China's Bubble Economy
The Chinese model of capitalism had long encouraged private debt. This meant that in 2020, Chinese companies’ debt represented 160 percent of GDP, compared to 115 percent in the eurozone and just 85 percent in the US. From 2007 to 2017, China added $24 trillion in debt at all levels, which was more than the US government's total debt of just under $20 trillion. As long as an enterprise looked like it was moving forward – with plenty of projects in the pipeline – banks gave it credit on the understanding that the strength of Chinese economic growth would always deliver profits. But with growth slowing from 10% to 5% annually, the music has stopped. Structural reforms away from debt dependent growth are the only viable alternative.
China Morning Post columnist Jake Van Der Kamp wrote 27 August 2017, China's economy had come to resemble a Ponzi scheme: "As long as it keeps growing everything is fine. When it stops growing it collapses." The Washington Post in 2015 reported that China used more cement in just two years — 2011 to 2013 — than the US used in all of the 20th century. China built cities without people, malls without customers, and roads without cars.
By September 2021 China Evergrande, once the country's second-largest real estate developer, was drowning in debt. Some 1.5 million people had put deposits on new homes that had yet to be built. A collapse could be catastrophic. Angry protesters gathered outside the real estate firm's headquarters, demanding to know about its future. Investors were growing increasingly nervous that if Evergrande were to collapse, this could spread to other property developers and create systemic risks for the banking system of the world's second-largest economy.
Evergrande’s business model is representative of China’s highly debt-dependent growth model. Evergrande is the world’s most indebted real estate developer; $300 billion is roughly equivalent to the entire public debt of Portugal. Unsurprisingly, senior executives admitted in August 2021 that they might be unable to meet all of their financial obligations. Evergrande was due to pay $15 billion to creditors by the end of 2021; but, as of late June 2021, it had only $13 billion to its name.
The Chinese Communist Party would have no choice but to save a company that is so emblematic of its economic growth model – and whose collapse would send shockwaves across the global economy.
A bubble is a situation that can occur when the price of an asset rises far higher than the item is actually worth. The assumption is that the next buyer will pay an even higher price for the asset. Major speculative economic bubbles have been known to occur from time to time, often with ruinous effects. Sometimes they are triggered by inexplicable phenomena (fads or crazes) or are kindled by the manipulative actions of individuals or corporations.
At the peak of the Dutch tulip mania in February 1637, tulip futures contracts sold for more than 10 times the annual income of a skilled craftsman. During the British Railway Mania of the 1840s, the newly emerging middle class invested their savings in prospective railway companies; many of those lost everything when the bubble collapsed. In the 1920s Americans overextended themselves to take advantage of the soaring stock market and expanding credit. When the Federal Reserve raised interest rates, the stock market crashed and the bank panics began. Florida's first real estate bubble was based on outside speculators, easy credit access for buyers, and rapidly appreciating property values for Florida swampland.
For decades Japan was the source of by far the largest foreign investment, foreign trade and foreign assistance for Southeast Asia. By the late 1980s Japan was referring to its relations with the nations of Southeast Asia as a "flying geese pattern" with Japan as the lead goose. But the bursting of Japan's economic bubble in 1991, and its failure to open its markets to goods from SEA following the Asian financial crisis cooked the lead goose, and Japan - while still important in the region - remained on the defensive against growing influence from Beijing and booming PRC trade with the region. The bursting of the economic "bubble" in 1991 saw the value of land and other assets collapse. The bursting of the asset bubble led to the collapse of Japan's banking sector and to persistent deflation, both of which have dampened domestic demand for two decades. The 1990s have been dubbed Japan's "Lost Decade", during which Japan's economy grew approximately 1 percent annually, compared to about 4 percent per year in the 1980s. Japan has struggled with low but stubborn deflation since 1998.
Even financial-world insiders had a hard time grasping the scope of the economic bubble in housing and finance that evolved during the years since 2001. In hindsight, the bubble in the U.S. housing market, the first indication of what would become a global financial crisis in the fall of 2008, should have been obvious. The prices of houses had risen beyond the salaries of many ordinary Americans, but the availability of new, riskier mortgage products fueled the rush to home ownership. What's more, the inflation in their real estate values had many homeowners feeling wealthy. Historically in the United States, housing prices had always gone up. Once asset values began to collapse, the banking and insurance crises occurred within months.
