Everybody agrees that the days of double digit GDP growth for China are well and truly over. The question becomes whether China will transition into a new phase of its economic development, a consumption based economy, one where lower GDP growth is the new normal.
However, whether you are a China bear or a bull, either way, there is consensus that there will be a landing of some kind, as China transitions to its next phrase. The question is not whether China will manage to navigate itself through a difficult transitional period, but whether, in the process it will see a soft landing, or whether it will see a hard landing.
The Soft Landing Scenario
China’s GDP growth is dependent on real estate with 33% of China’s economic infrastructure based on real estate. Everyone is in agreement that this has produced a Chinese real estate bubble. Buyers have enthusiastically brought up investment properties in the expectation that asset prices will continuously rise. Recently, however, real estate prices have fallen, triggering fears of a real estate bubble bursting — potentially with catastrophic consequences.
A group of China bulls acknowledges that real estate prices became overpriced following the post-GFC stimulus package, leading to the overbuilding of infrastructure, but downplays the adverse impact it will have. While overstimulation has created endless bridges to nowhere, with countless ghost cities full of empty apartments but nobody in them, this is downplayed as a glitch that can be overcome.
The arguments that none of this poses a serious problem include the following:
1. Strict macroprudential regulation of the mortgage market from the outset. This includes the requirement for large down payments, especially for second mortgages. Since real estate bubbles can only burst due to subprime lending practices — no subprime lending means no subprime crisis.
2. If real estate prices correct too quickly, the government will immediately step in rather than taking the laissez faire approach as the US government fatefully took with Lehman Brothers. China will not wait for a crisis to blow up before intervening aggressively to advert systemic contagion.
3. The debt resulting from the stimulus originates from the Chinese government, rather than from borrowing abroad. William Mitchell, one of the key exponents of Modern Monetary Theory (MMT), gives us a good argument to this effect. Although analysts such as Nouriel Roubini are predicting the imminent collapse of China:
My view is different.
I consider the Chinese government to be totally on top of managing their economy, which sets them apart from the leaders in the advanced world. They will not let a major economic crisis occur within their own borders. They have so much more scope to expand …
… China provides an economic example – when all other sources of expenditure fail, turn on public spending and do it quickly and don’t err on the conservative side.
My Chinese contacts informed me that at the time [of the GFC] there was no discussion over there about the country drowning in debt or that the government was going to “run out of money”. These ideas that crippled the recovery in the West were not allowed to germinate in China.
Since the Chinese government are never going to suddenly demand their money back from Chinese businesses, there is little likelihood of a systemic collapse from government debt. This follows the basic tenets of MMT, which does not hold such government issued debts to be a problem.
4. The recent drop in real estate prices is a deliberate correction, neatly engineered by Beijing in a controlled fashion, not a catastrophic bubble burst. If too much air is let out of the bubble, more stimulus will be applied to prop the bubble up, thus preventing it from collapsing abruptly. The property bubble deflation will be an orderly and controlled slow leak, not a sudden burst.
5. There is plenty of room to move to engineer a transition from an export led model of growth to consumption led growth:
It is clear that if investment slows, then the rate of accumulation of capital slows, and the growth in future productive capacity falls. So we might expect as China attempts to engineer a more or less orderly shift from capacity building to domestic consumption that its phenomenal growth rates (above 8 or 9 per cent) will taper somewhat.
6. Low government debt to GDP ratio. The Chinese central government has low debt – only 22% of GDP at the end of 2013. This leaves significant fiscal firepower in reserve that could readily be mobilised if a real estate sector downturn were to affect the wider economy. Japan left it too late to inject stimulus after the Japanese bubble burst, but China may be keen to avoid the same mistake.
7. The excess capacity in production and housing will eventually get soaked up as the economy grows. A huge number of workers living in rural areas are moving to cities, who will contribute to industrial output and purchase excess urban housing.
The pro-China authors worth reading here include: Dr Albert Cao (author of an upcoming book on the China property market), as well as William Mitchell’s blog.
The Hard Landing Scenario
The problem here is that centrally directed stimulus is meant to be a demand-side solution. By reallocating the unemployed into public works projects, or by putting excess production capacity back into use, it contributes to the productivity of the nation, while giving workers a wage. The workers go out and spend their wages, while the resulting infrastructure further contributes to future GDP growth.
If you over-stimulate in the form of excess real estate construction, then you end up doing the opposite of what you are trying to achieve. Rather than acting as demand side stimulus, you end up creating an excess of supply. You find yourself with a huge glut of excess housing which causes the prices of real estate to collapse the moment you stop propping the whole scheme up with more and more stimulus. Part of the problem is that building houses is an inefficient way of enhancing productivity.
