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Is China Facing a Minsky Moment?

Summary:
As Evergrande looks about to default on its debt many are asking whether this might be a Lehman moment for China. That is, are we about to see a wave of defaults that bring down the Chinese financial system as we did in Western countries in 2008? Much of the discussion is based on a misunderstanding. The Western financial system as it stood in 2008 was a largely laissez-faire system. There were, of course, regulations in place and there were also protections – most notably, deposit insurance. But ultimately, the system was basically market-based. This is what led to problems. When banks saw their loan-books turn sour they were faced with the very real possibility of default. True, the central banks – and some misguided governments., like Ireland – ultimately bailed them out,

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As Evergrande looks about to default on its debt many are asking whether this might be a Lehman moment for China. That is, are we about to see a wave of defaults that bring down the Chinese financial system as we did in Western countries in 2008?

Much of the discussion is based on a misunderstanding. The Western financial system as it stood in 2008 was a largely laissez-faire system. There were, of course, regulations in place and there were also protections – most notably, deposit insurance. But ultimately, the system was basically market-based.

This is what led to problems. When banks saw their loan-books turn sour they were faced with the very real possibility of default. True, the central banks – and some misguided governments., like Ireland – ultimately bailed them out, but this was a discretionary policy.

The Chinese economy is not a laissez-faire system, however. It has aspects of laissez-faire. The Chinese largely allow markets to distribute consumer goods, for example, in contrast to the old Soviet bloc economies. But much of the rest of the Chinese economy is firmly controlled by the government.

In practice, this works by the Chinese government effectively ordering state-owned companies to engage in large-scale investment spending. This investment spending creates jobs and this job creation generates consumption. The financing for this investment comes out of the banking system, which is almost completely controlled by the government.

Much of this investment spending does not prove profitable. So, the loans go sour. This is not a new phenomenon. We saw something identical in the 1990s. Here are the rates of non-performing loans (NPLs) that resulted from the massive state-led investment campaigns of the 1990s – taken from an excellent 2006 paper from the Bank of International Settlements.

Is China Facing a Minsky Moment?

As we can see, the numbers were enormous. NPLs accounted for some 36% of Chinese GDP in the 2000s.

Why then did the Chinese not have a 2008-style financial crisis? Well, the government simply got rid of the NPLs. They set up so-called ‘asset management companies’ (AMCs) and these vehicles took the NPLs off the bank balance sheets. What happened to the NPLs? Effectively they were flushed down the memory hole.

If you think this sounds like a shell game, then you have to recognise the reality that fiat-based monetary systems are always a sort of shell game. So long as the banking system is unconstrained in the amount of money it can create, and so long as the banking system (and the central bank) are under control of the government, then bad loans can always be flushed down the proverbial toilet.

In 2008, what did such damage to Western economies – as opposed to Western financial systems – was the drying up of investment spending associated with the real estate market. This led to the recession and economic stagnation that followed.

Will the collapse of Evergrande lead to lower investment spending in China? That is up to the government. If the government decide to tell the state-owned enterprises to turn off the investment taps, they will. But why would the government do this – after all, it would result in recession and unemployment?

Perhaps the Chinese government will order the state-owned enterprises to stop investing so much in building real estate. They could focus their investment spending elsewhere, of course – possibly to military build-up now that the Australians are beefing up their submarine defences. Or the Chinese government may just keep beefing up real estate investment. Ultimately, it is up to them.

When Western commentators say that this investment is building ‘roads to nowhere’ and that it will all collapse eventually, they are implicitly assuming that the Chinese economy is a market-based system and that market discipline will inevitably prevail. This is simply incorrect. Because, as I said before, the Chinese economy is, for the most part, not a market economy.

Ultimately, if you want to know what is going to happen to the Chinese real estate market in the coming years you should just as Xi Jinping and his lieutenants. Because it is their decision to make.

Philip Pilkington
Phillip Pilkington works in investment and has contributed to numerous online and print media outlets as a freelance economic journalist.

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