An unprecedented U.S. housing bubble began to inflate in the first quarter of 1998 and then popped in the second quarter of 2006. By 2008 the American housing bubble had run out of (good) borrowers. The result was that the remaining class of assets, commodities, became the next bubble, with oil quadrupling in price and basic foodstuffs rising between 40 and 70 percent in a little over a year. However, with the exception of oil, these were small markets, too small to sustain such volumes of liquidity, and these bubbles burst quickly. The commodity market collapse combined with losses in the subprime sector of the mortgage derivatives market triggered the Great Recession.
The renowned American economist Paul Krugman said 18 November 2016 that "China in 2016 looks a lot like Japan in 1989" — right before Tokyo headed into a prolonged period of financial crisis known as the "lost decade." China's current situation resembles that of Japan, Krugman said, "in terms of excessive saving, not enough investment opportunities, a real estate bubble. It looks a lot qualitatively like [Japan], but with much less of a safety net."
Krugman says it is not China's economic growth and dominance in the world economy that worries him. Rather, it is the likelihood of a coming economic downturn in China, and its enormous impact on the global economy, that concerns him. Asked whether the international community would come to China's rescue in a manner similar to the bank bailout program the U.S. government launched following the financial crisis of 2007-2008, Krugman shook his head: "No, even with the best will in the world, China is just too big — not too big to fail, but too big to save." He quickly added: "Who's going to do this? The Trump administration in America? The European Union, which is busy tearing itself apart? No, it's not going to be a global rescue."
During the mid-20th Century, the legitimacy of the Chineese Communist government rested on Communist ideology, and the "iron rice bowl" of cradle to grave wages and benefits. More recently, regime legitimacy, considered broadly, has been predicated on rapid economic growth. A failure to sustain such growth would pose a serious challenge to regime legitimacy. Inflation, because it has helped spark social instability in the past (e.g., 1989) and presumably could do so again, is a key concern of the Chinese Government.
Economic bubbles, generally defined as trade in high volumes at inflated values, or as too much money chasing too few assets, have appeared in a variety of countries at different developmental stages, often due to excessive liquidity in the financial system.
The 1997 Asian financial crisis brought this issue into sharp focus, and several commentators speculated about whether China's economic problems will overwhelm it. It is useful to remember that predictions of doom and collapse for an economy generally are no more accurate than those that foresee unending growth and freedom from the business cycle. Take them all with the appropriate dosage of salt, and keep focused on what really matters: enterprise reform, not growth rates, trade surpluses or currency markets. If China sustains its efforts to fix what is wrong with its economic structure, it will be able to overcome its short-term problems.
In China, concerns about the potential impact of the global financial crisis prompted the government in late-2008 to implement massive monetary and fiscal stimulus programs, including removal of bank lending quotas. As a result, in 2009 Chinese banks issued USD 1.5 trillion in new credit, roughly double the previous record set in 2008. While most of this money apparently reached its intended destinations -- infrastructure projects, industrial investment, and to a lesser extent programs to encourage consumption -- analysts estimate there was substantial (e.g., twenty percent) "leakage" into, among other places, the equity and real estate markets.
China's massive 2009 monetary stimulus program was instrumental in avoiding economic recession during the global crisis, but the huge amount of new credit flowing into the economy prompted concerns that asset bubbles could form -- and burst -- in the property and equity markets. Since the start of 2010, China's monetary policy agencies accordingly began to tighten credit availability, raising the reserve ratio requirement and announcing other regulatory measures. In the booming real estate market, which played a key role in keeping the economy booming in 2009, housing price increases accelerated, prompting Premier Wen Jiabao and the State Council to announce a slew of new lending, taxation, credit, and land policy measures to cool the market.
The US National Intelligence Council's Global Trends 2025 report noted in November 2008 [pg 50] "Although a protracted slump could pose a serious political threat, the regime would be tempted to deflect public criticism by blaming China's woes on foreign interference, stoking the more virulent and xenophobic forms of Chinese nationalism. Historically, people who become accustomed to rising living standards react angrily when their expectations are no longer met, and few people have had grounds for such high expectations as do the Chinese. China's international standing is based partly on foreigners' calculations that it is "the country of the future." If foreigners treat the country less deferentially, nationalistic Chinese could respond angrily."
