Robert Peston recently made a documentary on why China’s credit binge will lead to another global financial crisis. His thesis is simple. China’s credit growth is excessive and if it continues it will result in an inevitable crash echoing the recent subprime bubble and subsequent financial crisis.
I have spent much of my career analysing credit booms and busts, and it seems clear that the evidence from China is overwhelmingly different from the recent subprime boom and bust. Peston focuses in on a number of key areas, however his analysis fails to take account of the wider context of the Chinese economy and crucially the difference between investing in physical and financial assets.
China’s credit boom resembles the subprime bubble
The subprime bubble was a classic example of what is known as a Wicksellian cumulative credit process. This is a process whereby rising profits generates excess liquidity which flows into financial assets. These flows push up asset values, which in turn provide the banking sector with rising collateral values upon which to lend – generally to acquire more financial assets including existing real estate units. When rises in asset values begin to slow, this process reverses leading to defaults and a failure of the banking system. However to date there is little evidence that there is a Wicksellian cumulative process taking place in China. The rate of profit is in fact falling in China so the comparison to the sub-prime bubble is a poor one. What is driving the credit boom, as Peston implies in his report, is large scale local government investment in infrastructure or physical investment.
China’s investment binge is turning toxic
Peston rightly points out that China’s investment rate which already outpaced most other countries accelerated after the Lehman default. This causes Peston to postulate that the current increased over investment will lead to a potential crash of the banking system financing the investment. However Peston fails to highlight a number of crucial points here related to the wider context of the Chinese economy. Firstly, it was only in 2012 that the urban population exceeded that of the rural population. Over 600 million people live in rural communities – with the agricultural sector employing 266 million workers according to a 2012 report by Deutsche Bank. As China becomes wealthier, it will need to improve the productivity of its agricultural sector to catch up with the ever rising demand for food. However China has one of the most inefficient agricultural sectors in the world. The Deutsche Bank report argued that the South Korean farming sector was 40 times more productive than China mainly due to the inability to mortgage land deterring farmers from growing their small family holdings into large scale mechanized agribusinesses. For anyone that has studied the process of industrialisation, an excess of agricultural labour increases the level of urbanisation fueling industrialisation. At the moment China’s agricultural labour force is around 25% of the total labour force, in the USA the agricultural labour force is less than 1%. So what does this mean? China could potentially see an increase of its urban workforce by another 200 million people. However China needs to have the infrastructure to be able to house these workers and transportation systems to move them around. The only real difference between what happened in 19th century Britain and China today is the scale and speed of the change, but this process is an old and reasonably well understood one. The implication of all this is that much of this infrastructure is in fact required to facilitate this process.
Peston makes a good point on the rising prices of luxury flats which are being kept empty to restrict supply further. However this is how large chunks of the London property market functions. He could have taken this point further emphasising the various white elephant projects of building brand new cities which remain largely empty, however in the scale of the investment binge these are in the minority. Peston is right to argue that the prices of luxury flats will fall at some stage. The issue is understanding what impact falls might have on the financial system. In the subprime bubble, the fact that 20% of mortgages were sub prime was the critical issue as soon as the extent of negative equity was realised many householders decided to default all at the same time leading to financial collapse. However, in this case it is the local government who have mainly being financing the investments. So the main question to try and answer is whether the central government is solvent enough should several local governments default on their debt at the same time.
China is on the edge of financial collapse
Peston rightly cites the research of Charlene Chu at Fitch, a former colleague of mine. Chu’s research was ground breaking in identifying the poor capitalisation level of China’s banks. Her analysis may well have spurred the Communist Party into action to dampen credit expansion by the banks. However, when there is a demand for credit, financial innovation will generally find a way to supply it. In this case the shadow banking sector has boomed to supply local government with the credit they need to invest. The audit on the level of Chinese local government debt that Peston referred to in the report was published in December 2013. Although the amount of outstanding debt was much higher than expected, the current fiscal position of the Chinese government appears to be strong enough to absorb large scale defaults. And in the case of default on luxury apartment blocks, due to the rising demand for housing as the process of urbanisation continues, it may mean that rural workers end up living in luxury flats which the Communist Party provides as affordable housing.
China’s rate of growth is not sustainable
The arguments on China’s rate of growth are mostly poorly understood. Firstly one needs to distinguish between productivity growth and the ability of a country to throw more labour and capital at the economy – a point made by Paul Krugman and Alwyn Young back in the 1990s. China has a “surplus” of around 200 million agricultural workers that over time will most likely shift into industry. Secondly, the number of new workers coming into the labour force is lower than those leaving the workforce due to the single child policy. This shift will inevitably mean a lower rate of growth due to demographic issues. To his credit, Peston in the piece referred to a 4% figure of higher value added growth. (I assume what is meant by this is higher productivity growth) Economies with efficient infrastructures can add substantially to higher levels of productivity growth, hence a lot of the current infrastructure binge may well be crucial to supporting faster productivity growth. Indeed, Alex Field’s research on the US economy demonstrates that the main driver for the US recovery in the 1930s was not the advent of WW2 but the fastest period of productivity growth in the history of the United States. This was driven by infrastructure investment.
Without doubt some of the infrastructure investment will prove to have added no value to the economy, but the argument that China is about to fall into an abyss of economic depression due to an investment binge misses the wider contextual picture of China’s economy, and the difference between investing in financial and physical assets. Clearly rising property values are a major concern for China just as they are for many Western countries. However, it is also possible that China might decide to do something about this issue. Western governments have continually failed to tax the windfall profits from rising land prices thereby providing government support for what is fundamentally an unproductive activity and curiously taxing productive activities or income instead.
Despite these criticisms, as a piece of economic journalism I think Peston ought to be commended for these kinds of projects. He is an engaging and enthusiastic presenter. Indeed, I’d like to see him return to China in order to educate central bankers on the mechanics of inflation. China, not inflation targeting has been the more important reason why inflation fell in the 1990s and 2000s – and the failure of central bankers to understand this issue sufficiently has potentially even worse consequences for us all than a crash in the values of luxury properties.