China’s Coming Financial Crisis and the National Security Connection
China is more economically vulnerable to a confrontation with the United States than it likes to admit. However, that weakness is not driven primarily by a budding trade war with America. China’s export volume growth has begun to slow with all major trading partners, not just the United States. A decade of reckless domestic credit growth is the primary source of China’s vulnerability. And that credit growth only temporarily abated in early 2018. There are already signs of more stimulus on the way. Over the past decade, China has been pursuing excessive GDP growth targets using massive injections of credit. China may respond to U.S. tariffs by pumping even more money into the economy, thereby exacerbating the underlying credit bubble. However, a renewed stimulus is going to occur anyway. Slow loan growth in 2017 has caused weaker GDP growth in 2018. To meet its GDP growth target for 2019, China again needs stronger credit growth.
Valid questions hanging over Chinese economic data have important implications for national security. I do not subscribe to the view that China’s GDP is vastly overstated or that its economy is actually on the verge of collapse. However, a better reading of Chinese data, particularly on disguised lending, points to a very high probability of a Chinese financial crisis in the next three to five years. China’s disguised lending is hard to measure. But it can be measured and compared to other countries that experienced a financial crisis. Such an analysis shows China is not in danger next year but probably will be soon after.
We commonly hear that China cannot have a financial crisis because the government owns all the banks and can control them. It is true government ownership is a stabilizing factor. If the entire Chinese financial system was just the Bank of China, then it would be easy enough to control. But there is a tectonic shift already well under way in the financial sector as major banks lose market share to a proliferation of shadow and smaller provincial banks. The IMF 2016 Article IV report on China warned of “the increasing role of smaller and provincial banks, especially city commercial banks, which have greater exposure to shadow credit products and have grown rapidly.” It is in the funding of these smaller banks and shadow banks that the risks lie. The Chinese financial system cannot have a crisis today, but in three years’ time it will be exposed. Comparisonswith the many other countries that have had a financial crisis indicates that China’s risky funding is not quite at a threshold that would merit a panic, but it is only a few years away. While the Chinese government also regulates these smaller banks and shadow banks, the task becomes harder as they proliferate. We have already seen a delay of about two years between the rise of disguised lending in 2015 and a regulatory response in 2017.
Ten years ago, the five largest banks in China accounted for most of the country’s financial system. They have already shrunk to around a quarter of the system. This change continues and shows why the old assumptions about government control of the system should be questioned.
In theory, government control is good for stability. In practice, however, two things have to happen to avoid a crisis: First, the government has to use its power to make the right policy choice, and second, it has to avoid making a Lehman-style regulatory mistake.
Rather than making the right choice to tackle the root of the problem by engineering a structural slowing of credit growth, with a much lower GDP growth target as a foundation, China has been dithering and taking half-measures. As we have seen over the past year, it is easy to do some cyclical slowing in credit growth when the economy is doing well. But credit was still growing and the government bent over backwards to keep interest rates low. Now that the economy is growing, talk has quickly switched to stimulus and maintaining GDP growth. This is the opposite of what China has to do if it is going to avert a crisis.
While the government owns the banks, that does not stop officials from making regulatory mistakes. We have already seen regulatory mistakes such as mishandling of RMB market volatility in 2015. We have also seen well-handled, timely, and complex crisis management failing financial companies. But that does not mean they always handle every crisis well and will continue to do so. The law of probability indicates that eventually something will go wrong and, like every other country, China will have a financial crisis.
Once the pool of opaque funding in the financial system reaches a critical mass, it is only a matter of time before regulators make a mistake and a panic sets in. As viewers of Too Big to Fail will recall, when a crisis starts quick action is essential. A mistake in China could be as simple as a delay of a day or two in getting a rescue package together as a property developer fails. In recent years, we have seen regulatory mistakes, so we know China’s leaders are not infallible. Once shadow bank lending is big enough in a few years, despite the frantic efforts of the government, credit markets could freeze for a brief period and the economy could go into recession.
The panic will last longer than a few days. China’s financial system is becoming a very large and increasingly obscure system. When a panic hits, lenders do not know if the borrowers they are lending to are solvent so it takes a while for credit flows to return to normal. A government order to restart lending cannot be fully implemented instantly while people holding trillions are refusing to provide funds and are trying to get their money out of China. Government intervention will keep the system ticking over but at a lower level. Government ownership doesn’t necessarily make intervention quick and effective. Bureaucrats will be very fearful of being punished for lending to counterparties who collapse, and there will be many collapses in progress. Also the stakes will be very high given the sums of money involved and many bureaucrats will want to refer big decisions to someone higher up which will slow the process. For a recession to occur it only takes a month or two of slower credit flows.
China’s disguised lending, which has ballooned over the past decade, makes it much harder for both the government and financial markets to assess the build-up of risk in China’s financial system. As a result China has not acted fast enough to avert a crisis, and now the required adjustments are too large to be politically palatable. China’s leaders are not willing to see GDP growth fall to 2 percent as part of a serious deleveraging, and probably underestimate the risk of a recession if they keep stimulating.