The conventional wisdom on Asia's economy is that the economic challenges ahead center on China's rapid rise. Economists debate about hard or soft landings and a possible bursting of the China economic bubble. For two decades pessimists have suggested that China's economic bubble will inevitably burst - that it will not be able to feed itself or that it will run out of steam for lack of energy. The world has a very large stake in China's success. It is one of the main engines of growth in the world economy.
Eswar Prasad, the senior professor of trade policy at Cornell University, and formerly the head of the IMF's China Division, noted in 2008 that a lot of money has been funneled to state enterprises, which are financially unviable, and by 2008 the legacy of those non-performing loans was coming home to roost. Banking sector weaknesses have contributed to the very unbalanced pattern of economic development in recent years, which means that investment has been the primary driver of growth, accounting for almost 40 percent of GDP and more than half of GDP growth in recent years. The investment boom has raised fears of a resurgence in non-performing loans if the economy were to slow down and there are also risks of asset-priced bubbles and a future deflation in the economy.
By 2010 China's economy was growing at nearly 10 percent, as though the global financial crisis never occurred. The Chinese government has poured money into pouring concrete, maintaining high employment with infrastructure and real estate projects. In 2009, new floor space doubled and residential real estate prices surged 25 percent. The Chinese keep building new skyscrapers even though existing ones remain vacant. Kangbashi is a brand new city has been constructed in the desert in Inner Mongolia. It is a "ghost city". There are rows and rows of new apartment blocks with nobody living in them.
Sharp increase in house prices combined with the extraordinary Chinese lending growth during 2009 has led to concerns of an emerging real estate bubble. For China as a whole, as of late 2010 the levels of house prices did not seem significantly higher than would be justified by underlying fundamentals. However, there are signs of overvaluation in some cities' mass-market and luxury segments. Unlike advanced economies before 2007-8, prices have tended to correct frequently in China. Given persistently low real interest rates, lack of alternative investment and mortgage-to-GDP trend, rapid property price growth in China has, and will continue to have, a structural driver. Structurally low real interest rates (particularly relative to income growth), high saving (and therefore ample liquidity), and a lack of alternative investment and property tax all work to promote excessive house price inflation. Given the importance of the real estate sector in China's economy, the adverse impact of abrupt corrections in property prices is a serious concern.
By late 2010 Richard Duncan, chief economist at Blackhorse Asset Management Pte., warned that China's economy is history's biggest bubble and may be headed for collapse. "China has the greatest economic bubble in history," said Duncan, author of "The Dollar Crisis" first published in 2003. "There's a real risk it's going to collapse in a Great Depression-style scenario."
China doesn't provide its citizens with many investment outlets. Real estate happens to be one of the few options available. By December 2010 residential real estate in 35 large and medium-sized cities in China was, on average, about 29.5 percent overpriced, according to estimates of the Chinese Academy of Social Sciences (CASS). CASS, which is affiliated with China's State Council, said in five of those cities, homes are over 50 percent overpriced. The Chinese real estate bubble, which increased several-fold over the last few years, is more severe compared to the US bubble. Like all bubbles, a collapse in the Chinese market would be a serious risk to the confidence and the economy.
Diana Choyleva of Lombard Street Research, said "China is trying to keep the game going as if nothing has changed, but cannot do so. It dares not raise rates fast enough to let air out of the bubble because this would expose the bad debts of the banking system. The Chinese growth machine is likely to continue to function in the minds of people long after it has no visible means of support. China's potential growth rate could well halve to 5 percent this decade."
In China, spending on fixed-asset investment is an important measure of infrastructure spending, heavily weighted toward government and real estate projects. The figure hovered around 20 percent of gross domestic product in the United States, and about 35 percent of gross domestic product in Japan at the peak of its building boom in the 1980s. In China it equals nearly 70 percent of gross domestic product. This helps explain China's high economic growth rates [as it fueled Japan's growth in the 1980s] but as with Japan, it also reflects a dangerous dependence on infrastructure spending.
On 27 June 2011, China's National Audit Office (NAO) released a comprehensive audit report on local government debt, which provides greater clarity on the size and breakdown of such liabilities. The NAO assesses this debt at RMB 10.7 trillion, of which RMB 8.5 trillion are funded by bank loans. However, the NAO report understated the size of the local government loans that could become problematic. The credit rating agency Moody’s said China’s local government debt may be 3.5 trillion renminbi ($540 billion) larger than auditors estimated, potentially putting banks on the hook for deeper losses that could threaten their credit ratings.
