By Emil Pulsifer, Guest Rogue
Those who fail to learn from history are doomed to repeat it.
Before China became the leading developing nation, there were the Asian Tigers: Hong Kong, Singapore, South Korea and Taiwan. In the late 1990s a financial crisis gripped Southeast Asia that threatened to spread into a global financial meltdown.
In many significant respects, the parallels with China are eerily disturbing. While it is true that there are important, fundamental differences which preclude an exact replay, there have been other developments since that time, such as growth in the derivatives market and the securitization of debt which have the potential to spread financial contagion. Leverage is a fearsome thing, and risk predictions are notoriously unreliable and often consider only the initial stages: we have only to look at the recent example of the Great Recession, in which a small but very sick portion of the U.S. housing market spread to the national housing market and thence, via securitized and bundled loans, to the global financial system.
A few bullet points will suffice to give the reader a background on the Asian Tigers crisis. The summary is taken closely from International Business: Competing in the Global Marketplace by Charles W.L. Hill (6th Edition, 2008).
• Exports had been the engine of economic growth in these countries. The nature of exports had also shifted significantly from basic materials and products such as textiles, to complex and increasingly high-technology products such as semiconductors and microcircuits.
• The wealth created by export-led growth helped fuel an investment boom in domestic commercial and residential property, industrial assets, and infrastructure. The value of commercial and residential real estate soared, particularly in major cities. This fed a building boom financed with heavy borrowing from banks.
• In many cases, governments embarked on huge infrastructure projects. Throughout the region governments also encouraged private business to invest in certain sectors of the economy in accord with "national goals" and "industrialization strategy." Many of these businesses built up massive debts that were multiples of their equity. Many of these businesses were also granted lucrative monopolies or elite, oligopolist advantages by governments.
• By the mid-1990s Southeast Asia was in the grips of an unprecedented investment boom, much of it financed with borrowed money.
• As the volume of investments ballooned, often at the bequest of national governments, the quality of many of these investments declined significantly. The investments were also made on the basis of unrealistic projections of future demand conditions. The result was excess capacity and overbuilding.
• Excess capacity and overbuilding resulted in price and valuation drops which made it difficult for companies to make the scheduled debt payments on the debt they had taken on to build the extra capacity.
• A complicating factor was that by the mid-1990s, although exports were still expanding across the region, imports were too. The investments in infrastructure, industrial capacity, and real estate development were sucking in foreign goods at an unprecedented rate, as Asian countries purchased capital equipment and materials from America, Europe and Japan to build with.
• A number of major financial institutions had been borrowing at low interest rates and lending to local property developers at much higher interest rates. However, due to speculative overbuilding these developers could not sell their commercial and residential property, forcing them to default on obligations. This left the banks holding the bag.
• Sensing the beginnings of the crisis, investors fled local stock markets, selling their positions and converting them to U.S. dollars. This drove down local currencies. Foreign exchange dealers and hedge funds started speculating against the local currencies, selling them short. The governments, who had pegged their currencies to the U.S. dollar, tried to shore them up, but only succeeded in depleting their foreign exchange reserves. The slide in the value of local currencies increased the amount necessary to service outstanding loans taken on by local financial institutions and businesses. This increased the likelihood of bankruptcies and further pulled down the local stock markets.
Now, there are some very important differences between the Asian Tigers crisis and the China situation which need to be pointed out before we go any further.
The first is that much of the borrowing by the Asian Tigers had been in U.S. currency from international banks. The second is that, unlike many of the Southest Asia states who saw their balance of payments go into the red during the mid-1990s, China has the largest accumulation of foreign exchange reserves in the world.
This is not to say that mainland China is without foreign exposure. Large portions of the China bubble have been inflated with the assistance of Hong Kong banks, which in turn have close connections with western international banks globally. In just the last three years, Hong Kong banks have increased their lending to mainland China from 25 percent of Hong Kong GDP to 110 percent
Furthermore, as much as 25 percent of foreign direct investment in mainland China is "round-trip" money sent by Chinese businessmen offshore, then returned to China using disguised accounts. This was done to obtain the favorable treatment afforded to foreign firms (though in the last few years China has restricted or begun to phase out many incentives to foreign firms). Though this does not represent foreign debt per se, it suggests the possibility of unrecognized arbitrage by Chinese investors: In recent years, U.S. interest rates have been extremely low and it would not be impossible to obtain loans through intermediaries and shell corporations and then re-loan the money to local developers at much higher rates of interest.
Note also that there are many partnerships between the Chinese government and private foreign investors (e.g., jointly owned factories and assembly plants) and though these foreign investors have their own financing, the success of their ventures depends in many cases on the ability of Chinese businessmen, investors, and banks to remain solvent; thus foreign financing is indirectly vulnerable.
Though important to a balanced analysis, these nuances may ultimately be less important to the global economy than interlinked international commodities and derivatives markets. Before examining that aspect,let's briefly examine where China stands today in comparison with the Asian Tigers.