We can see many possible triggers developing. One of the most likely is an uncontrolled devaluation of the RMB. The credit growth that fuels shadow bank funding is also eroding China’s foreign exchange reserves as a portion of the growing financial assets leaks offshore. Although China’s foreign exchange leakage is cyclical, it grows over the long term in line with growth in financial assets. At present, the RMB is stabilized by a managed peg to a basket of currencies. The peg is backed up by China’s $3 trillion USD foreign exchange reserves. Those reserves fell by 25 percent three years ago. When the reserves fall below $2 trillion, confidence in the system can evaporate quickly. When foreign exchange reserves are depleted, the government no longer has the ability to support the peg and the result is a free float. In a panic situation, this would mean a sharp devaluation and volatility. In the absence of restrained credit growth, the government could avoid a chaotic devaluation by engineering a managed devaluation. The end result would also be a large devaluation but with less of a shock to the financial system. However, in practice it may be impossible to engineer a smooth large devaluation. Managed devaluations can quickly raise expectations of further devaluation, which could set off a panic leading to accelerated capital flight and loss of foreign exchange reserves. So the process could quickly become unmanageable.
What would a financial crisis mean for China’s economy, political system, and ability to fund its military? Like the United States after the Great Financial Crisis in 2008, a Chinese financial crisis will lead to a nasty recession but not an economic collapse. GDP growth will likely recover after a year or two, cushioned by a weaker exchange rate, liquidity injections, and a large state-owned sector that will keep ticking over. Defense spending may be wound back as the government focuses on internal security, bank bailouts, and income support to avert social unrest. But that would be temporary and defense spending would resume its steady upward march after just a few years.
The biggest national security issues, however, arise from the unpredictable political impact of a recession in China. We learned this, or should have, during the 1997 to 1998 Asian crisis. China may have had a disguised recession or near recession in 1998, but it was in a much smaller economy. Apart from that one episode there is no collective memory of recession and how to deal with it. As such, China is now psychologically unprepared to deal with the challenges of a recession. China’s coming recession will be accompanied by a large uncontrolled devaluation of the RMB as foreign exchange reserves evaporate, so it will be impossible to conceal this time. All asset prices, including housing prices, will be hit. Combine the shock of an unexpected economic setback with tensions in a one party state where a single individual has been calling the shots, and political instability could set in. While Xi’s anti-corruption campaign has not eliminated corruption, it has created many enemies who are biding their time.
Minxin Pei has documented the activities of China’s powerful corruption networks. These networks, not a debilitated civil society, represent the alternative government of China. Competition between them could easily be destabilizing in a winner-take-all political environment. While our understanding of elite politics in China is poor, a recession would likely discredit the existing leadership and set off intense competition between corrupt factions for control of China. Bo Xilai, a former Chongqing party chief and Politburo member, was purged in 2012 but his son appears to still be interested in politics. While the outcome is impossible to predict, we can see the conditions in place for destabilizing events ranging from military adventurism to civil war. Alternatively, the regime could reassert its stability through increased repression, which would make China harder to deal with and would spill over into the Chinese diaspora.
China’s Belt and Road Initiative has never had a real economic base. It is all about power projection (such as the Gwadar port) and would quickly be dropped by Beijing as a post-crisis China becomes focused on domestic political and economic stability.
Any Chinese military adventurism is likely to be focused on Taiwan. China’s military is currently poorly equipped for an invasion of Taiwan, which has difficult geography and a substantial military, making an invasion of Taiwan unlikely to succeed. However, it is possible the Chinese leadership would miscalculate the risks, leaving it in a limited war with no clear resolution that would quickly draw in Japan and the United States.
China has spent most of its history disunited, reflecting its geography. It has a number of widely dispersed economic centers. It was in outright civil war as recently as the 1960s. If competition between political factions remains unresolved, a civil war could develop, leaving China as a battleground where Russia, Japan, and the United States seek to influence the outcome. This scenario would stall or even end China’s rise as a global military and political power.
Less chaotic outcomes include Xi successfully hanging on but with weakened prestige and heightened paranoia, or a quick transition to another leader fronting his own corruption network. China does not need a democratic transition to resume economic growth and military spending. We would be dealing with a China that has lost its post-Global Financial Crisis hubris, but which would become harder to deal with as it grows more insular, all the while blaming domestic problems on external forces.
Stephen Joske was senior adviser to the Australian Treasurer during the 1997–98 Asian crisis. He later worked as the Senior Treasury Representative at the Australian Embassy in Beijing, and also worked on Chinese economic issues at the Office of National Assessments. After leaving government he ran the Economist Intelligence Unit’s China Forecasting Service in Beijing and then spent six years with AustralianSuper, Australia’s largest pension fund, in Beijing looking at financial market implications of Chinese macroeconomic issues.