At some point this process of propping up the property bubble with more and more overstimulation has to stop. The end result will be a collapse in real estate prices. A huge amount of money put into real estate by speculators will be lost, leading to an economic crisis.
A collapse in property asset prices may reveal the stark truth of the extent to which the Chinese shadow banking system has spread its tentacles through the entire economy, while uncovering hidden Ponzi schemes, and rampant corruption. This accumulation of toxic debt that managed to worm its way around all the official macroprudential measures to curtail subprime lending, could lead to a collapse of the financial system. If the government intervenes to bail the shadow banking system out, this will result in the creation of unproductive zombie banks and businesses which will drag the economy down.
Furthermore, the claim that property asset bubbles can only collapse if burst by American styled subprime lending practices is problematic. However, as previously discussed, the Japanese example (as well as the Spanish one) shows that asset bubble deflation can be initiated through differing mechanisms, and that this can perfectly well occur in the absence of American styled subprime lending. History never repeats — but, as the saying goes — it often rhymes.
Even though there have been strict macroprudential measures imposed in China, requiring 30-40% down payments on properties, these restriction are steadily being slackened off each time the real estate market slumps.
Meanwhile, Beijing has become overleveraged with debts accumulating at an enormous rate. The total debt in China has now reached to around 250% of GDP. If this is allowed to continue, mainstream economists worry that the country will “run out of money” and a national debt crisis will ensue. To avert this, it is asserted that China has to go through a deleveraging process. Unproductive banks and businesses must be allowed to fail rather than being continually bailed out.
Even if the idea that unproblematic Chinese debt issues from the government, rather than being the result of borrowing from overseas, Mitchell suggests that as China moves away from post-Marxian centralist ideology, it will take on more and more mainstream Western neoliberal theories brought home by PhD students returning from abroad:
Presumably, as more US-trained PhD students go back to China with their nonsensical [neoliberal] economic theories things will change.
These PhD students will urge the government to deleverage on the grounds that all government debt is necessarily toxic and dangerous. If Beijing listens to these younger economists urging reform, the end result may be a replay of the bursting of the Japanese real estate bubble and the two lost decades that ensued.
It that was not enough, even a China bull like William Mitchell has this say:
They have so much more scope to expand although all of us will rue the environment impacts of that expansion.
A runner at the Beijing marathon wears a gas mask to protest the air pollution in China. Despite warnings from medical experts about hazardous air pollution, authorities refused to cancel the event
Pollution has gotten so out of hand that some parts of China are slowly becoming uninhabitable, the air unbreathable. With it will grow the discontent of the people towards Beijing. Those who can afford to will understandably want to get out — a vote of no confidence in a regime in which they are not allowed meaningful participation, and which they expect will fail to address their concerns.
Bearish authors predicting China will crash and burn are numerous, and have been at it singing the same tune for years. Here are typical articles warning about Chinese debt and the zombification of the financial system. Yet the sky has yet to fall on our heads. Amongst economists, William Mitchell mentions Roubini, but Harry Dent is also predicting China will go the way of Japan.
So What Will Really Happen?
How the Chinese economy should be steered is a matter of fierce debate in Beijing. The Chinese will be having the same debate as we are. What the future holds remains as always profoundly uncertain.
In Beijing, there is a strong divide between the conservatives and the reformists. The reformists want a greater role for the market, and want to shift control of the economy to the free market, through reform. The conservatives want to maintain central control over the economy.
In short, the conservatives want centrally engineered growth of the economy. The reformists want to see less centrally planned stimulus, resulting in a systemic deleveraging, as the government spends less to stimulate growth, and hands control over to the free market.
If China goes through a deleveraging process, then this will result in a more rapid deflation of the real estate bubble. President Xi is pushing China in this direction, but he needs to consolidate power before he can push through this reform. The process of cleansing China of shadow banks, corruption, and of zombie banks supported by the government will be seen as painful, but necessary. There could even be a recession along with way towards reform.
This would represent China taking up more Western neoliberal economic principles in accepting the common Western advice for the need to deleverage.
On the other hand, the conservatives will probably like what MMT theorists such as William Mitchell have to say. They will argue that China has a long way to go before it can call itself a developed nation. There is much centrally directed development that needs to continue. If the real estate bubble burst has negative impact on the economy, they will demand stimulus to further prop up growth.
The trouble is that China has gotten into a habit of overstimulating the wrong sectors of the economy, resulting in gross misallocation of funds. All towards the easy path towards propping up the GDP growth figures as part of a massive propaganda exercise. The problem is that overbuilding real estate is not quality GDP. Worse still, regionals authorities achieve their growth targets ordered by Beijing through easy liquidity obtained from the shadow banking sector.