First, those exports. The true nature of China's economy may come as a surprise to those who regard it as an export-driven engine. As recently as 2005 net exports accounted for slightly more than 20 percent of annual growth there. But as this simple graph (courtesy of The Economist) shows, since 2008 net exports have either contributed only negligibly to growth or else have actually subtracted from growth (as China imported more than it exported):
You can see the graph in context here. As it shows, consumption (which includes government consumption) and fixed investment (infrastructure) accounted for all or nearly all economic growth in China recently. Foreign demand has decreased, first as a result of the Great Recession and second as a result of persistent slow growth in the U.S. and elsewhere. The European Union is in recession and even the notoriously optimistic World Bank forecasters expect it to remain in "negative growth" through 2013. Even Germany, Europe's powerhouse, has cut its own growth forecast for 2013 to just 0.4 percent; France is even weaker, and Great Britain is expected by many to enter recession during 2013.
In order to keep the Chinese economy growing, then, both the government and local investors have relied on an orgy of easy money and property development. In the words of Foreign Affairs, underwriting the impressive facade of the Chinese economy is an incredibly risky strategy:
(Local Chinese) Governments borrow money using land as collateral and repay the interest on their loans using funds they earn from selling or leasing the same land. All this means that the Chinese economy depends on a buoyant real estate market to keep grinding. If housing and land prices fall dramatically, a fiscal or banking crisis would likely soon follow. Meanwhile, local officials' hunger for land has displaced millions of farmers, leading to 120,000 land-related protests each year... Private analysts put the (size of local government debt) between 50 and 100 percent of GDP, depending on whether local governments' contingent liabilities or indirect debts (debts owed by government-owned and government-related entities) are included... The banks' accounting tricks treat only a symptom of the problem. Eventually, banks will become unable to roll over loans because they will run out of fresh money. And officials' ability to pay off loan interest depends on the continued rise of real estate prices and a buoyant economy, neither of which can be taken for granted.
Indeed they can't, a point Patrick Chovanic makes in the same journal:
As 2011 progressed, developers scrambled for new lines of financing to keep their overstocked inventories. They first relied on bank loans (until they were cut off), then high-yield bonds in Hong Kong (until the market soured), then private investment vehicles (sponsored by banks as an end run around lending constraints), and finally, in some cases, loan sharks. By the end of last summer, many Chinese developers had run out of options and were forced to begin liquidating inventory. Hence, the price slashing: 30, 40, and even 50 percent discounts...Residential real estate construction now accounts for nearly ten percent of the country's total GDP -- four percentage points higher than it did at the peak of the U.S. housing bubble in 2005."
...new urban residents are not the immediate drivers of China's recent run-up in real estate. Chinese investors, large and small, are the ones creating the market. For more than a decade, they have bet on longer-term demand trends by buying up multiple units -- often dozens at a time -- which they then leave empty with the belief that prices will rise. Estimates of such idle holdings range anywhere from 10 million to 65 million homes; no one really knows the exact number, but the visual impression created by vast "ghost" districts, filled with row upon row of uninhabited villas and apartment complexes, leaves one with a sense of investments with, literally, nothing inside.
...more than 100 local government land auctions failed last month, and land sale revenues in Beijing are down 15 percent this year. Without them, local governments have no way to repay the heavy loans they have taken out to fund ambitious infrastructure projects, or the additional loans they will need to keep driving GDP growth next year...the collapse in property prices has sparked a full-blown credit crisis, with reports of ruined businessmen leaping off building rooftops; some are fleeing the country."
...Ironically, as Chinese investors start pulling their money out of property, many are putting it into bank- and trust-sponsored "private wealth management" vehicles that promise high fixed rates of return but channel the proceeds into investments -- like real estate developers and local government bonds -- whose returns are themselves predicated on ever rising property prices. Many fear this repackaging of real estate risk is laying the foundation for a follow-on crisis that some are labeling the Chinese equivalent of Wall Street's collateralized-debt-obligation mess."
KPMG reports that wealth-management trust companies will soon overtake insurance to become the second largest sector in the Chinese financial industry. Xiao Gang, the chairman of the Bank of China, went on record as saying that the way trust companies were run was "fundamentally a Ponzi scheme".
If anything, the amount of real estate driven borrowing in China is seriously underestimated by Chinese authorities (or at least, their public spokesmen). Unofficially, however, they have seen it coming.
Li Zuojun, a Chinese researcher with the National Development and Research Center of the State Council, delivered a speech on Sept. 17, 2011 titled, "Economic Crisis Will Befall China in 2013." The speech, predicting an economic meltdown, was presented at an internal meeting of the Changsha Alumni Organization of Huazhong University of Science and Technology, according to Deutsche Welle. As the New York Times reported, "Foreign analysts have warned that borrowers in many industrial sectors have used bank loans to speculate in real estate, so that the banking sector may have an unintentionally large exposure to the country’s real estate market."
Note also that domestic credit as a percentage of GDP has risen from 125 percent to 200 percent over the last four years.
China's excess capacity in its manufacturing sector was reported by the International Monetary Fund to be 40 percent in 2011. China's corporate sector is highly leveraged, saddled with debt equaling 120 percent of GDP at the end of 2011 and increasing into 2012.
