Streetwise Professor

December 19, 2011

The Chinese Humpty Dumpty

Filed under: Economics,Energy,Financial Crisis II,Politics — The Professor @ 12:55 pm

I’ve opined for over two years that China’s economy is very fragile and deceptively robust: I characterized it as a “Michael Jackson economy” kept functioning by doses of artificial stimulants, which postpone the ultimate adjustment, but which make that reckoning all the more harrowing when it comes–as it must. There have been other advocates of this view, notably short sellers like Jim Chanos, but until relatively recently the consensus was that China would slow gently, and experience a “soft landing”.  In recent weeks, however, the consensus is clearly shifting towards the alternative view that China is increasingly vulnerable to a big fall.

This is best illustrated by the fact that nearly polar ends of the opinion spectrum, from the WSJ to Krugman, have agreed that China’s situation is increasingly fraught.

The previous optimism by some was actually the primary reason for my pessimism.  The Tom Friedman School of Sinology, which has far too many adherents (including many corporate types here in the US), argues that China’s centralized policymaking system will allow it to respond to crises in a forceful, technocratic way unhindered by the political messiness that has interfered with economic policy in the US, and particularly Europe.

Alas, fascism always has its admirers, not least among the smart set opinion makers and the board rooms of large corporations, where it is all to common to think of economies like companies run by managerial fiat, rather than as spontaneous orders coordinated via the price system and other forms of market contracting.

To me, this centralization is a bug, not a feature.  Centralized resource allocation invariably leads to substantial distortions.  In China’s case, the extreme orientation towards investment in driving GDP growth should be a clear signal of misallocation.  In 2008 and 2009, China responded to the crisis by dramatically easing credit and encouraging investment in infrastructure and housing.  A lot of money got spent, and a lot of measured GDP was created, but it is increasingly doubtful that the true market value of these investments, which would represent the actual value created, is anywhere near the amount invested.  The decline in housing prices is one symptom of that.  The fact that many big infrastructure projects, like the glittering high speed rail systems that Obama marvels over like an 8 year old watching a Lionel whiz around the track on Christmas morning, are unable to cover even variable costs, let alone generate a return on investment, is another.

Governments can spend, or distort prices to encourage spending.  Creating actual value from the spending is something else again.

Moreover, China’s supposedly wise planners have created a financial system that would make Rube Goldberg proud, and which exhibits all the pathologies and brittleness of past systems that have collapsed in ugly crashes.

The Chinese have constructed a system that is intended to (a) channel savings via big banks for lending to the kinds of companies and projects that the government wants to support, and (b) generates spreads for banks to help them generate income to overcome the consequences of past bad investments.  This system involves paying very low rates to depositors who have limited investment alternatives.  Most Chinese depositors actually earn negative real returns.

But these price controls–like all price controls–encourage efforts to circumvent them.  In China’s case, investors looking for higher returns are circumventing the formal banking sector by directing capital to the informal shadow banking system. This system utilizes a crazy quilt of products like wealth management products, letters of credit, and bank acceptances.

Much of the capital raised via the shadow banking system has been channeled into real estate, loans to companies rationed out of the formal banking system as the result of government policies to try to rein in inflation and speculation, and to lending to local governments with extremely dodgy finances (being heavily dependent on real estate sales for funding).  Thus, the asset side of the balance sheets of these entities is extremely risky.  The liability side is, moreover, very fragile and prone to runs–just like the shadow banking system in the US was in 2007-2008.

Put this together and you have a very big financial Humpty Dumpty teetering on the verge of a very big fall: risky assets funded with run-prone liabilities, and all that operating in the financial shadows.  Those who marvel at the wonders of a state dominated system (e.g., the Tom Friedman China cult) are not worried.  They are serenely confident that all the Party’s horsemen and all the Party’s men will be able to put Humpty Dumpty back together again.  This optimism is passing strange, given that CCP policies are primarily responsible for Humpty Dumpty’s existence, and his parlous state: policies that encouraged the rapid expansion of a shadow banking system, and which stimulated extremely investment-intensive growth with little regard to the economics of the projects this stimulus spawned.

What could give Humpty a push?  Well, given China’s export-orientation, the most obvious candidate is a slowdown in Europe which appears increasingly certain.  The main open question here is how severe the contraction will be.  That depends on the wildly unpredictable (because it is primarily politically-driven) outcome of attempts to address its sovereign debt crisis.  But it is also possible that Humpty could fall purely due to internal factors, without an external push.  The existing balance is very precarious.

As I’ve mentioned before (mainly in the comments), it is very difficult to predict the timing of these things.  But it is plain to see that Humpty is teetering, and that the odds of a fall are appreciable.