The danger is that instead of centrally directing development aiming to improve creating sustainable growth, reducing social inequality, improving the environment, and setting up an all encompassing system of universal heath coverage and social welfare, China seems content to prop up its GDP by any dubious means as a capitalist ego building exercise.
Bo Xilai may have been the last chance for China to fight corruption and reform towards to an ideal of social democracy. He has been silenced. Now the old socialist ideals have been vanquished, all that risks remaining is crony capitalism, gross wealth inequity, brutal neoliberalist imposition of austerity, and endemic corruption, while the ordinary disempowered citizen is forced to suffer in silence.
The irony is that Marx predicted that social revolution would arise with the growth of an increasingly unruly middle class in advanced industrialised nations. He never predicted revolution in backward agrarian based peasant economies such as Imperial Russia or China. The sort of social environment that Marx thought was fit for revolution is more like the China of today.
While William Mitchell may well prove right when he wrote that “I consider the Chinese government to be totally on top of managing their economy, which sets them apart from the leaders in the advanced world”, the corrupting powers of monetarism, and the seductions of casino capitalism may yet bring down Beijing.
The Impact on Australia
In some ways, the previous discussion is rather moot. Either way, whether there is a soft-landing or a hard-landing for China, both outcomes are going to result in difficulties for Australia. The choice between one or the other, is a choice between bad or worse. The likelihood of an Australian soft landing are even more remote than for China.
If China has a soft landing, it will transform into a consumer based economy, then the mining boom is over as centrally driven massive construction ends. If China has a hard landing, the mining boom will also be over. Australia has done precious little actively transition itself to a post-mining boom productivity based economy, that hardship has to result. Australia has simply become way too reliant on mineral exports to China:
A collapsing real estate market will push a lot of Chinese investors out of China. They will take their equity to places like Australia, thus further pushing up property prices in places like Sydney and Vancouver. This is what happened when the Japanese real estate bubble burst, and there was short-lived rush to invest in international property. That was when Japanese investors purchased landmark real estate like the Rockefeller Center. As the Japanese bubble collapsed, these properties were sold off at a severe loss.
It is likely that there will be a phase lag between the peak of the Chinese real estate market and the Australian real estate market. The length of the delay depends on events in China, and the velocity of the deflation of the Chinese real estate bubble. The Australian market will peak between 9 to 24 months after the Chinese one, depending on whether there is a soft or hard landing.
The process of sneaking grey money out of China has already begun, as President Xi clamps down on shadow banking and corruption. This has accelerated a trend to escaping out of the country to destinations such as Australia, resulting in a rise in real estate prices in favoured cities.
On numerous occasions the iron ore price looked like it was head back down towards historical levels close to $20-30 per tonne, only to be propped up by yet another stimulus package from Beijing instigating yet more massive infrastructure building (Figure from SMH)
There may still be a repeat of what happened around 2012, when Chinese property prices dropped. There a stimulus package arrived to producing another round of real estate constructing thus propping up Australian iron ore prices, and prolonged the mining boom another day. This seems to have convinced the mining industry that China can always be counted on to come to their rescue with another stimulus package.
However, the current line from Being is officially “no big stimulus“. As President Xi consolidates his position, the old policy of endless stimulus may be more consistently replaced with a policy of systematic deleverage and neoliberal austerity.
Alas, the simple conclusion is that we have no crystal ball, and that no definitive conclusions are humanly possible. Yet what remains certain is that the future of China remains uncertain, while the future of Australia seems rather grave.
However, if the reformists, lead by President Xi, get their way in Beijing, a process of painful deleveraging will occur in China. That means deleveraging will begin in Australia too, which will see the popping of asset bubbles, and a cycle of stagnant deflation.
The other trouble is that William Mitchell also warns us that:
[China’s] problems are going to be political – taming an increasingly rowdy middle class.
If the middle class lose a lot of their life savings in a real estate bubble burst, there could be a great deal of anger towards the government. The sort of protests in the streets of Hong Kong could spread to the mainland. Regional separatist movements, even civil war could break out.
Civil unrest in China following an economic downturn with collapsing real estate market will push a lot of Chinese people out of China. They will try to escape with a lot of equity to places like Australia, thus further pushing up property prices in places like Sydney and Vancouver.
It is difficult to imagine that China’s path into the future could only be plain sailing without a single obstacle along their way. However bright the long-term future may turn out to be, somewhere along the way there will arise challenges. To date, China has had it too easy.
No doubt about it, Australia’s destiny will be closely intertwined with that of China, and the ride may be about to get a whole lot bumpier.