If the real estate sell-off continues and broadens, according to one analyst's report, China can expect: "...a sharp growth slowdown. This would cut corporate margins sharply, making profits plunge, and triggering a downward spiral in domestic demand. Bankruptcies and unemployment would occur on a large scale, endangering financial and social stability...The rapid development of the non-bank credit market (in China) in the last few years, especially shadow banking activities, has created a new vector through which a systemic liquidity crunch could take place. Capital outflow would likely ensue, stretching domestic liquidity conditions further."
Of course, the Chinese government may step in with a bail-out. Indeed, it is hard to see how it could avoid doing so if the crisis progresses to this point. That, however, would not only risk reinflating the bubble but could also risk hyperinflation; and the specter of this is precisely what prompted Chinese authorities to put the brakes on the economy, which is what pricked the real estate bubble to begin with, as it reduced developers' access to credit:
"...Real estate investment has continued growing at nearly 30 percent annually. But inflation began to rise from 1.5 percent in January 2010 to a peak of 6.5 percent in July 2011, and authorities began to sweat. They broadened their cooling efforts. The central bank tightened credit expansion, and China's economy began to slow." (from the second Foreign Affairs link above)
Now to the broader consequences. How badly would this affect the global economy? One estimate says that a "hard landing" in China could cut global GDP by 60 percent; produce a 50 percent drop in base metals prices and a 30 precent drop in Brent crude oil prices (China represents a huge chunk of the commodities market); slash European equities by 20 percent; and cause "interest rate swap levels" to fall to historical lows across the region.
But could that be just the beginning? Reuters reported that China plans to renege on "loss-making commodities derivatives trades."
One should also not forget the power of leverage to turn comparatively small financial disruptions into much larger ones; the international banking community is linked as never before and one thing leads to another. Because I'm scarcely an authority on derivatives I'm determined to resist the urge to be alarmist, but I would be remiss if I didn't examine the possible ripple effects of a Chinese economic meltdown.
The Bank of International Settlements keeps statistics on over-the-counter (OTC) derivatives in the G10 countries and Switzerland. Obviously, this is only a fraction of total global derivatives, albeit a large and important one. As of June 2012 the notional value outstanding of these was $639 trillion dollars. However, a better measure of risk for OTC derivatives is gross market value: this represents the actual cost to financial markets if all of the derivatives contracts defaulted. In June 2012 the gross market value of these was $25.3 trillion. By contrast, the World Bank put total global economic output (GDP) at $70 trillion (U.S. dollars) in 2011.
Obviously, we wouldn't expect all of these to default. The good news is that the gross market value of commodities derivatives is only $390 billion in 2012, and only a portion of these could be expected to default. The bad news: OTC derivatives are only part of the derivatives market. The other part consists of exchange-traded derivatives. According to the BIS: "There are no available statistics in the exchange traded derivatives markets that are comparable to gross market values as calculated in the OTC markets. That is because exchange traded derivatives are commonly marked-to-market on a daily basis. As such, traders pay any losses and collect any profits on a daily basis."
The outstanding value of these already marked-to-market derivatives is quite high. Exchange traded derivatives come in two flavors: futures, and options. The value of these as of September 2012 was respectively $25 trillion and $31 trillion.
Again, obviously only a fraction of these might cause trouble in the event of a Chinese meltdown. But even a small fraction of a very large number can still be a very large number — an amount, say, that would cause severe hardship to financial institutions still reeling from the global financial near-collapse of the Great Recession; and the effects of a Chinese meltdown are not necessarily limited to the initial effects, as other markets may bedragged down in turn.
According to economic analyst Jesse Colombo, who was described by the Times of London as one of the "ten people who predicted the financial meltdown" in 2008, China is actually a bubble within a much wider bubble.
"China has clearly veered off of its successful original path of reform and modernization, while large parts of their economy have devolved into a classic bubble," he writes. "China will soon face the terrible consequences that inevitably come when bubbles of this magnitude pop. The popping of China’s bubble will also pop bubbles that are derivatives of it, primarily the bubbles in commodities, emerging markets, Canada and Australia. While China’s economy may very well have a bright long-term future, the same could be said about the U.S. economy in 1929 before it plunged into the Great Depression." (Colombo also has a broader commodities-bubble web-page).
According to Zhang Ziyi,"Crouching Tiger, Hidden Dragon is a common expression which refers to the mysteries that lie below the surface of society and our everyday lives. The expression is a reminder never to underestimate our own dragons and tigers - they can spring out at any time."
In Chinese mythology, dragons are a symbol of good luck. In the Greek mythology of the West from which the word dragon stems, "Draco" was a dangerous and greedy creature that caused great evil. The creation of a new consumer society by China's totalitarian government has brought great wealth to a new elite class within China while driving up the price of basic foodstuffs and living space for the toiling majority of its workers and seizing ancestral farming land from many others, forcing them into a life of wage-slavery in smog-filled, overcrowded metropolises; while for the rest of the world, vastly accelerating global climate change and driving up the price of basic commodities. Only time will tell how the current crisis will play out.
Let history judge the implications.