This helps explain why open interest in very low strike crude oil puts is increasing dramatically: if Humpty does fall, it will be extremely bearish for commodities.  (Deep-out-of-the-money-calls on crude are also quite popular now, reflecting the situation with Iran.)

So I remain pessimistic on China.  It is interesting to have much more company in that view.  Interesting, and at the same time a little unsettling: having Krugman on the same side is always reason for a rethink!

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  1. The alarmists have called about ten of the last zero Chinese recessions, so there is ample ground for continued skepticism.

    Comment by Sublime Oblivion — December 19, 2011 @ 3:14 pm

  2. […] – The Chinese humpty dumpty. […]

    Pingback by FT Alphaville » Further reading — December 20, 2011 @ 2:16 am

  3. Not as much as the grounds for skepticism regarding anything you write SO

    Comment by Andrew — December 20, 2011 @ 4:59 am

  4. What will prevent them from papering over this time as well by pushing all the bad debt to separate SPVs? Will they be able to build another tier over the quicksand?

    Comment by Surya — December 20, 2011 @ 7:34 am

  5. Basically I dont know who will pull the plug. What they have done in the past amounts to screwing those who save – the majority of Chinese public. As long as they are able to repress the masses, they can continue doing this.

    Comment by Surya — December 20, 2011 @ 7:36 am

  6. @Surya–I’m sure that’s the plan. That’s what they’ve done in the past. But the capacity to do that is not unlimited, and the scale of the problem now is arguably much greater. Moreover, the previous Enron-esque games were done when the economy was still growing very rapidly. It’s a lot harder to do that if the economy is growing more slowly, or not growing at all.

    And the conundrum they face now is that it harder to screw the savers b/c of the development of alternatives–the shadow banks.

    The ProfessorComment by The Professor — December 20, 2011 @ 10:14 am

  7. […] Why China is the “Michael Jackson” economy — Streetwise Professor […]

    Pingback by Counterparties | Felix Salmon — December 20, 2011 @ 4:41 pm

  8. I think you’re pretty much dead-on here. I’ve expressed very similar sentiments on my newly-launched blog:

    “Alas, fascism always has its admirers, not least among the smart set opinion makers and the board rooms of large corporations, where it is all to common to think of economies like companies run by managerial fiat, rather than as spontaneous orders coordinated via the price system and other forms of market contracting.

    To me, this centralization is a bug, not a feature. ”

    Whats even more problematic is that the actual centralization of power has gradually dispersed in the last 10-15 years or so. The western consensus that China’s elite can singlehandedly arrest any decline ignores the fact that decision making is increasingly consensus driven and there are no dominant personalities capable of forcing unilateral action. Local leaders follow central directives selectively and have a lot of freedom to do as they please. If you’re more interested I’d highly recommend taking a spin through the slide deck I allude to in my post.

    Comment by Bleichroeder — December 20, 2011 @ 5:31 pm

  9. “Interesting, and at the same time a little unsettling: having Krugman on the same side is always reason for a rethink!”

    Why would you say that? I’d rethink my position if I found that the other person, Krugman here, has been basically correct in what his position has been all through the current economic malaise. But, being a professor myself, I understand that you have to distort reality as long as possible or toss away your life’s work. Sounds familiar when talking about China, doesn’t it? But as you said, the reckoning comes whether you want it to or not, and no matter how long you keep bailing the boat keeps filling. I just wish people would keep the politics out of the discipline. Not only is it incorrect and leads to grossly stupid machinations to justify economic positions (not unlike those of Fundamentalist Christians) but it demeans and cheapens the discipline as a whole.

    China is due for a tremendous thud, as is the “freshwater” school which has never made any sense to me anyhow. Morally, mathematically, and logically specious both.

    Comment by skyman123 — December 21, 2011 @ 9:12 am

  10. @Bleichroeder–Thanks. Excellent post, excellent presentation. The political economy angle is extremely important. I’ll keep a close eye on your blog.

    The ProfessorComment by The Professor — December 21, 2011 @ 9:18 am

  11. I have no dog in the fight of who sucks less at the moment: Oceania or Eastasia.

    Comment by Mr. X — December 21, 2011 @ 5:08 pm

  12. […] Professor: The Chinese Humpty-Dumpty No Hard Landing for China, Just an Old Fashioned Crash ……..I will briefly sum up my […]

    Pingback by China Hamsterwheel - PPRuNe Forums — December 25, 2011 @ 3:59 am

  13. Wherever one looks, so many plutocrats and klepto-bureaucrats, so much hubris, greed, oppression and wealth destruction!

    Fortunately, realists know that the most efficacious path to responsible government and to economic and social liberalization lies in questioning the sanity of the political leaders and participants in public movements who demand reform.


    Comment by TokyoTom — December 28, 2011 @ 12:40 am

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