the Chinese economy transitions from infrastructure building-centric to consumer economy-centric. That transition is still going on, and the Chinese banking systems are still smoothing the transition by creating more debt.
As mentioned above, it is common during a boom/bubble cycle (Who can tell the difference until after the bubble pops?) for new financial instruments to be invented and their use to spread quickly and widely. In the 2000's in the US the high-profile example of this is what came to be called CDO's (Collateralized Debt Obligations) and these became the high-profile Blame Them instruments (my term) to explain the bubble and its popping. (They are still in use today, by the way, but they have a slightly different name. And now they are understood much better -- a Lesson Learned example.) In China the shadow banking products and WMP's are the new instruments.
This 10 Jun 16 WSJ article, China’s Banks: How Fixing Problems Can Make Them Worse Document 82 could leave banks with a capital hole of more than $150 billion by Anjani Trivedi, talks more about how much debt is being kept off the balance sheets now.
From the article, "China’s banking regulator is forcing banks to fess up—and account for—the worst type of credit products buried on- and off-balance sheets under a regulation known as Document 82, released in May. While that is an admirable effort, because the problem has grown so large, regulators may now have to enforce a limp version of the rules. In its current form, Document 82 could leave banks with a more than 1 trillion yuan ($152.4 billion) capital hole."
Related issues: China, like the US, is currently experiencing a lot of growth in its first-tier cities, and mediocre-to-slow growth in the rest. This is making an imbalance between housing built and housing demanded. The first-tier housing prices are rising fast while the rest are rising much more modestly.
In this boom there are demographic considerations. Even more than in the US, China's population is "graying" -- the average age is going up fast because of the success it has had in population control over the last few decades.
In sum, China is laying the foundation for a crash. When it starts will be surprising. How it will unfold will also be surprising. But some characteristics can be forecast.
Update: Foretelling the future or Lesson Learned?This 11 Jun 16 Economist article, Wenzhou’s economy It once was lost A city renowned for its business acumen battles to recover from a financial crisis, is about a crash suffered in 2011 in east China's Wenzhou city. Lots of debts not paid and lots of dreams lost. This happened just recently, in 2011, so it could be a case of Lesson Learned and the rest of China will avoid these pitfalls. ...it could be. From the article, "These days, Wenzhou is quietly getting back to work. Housing prices have started to rise again. The city’s economic growth topped 8% last year, the fastest since 2011. But with bad loans still clogging its bank system, many of the city’s scars remain unhealed. Wenzhou is an outlier at the wild end of the Chinese economy. Yet its trajectory—from painful downturn to halting recovery—may suggest what lies ahead for the most debt-laden parts of the country." |
When it finally comes the crash will be a surprise, just as the 2007 crash was. But another common characteristic of crashes is after they happen, and evolve, people will look back and point out obvious triggers. This is a mix of lesson learning and Monday Morning Quarterbacking.
That said, I'm going to make my forecasts for what the trigger will be.
The most likely trigger will be rising interest rates. This will trigger because it will put a big squeeze on rolling over the existing debt. The most likely source for that rate rise will be the US Fed raising interest rates in the US. When this happens it will suck money away from risky investing in Chinese finances. The squeeze will begin with this flow away from China. (For this reason the worries Janet Yellen's expresses about rate rise repercussions are likely to become prophetic.)
The Fed rate raising is one possibility. There are others:
o If business around the world starts to seriously pick up, and the demand for investing money seriously picks up along with it, that will crimp style in China's debt growing for the same reason as Fed rate raising. It will suck away cheap investing money.
o There is currently a dearth of positive feedback investing opportunities. We don't currently have the equivalent of 1800's railroad building opportunities. This is why interest rates have stayed so low for so long since 2007.
This could change. A new suite of technologies that encourage heavy investing could appear and become popular. A biotech breakthrough of some sort might start this. Another possibility for positive feedback heavy investing, but using current technologies, would be building "smart cities" that become renown for their industry incubating abilities. Yet another possibility is that many governments could reform their current overly prescriptive and micromanaging business regulations so that investing in current technologies gets more attractive. (as I put it, the "grief level" for starting and growing businesses could get lower)
o Another possibility is a US 2007 equivalent -- for some reason property values in China's first-tier cities stop steadily rising and instead start to decline. And when this happens the collateral for the property debt gets squeezed, and rolling over the property debt becomes a crisis, and that crisis then widens to other kinds of debts.
The pain will be felt first in China's banking and property sectors. The "shadow loans" the banks are currently making in increasing quantities will come out of the shadows and rolling them over will become expensive and painful. And, even more important, scary and high-profile. When scary words start spreading fast and thick through the financing and saving communities, this will become some form of a bank panic.
This panic won't be the first recent one that China's finance has experienced. China experienced mainland stock market exchange panics in the summer and fall of 2015, but the government had the resources to keep those panics from spreading -- they ended in just a few days. What will make this "big one" different is that the government will either run out of resources or choose not to employ them. (In 2008 the US government agencies chose not to rescue Lehman Brothers, even though days earlier they had rescued a couple other Wall Street companies through "shotgun mergers". When Lehman formally failed, that's when things got seriously scary and high-profile.)
What will make this The Big One is the panic will last for weeks, not days, and then spread. How it spreads will become memorable, but it will be surprising while the spreading is happening.
My guess on spreading is it will start with real estate. When the demand for first-tier city real estate slows, and prices start declining, that will upset the current debt rollover routines tremendously. This will be the first big symptom that a crash is underway. The crisis will then move out from there into other highly-leveraged business and government activities in China. Rolling over short term debt all through China will become a crisis.