Utilization rates in steel, aluminum, cement and shipbuilding are all below 75 percent, the Ministry of Industry and Information Technology announced at a news conference in April 2014. It said that in March 2014, prices of domestic industrial products had been falling for 25 consecutive months. To help small companies that must shut down, the government will provide subsidies for staff settlement. Seven industries - namely, steel, nonferrous metals, construction, manufacturing, petrochemical, light industry and textiles - would be the major beneficiaries of the subsidies.
China's annual steel production capacity is estimated at about 1 billion tons. China's top economic planners estimate that China produces about 20% more steel output than it needs. This 200 million tons of excess production capacity surpasses the US annual output of 87 million tons or the European Union's 166 million tons.
The price of iron and steel products was already very low. But as long as there was still a little net profit, they keep the factory running. The inventory is dealt at a price even lower than its cost price, otherwise, they are just piles of rubbish. Many factories are still in production, leaving massive inventories deposited in open sites for one to two years. Mills have to keep generating cash flow to cover interest expenses even if they are loss-making. It is very costly to re-heat a blast furnace (around RMB15m-20m to re-heat, not to mention that the coking plant may break after suspension), so steel mills prefer not to stop their blast furnaces at all.
In the first decade of the 21st Century, due to the city’s rich iron ore resources, well-established steel industry and plentiful skilled workers, Tangshan’s steel production capacity increased rapidly to about 150 million tons per year, accounting for an eighth of China’s total iron and steel output. In recent years, however, due to outdated technology, its products can barely compete in the market.
China's State Council, the country's cabinet, was tackling the production overcapacity problem. In October 2013, the State Council proposed to eliminate backward productivity. With regards to the steel industry, over five years, production capacity should be reduced by 80 million tons, 60 million of which come from Hebei Province. Tangshan’s production alone would decrease by 40 million tons.
A mission from the International Monetary Fund (IMF), noted May 28, 2013, : "Notwithstanding this relatively favorable near-term outlook, China’s economy faces important challenges. In particular, the rapid growth in total social financing — a broad measure of credit — raises concerns about the quality of investment and its impact on repayment capacity, especially since a fast-growing share of credit is flowing through less-well supervised parts of the financial system. While good progress has been made with external rebalancing, growth has become too dependent on the continued expansion of investment, much of it by the property sector and local governments whose financial position is being affected as a result."
Home prices in major Chinese cities continued to climb in 2013 despite repeated government efforts to cool the sector. China's National Bureau of Statistics announced 17 January 2014 that on a yearly basis, of a statistical pool of 70 major Chinese cities, all the cities but Wenzhou reported gains in new home prices. First-tier cities continued to lead rises, with the prices of new homes in Beijing and Shanghai surging over 20 percent from a year ago. And those in major provincial capitals are expected to exceed 10 percent for the year.
China's property sector showed new signs of cooling in April 2014, with more Chinese cities reporting month-on-month drops in prices and fewer cities reporting gains, official data showed on 18 May 2014. Of a statistical pool of 70 major Chinese cities, new homes in eight cities saw month-on-month price declines in April, double that for March, the National Bureau of Statistics (NBS) said in a statement. A total of 44 cities saw month-on-month price gains in new home prices last month, down from 56 for March and 57 for February, the NBS data showed. Among the 44 cities with rising new home prices, growth decelerated in 31 in April.
China's real estate market continued to weaken but with narrowing price drops in March 2015, leaving analysts to expect a further rebound with new relaxed mortgage rules. Of 70 large and medium-sized cities surveyed, the number that saw new home prices dip on a monthly basis in March stood at 50, 16 fewer than in February 2015, the National Bureau of Statistics (NBS) said on 18 April 2015. For existing homes, 48 cities saw month-on-month price declines in March. That was 13 fewer than in February, and the number of cities reporting price increases rose to 12 from five in February.
A majority of China's local governments failed to meet their targets for home price growth for 2013. At the start of 2013, almost all of major cities set price growth targets, following the requirement from the State Council, the cabinet, to cool down the real estate market. Beijing and Shanghai promised to keep property prices at a "stable" level.
