Oxford University Press, May 2020.
As much as China's crash has been predicted, someone needed to explain why it hasn't happened. And no one could be more credible in doing so than Tom Orlik who has reported insightfully on China since 2011, first with the Wall Street Journal, then with Bloomberg where he is now Chief Economist.
Warnings of trouble have been sounding ever since the 4 trillion yuan (15% of GDP) stimulus that propelled China out of the Great Financial Crisis. The stimulus was financed mainly by debt of local governments and state-owned enterprises. Debt continued to pile on until the ratio to GDP reached 250% in 2016, a level far out of line with other countries of China's per capita income level. Moreover, the debt took on increasingly risky forms as the financial sector was liberalized and shadow banking proliferated. This shadow banking involved intermediaries lending to enterprises, then securitizing the loans and selling the assets to banks which in turn packaged them into wealth management products for retail depositors. The system suffered from opacity and the moral hazard that comes from belief in government bailing out any losses. The lending boom fueled investment in wasteful infrastructure projects, industrial overcapacity, and vast tracts of empty real estate development.
Signs of fragility emerged in 2015. A soaring stock market prompted concerned regulators to threaten caps on margin buying. Panic ensued, with the market losing a third of its value in three weeks at which point trading was halted. Also telling, capital flight brought downward pressure on the yuan that the central bank arrested only by giving up half a trillion dollars in foreign reserves. Yet throughout, somehow the real economy remained unshaken.
Policymakers nevertheless heeded the warnings and took action on multiple fronts. First, they rolled out a program of "supply side reforms" to cut overcapacity in industry through mergers and shutdowns. Second, to animate the ghost towns thrown up by overzealous developers, old neighborhoods were razed and their occupants provided with escrow accounts to purchase new units. Mortgage loans and urban residence permits were rolled into the deal. The fiscal outlays were recouped as property developers took on new projects and the tax base was expanded. Third, to address fragility in the financial sector, asset management companies were established at province level to buy up bad loans from banks at a discount. Fourth, overextended local government financing vehicles were granted debt swaps that transformed short term loans at high interest rates into long term loans at low interest rates. Finally, banks were subjected to regulatory oversight with good behavior rewarded and bad behavior penalized by way of differential interest rates paid on reserves and various business activities permitted or prohibited. Overall, the program succeeded in stabilizing the debt to GDP ratio through 2017 and 2018 and substantially lowering systemic risk.
How was China able to achieve such a feat in defiance of widespread forecasts of doom? Orlik attributes it to "a combination of the underlying resilience of the economy and financial system, the underappreciated ingenuity of policymakers, and the unusual resources of an authoritarian state." (p. 118) Resilience of the economy arises in no small part from how far China remains from the development frontier in combination with the steadfast will of the country's developmental state to reach that frontier. Resilience of the financial system rests on high savings deposits that provide a stable source of funding for banks. The ingenuity of policymakers and the capacity of the leadership to wield power are on display in all aspects of the course change engineered to rein in debt and reduce financial risk. Where but China could slums be razed across a nationwide urban landscape with residents relocated to whole new cities? It does take a special kind of vision and authority.
Much has happened in the world since the book went to press. But in a recent interview on Sinica Podcast, Orlik stuck by his position that no crisis is imminent. Indeed, if China had been teetering on the brink of crisis, the economic downturn wrought by the pandemic should have provided the tipping point, and there is yet no inkling of any sweeping default on debt or loss of confidence in the financial system about to transpire. On the contrary, because China went into the pandemic on a relatively strong financial footing, the government has space to engage in stimulus.
I have one quibble with the book. Orlik sees the root problem of China's saving/consumption imbalance and resulting need for constant demand stimulus – it's "original sin" as he puts it in the Sinica podcast (39:18) – as lying with the one-child policy. The argument is that the one-child policy, along with an inadequate social welfare system, has motivated high precautionary saving to ensure sustenance in old age. The empirical evidence does not support this argument, however, either for China in time series, since the one-child policy was introduced in 1980 and the saving rate only shot up in the 2000-aughts, or across countries, since all countries that experienced a rapid growth take-off showed a steep rise in their saving rates and none but China had a one-child policy. Articulation of an alternative explanation for China's unbalanced growth must await another blog post. In any case, this is only a quibble because the original insights of Orlik's book on how China averted a meltdown hold up regardless of the explanation invoked for underlying imbalances. Others, too, have gotten this explanation wrong. That quibble aside, the book provides compelling answers to important questions.
Follow-up post: "The Real Reason for China's Unbalanced Growth"