That businesses and workers suffer in this crash will be no surprise. That overextended businesses will come to local governments (provincial and city) looking for bailout help will be no surprise. The surprise this time will be that the local governments are themselves overextended -- they will be much more limited in how much bailout help they can extend.
As this limitation becomes widely known to Chinese people, foreign businesses and foreign investors, this will be the core of the Great Worry that will spread through China.
Then the crisis will evolve. It will move beyond business and property issues. Some time after bailing out stops working as a worry balm, the national government will respond with distraction -- it will encourage people to think about something else. One form of this will be bread and circus projects. But the most common, and likely, form of distraction is to hype nationalism in its various flavors, including militarism and Blame Them -- as in, "This problem is caused by a foreign conspiracy, and parades and growing our military will help solve it. See... these military incidents show that we need to pay attention to our borders, not our bank books."
Given that the military theater where this is currently going on is the South China Sea area, that is likely to remain a center of this new wave of even bigger and more threatening theater. How much more violent it will get will be the surprising element.
Much of the developing world just got bit by the China Commodities Bust of 2014/15 as it transitioned from infrastructure growth to consumer growth. This is a lesson learned. This means that the rest of the world will not be as surprised by this upcoming debt crash and will respond to it better and more quickly -- the crash spread will be muted. If the crash spreads deeply and widely it will be because of some surprise element, not because there is simply a crash happening.
An example of a surprise element could be that China flat-out stops investing in various developing countries' projects and those investments were a substantial part of those developing country's total investing funds. That would be a hard bite and a significant spread. The part of the world most sensitive to this kind of tactic would be the African nations China has been heavily investing in over the last decade.
India is likely to get bitten as well. For the last couple years, under Modi's leadership, India is more than usual trying to boost its economic growth, much as China started doing two decades ago when Mao's rule ended and Deng's began. This means its debts are growing faster and in different ways than they have in the past -- as in, the "more new styles of financing" pattern. When China busts, this novelty in what India is up to will make them susceptible to a sympathetic bust.
Another class of project likely to suffer are the oil and gas pipeline projects being built between Russia and China. I recall some of these being consummated as Putin was busy looking for support following his gobbling up Crimea. I suspect those signings were hasty, and the projects themselves have become "spoiled brat" projects (my term) -- they are not getting proper attention from both sides and as a result they are progressing much slower than planned. This bubble bursting could derail them indefinitely.
An example of someone already bitten hard is Brazil. It is currently suffering its deepest recession in many decades. It could get worse, but that won't surprise, it will just prolong what is currently being experienced.
The fear caused by a crash in China will worry other places in the world. Some of that worry will be based on direct consequences. Those foreign companies betting on building their consumer goods presence in China will suffer directly. The Chinese middle class will become more savings intensive and feel less like splurging. (This is an example of this crash affecting different companies than the Commodities Bust of the early 2010's did. Those were mostly resource extracting companies.)
Much of the worry will be indirect. The worries in India finance mentioned above are an example of that.
One way the worry will express itself around the world is by more spending on military. Many defense companies will thrive.
The key theme of the early aftermath will be Blame Them -- lots of people and organizations will be explaining why the bust wasn't their fault. As in the 2007 aftermath there will be a flood of new regulations in China to keep this kind of bust from happening again. And, as with most such regulating after every big surprising bust, the regulations will be cumbersome to enact, and won't solve the problem. The problem will be solved by the lessons learned irregardless of the laws passed. The US versions of this happening are the Sarbanes–Oxley Act of 2002 and the Dodd–Frank Act of 2010.
Because the Chinese governing system is not as transparent as the US system, what form this overprescriptive regulating will take will not be as clear to outsiders, but it will still be happening.
The aftermath will be different. How business is done in China, and what kind of business is done, will be different than it was during the boom. The hot item industries that are inherently hot (not fads) will cool for a decade. Think of US high tech businesses following the Dot Com bust of 2000: Many disappeared (the fads), those that survived languished for a decade, then some of those survivors grew mightily again and are now famous and prosperous pillars of high tech in the 2010's.
Likewise property values will languish for a decade as well, especially those not in first-tier cities.
Crashes and bank panics bring hardships and scariness to the communities that are in the center of the bust. That part is obvious. The surprise is this hardship and scariness then often manifests itself as a violent social revolution a few years later, in a different part of the world. One recent example being the US crash of 2008 creating the Arab Spring in 2011, and an earlier example being the world-wide bank panic of 1857 creating the American Civil War in 1861.
Where the revolution takes place will be surprising. As the above examples show, it is often not where the crash and bank panic is centered. (although it can be -- the French Revolution is an example of social unrest happening where the crash did)
My forecast: The Middle East is "revolutioned out" so it will be somewhere else -- my first guess is somewhere in Africa. It should be a place that is beginning its transition into the Industrial Age, has a lot of optimism about what is coming, but the government isn't keeping up with the change. ...Hmm... This sounds a lot like China, so this could be another time of social seismic shift in China -- the Tiananmen Square sequel.
I see exciting times coming. These will be exciting in the financial and social arenas. The crisis will become high-profile and acute when something triggers a debt bust in China. As this debt bust grows in magnitude it will spread from businesses and governments in China to businesses in the rest of the world.
Because lessons have been learned, it will not spread in the same way, or through the same industries, that were bitten by the 2010's Great Commodities Bust. How it spreads will be surprising.
If the bust gets big enough and the fearful worries get deep enough, it will be followed in four years by a big social revolution, comparable to the Arab Spring, but not taking place in the Middle East.
--The End--