Strong demand from first-home buyers, a bullish land market and a stable credit environment all fueled the skyrocketing prices. A red-hot land market strengthened buyers' expectations of a further price hike. Beijing, for instance, saw the value of land sales rising 181.2 percent year-on-year in 2013 to 182.2 billion yuan ($29.4 billion), according to Century 21. Sales of land for residential buildings soared 240 percent year-on-year to 127.8 billion yuan, with the average price of floor space rising 48.7 percent to 11,102 yuan [US$ 1,835.53] per square meter [10.764ft² or 0.00025 acres] So the price of residential land worked out to about US$7,500,000 per acre. In the US, land prices can vary greatly from as little as $500 per acre for very poor, remote areas, to well over $100,000 per acre for land for development purposes.
According to the Chinese Academy of Sciences, a government think tank, housing prices would rise 7.6-percent year on year in 2014. Residential housing prices in first-tier cities may increase even faster to 10.2 percent on the year. Housing prices were expected to grow faster after the first quarter. The CASS report said first and second tier housing prices may flatten out as early as the first quarter next year. Prices there were expected to then remain stable and even fall by the fourth quarter. The academy saw GDP growth for 2014 at 7.6 percent, CPI to increase by 3.1 percent on an annual basis, and foreign trade volume to grow 8.2 percent year on year.
World markets tumbled 27 July 2015 after the main Chinese stock market suffered its biggest plunge in eight years. European markets dropped to two-week lows, and US indices were down for the fifth straight session. The Chinese government’s dramatic efforts to prop up the mainland’s falling stock markets suffered a serious setback as major indexes suffered their biggest single-day plunge in eight years. The Shanghai Composite index lost 8.5 percent, while the CSI300 index of the largest listed companies in Shanghai and Shenzhen shed 8.6 percent.
Some analysts attributed the selloffs to investors’ profit-taking following the government’s massive capital support, which succeeded in bolstering shares over the past three weeks. As China’s mainland stock markets rose over the previous year, many investors borrowed money to buy stocks, in what is known as margin lending. But as markets have fallen, many investors could struggle to pay back the loans.
The Financial times reported that Lin Zuoming cast the actions of Avic Heibao, a listed manufacturing subsidiary of Lin's company Avic, as part of a heroic struggle against foreign aggression. “This stock disaster was a premeditated plot, a well-prepared case of malicious short selling and part of a powerful, tumultuous economic war launched against China,” Mr Lin said in an interview with state media. “The war launched against [the Chinese stock market] is an attack on the five-starred red [Chinese national] flag.”
The term "malicious short selling" is a legally dubious term. Short selling is legal, though limited, in China, and there is no legal definition of a “malicious” form of the activity. But it appears to the basis on which the Ministry of Public Security is looking for targets on which to blame the recent stock panic.
In an editorial Lin penned for a state-run nationalist newspaper, Lin also blamed US plots for the problems in the Japanese economy in the early 1990s and for the 1997 Asian financial crisis. The two largest shareholders of AVIC Heibao Co., a publicly listed branch of state-owned aerospace manufacturer Aviation Industry Corp. of China, were under investigation for liquidating shares inappropriately. The China Securities Regulatory Commission banned senior executives and some shareholders from dumping stocks for the next six months.
Albert Edwards, from Societe Generale, stated that "I remain convinced we are witnessing a bubble of epic proportions which will burst - catching investors as unawares as the bursting of the Asian bubbles of the mid-1990s."
The Chinese Government's failure to satisfy popular needs for job creation could trigger political unrest. Financial distress would also worsen corruption, compound unemployment, poverty, and social unrest, and reduce foreign direct investment. The "iron rice bowl" of cradle to grave wages and benefits has disappeared and a modern social safety net has not yet been erected. If China's economy takes a downward turn, regional security would weaken, resulting in heightened prospects for political instability, crime, narcotics trafficking, and illegal migration. China could face significant domestic political instability and violence, and sustained armed unrest from separatist movements along its western borders. China's leadership would almost certainly take a "hard line" approach to these domestic challenges, and would be equally likely to take a hard line on international issues as well. Concerns regarding regional stability are likely to grow, owing to the ongoing crisis over North Korea, and continuing tensions between China and Taiwan and Japan. Chinese suspicions, misperceptions and miscalculations could lead to a military clash.
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