STEPHEN JOSKE
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.
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