The China risk

Things seem a little...complacent around here

Stocks are wobbling this week on concerns that financial troubles at Evergrande, a Chinese property developer, could lead to broader financial havoc. Evergrande owes a lot of money—about $300bn—and is often said to be too big to fail, so it’s understandable that markets which have been on an extraordinary tear this year might experience a little selling while waiting to see how this mess develops. At the same time, there is widespread faith that the Chinese government, recognizing that a massive financial crisis would be bad, will ultimately step in to limit the damage. That’s certainly what I expect to happen. In China, the global financial crisis represented a damning indictment of anglo-American capitalism and of the competence of Western leadership. It seems hard to imagine that Xi Jinping might allow anything like that to unfold on his watch.

When you stop to think about it, though, that’s kind of a strange perspective to have: supreme confidence that Xi is first and foremost keen to avoid financial-market turmoil and is more than capable of preventing a crisis. The world seems to be betting on this outcome; despite today’s drop, the S&P 500 is up about 30% over the past year, which wouldn’t seem to betray a huge lack of faith in the steward of one of the world’s two economic mainstays. Indeed, the fact that we’re all so certain that this won’t explode spectacularly makes me wonder whether there isn’t a China Risk out there that’s wildly underpriced on markets.

For starters, why should we be so confident that Xi has this under control? Financial markets are messy and complicated, and it can be difficult to perceive where the landmines are buried. In 2008, there were creditable hands at the wheel; Treasury was run by the former head of Goldman Sachs and the Fed was led by a scholar of the Great Depression. Hank Paulson and Ben Bernanke certainly did not wish to trigger the mess that followed the failure of Lehman Brothers; among other things, their aim in allowing Lehman to fail was to limit moral hazard, but the storm that followed forced the government to intervene and support troubled firms and markets to a far greater degree than they’d had to before Lehman went down. But trigger it they did.

What’s more, they made their errors in a society in which experts, financial professionals, and lowly bloggers could all have their say, could all make their case for what should be done and why and how the government was screwing it all up. Xi may be brilliant—I don’t know, but he may be—but he’s still human, he’s still dealing with financial markets that can surprise any of us, and he’s doing it in an environment in which he may not be getting all the information that he needs. Confidence in the competence of the Party leadership is one thing; the assumption that they wield superhuman powers of risk perception and systems management is quite another. 

Beyond that, we know that there are constraints on policymaking in China that prevent the government from doing things it really ought to be doing. The danger that Evergrande poses is a product of the difficulty China has had putting its economy on a more balanced footing. For years, its government has been aware of the risks it has courted by relying so heavily on investment; by suppressing domestic consumption; by allowing a wildly outsized real-estate sector to drive growth; by facilitating increases in government, corporate and household debt; and so on. It has taken some steps at various points to try to address the problems it’s stored up, but with decidedly middling effects. In the years immediately prior to the pandemic, for instance, credit growth did slow from eye-popping double-digit rates. But debt as a share of GDP never fell by all that much and leapt to new highs after the pandemic struck. And Xi is now stuck in a position in which he very much needs domestic demand to grow, but also wants one of the growth engines of the economy to shrink. And he may, in allowing Evergrande to slip into default, trigger a collapse in property prices and a drop in employment that seriously depresses consumption.

There are things that China’s government could or might yet do to shore up household incomes and domestic demand: steps that lots of people and institutions have been outlining for years now. It could shore up the threadbare social safety net and engage in much more income redistribution, for example. There are many Economist leader pages’ worth of ideas for Chinese reform. Or China could buck orthodoxy and issue monthly money-financed checks to every household; that would certainly goose domestic demand, quite possibly for less trouble than China stored up pumping credit into property markets. But for reasons of political economy or ideology or who knows what, it hasn’t managed to do what needs doing. Instead, Xi is engaging in a crusade against private capital in pursuit of “common prosperity”.

All of which is to say, if you feel fairly certain that the government will see the economy through these treacherous straits, you need somehow to square that certainty with the fact that the government has allowed the economy to sail into these treacherous straits—indeed, deserves significant blame for the straits being there in the first place. 

But wait, hasn’t China managed to maintain robust growth for four decades now? Doesn’t that attest to the macroeconomic competence of the folks in charge? There is no dodging the fact that China’s growth miracle is a remarkable one, which has survived some extreme challenges and seen off many a naysayer. But there is a difference between economic governance which has not made fatal errors and economic governance which cannot make fatal errors. Attributing supernatural competence to the government in Beijing is just as big a mistake as failing to recognize that Chinese growth hasn’t in some significant way been a sham. 

Present circumstances are substantially more difficult than anything China has had to confront in the recent past. They are more geopolitically fraught; China can’t be sure whether America and Europe might extend a degree of forbearance in the midst of a crisis or press their advantage while China is vulnerable. The Chinese economy is far larger than it used to be: so big that its stumbles can shake the rest of the world enough to generate negative effects which wash back over the Chinese economy. As much experience as its top leaders have gained over the past few decades, they’ve never been in circumstances like these: in the midst of a pandemic, confronting a shrinking labor force, dealing with firms around the rich world that are reassessing their dependence on China. 

Smart, experienced, well-intentioned people in positions of responsibility make mistakes. Even if they’re Chinese. Looking at the landscape, it’s not clear to me that this basic feature of reality is reflected in market prices.

But the most significant piece of underpriced China Risk has to be the failure to come to grips with the political revolution now unfolding in China. Xi, it seems clear, believes that there are serious problems with Western capitalism. He appears to be a true-believing socialist who is determined to create in China a new economic system the likes of which the world has never seen. He is not afraid to upset some extremely large and valuable apple carts in pursuing this goal. Xi has brought low the titans of China’s tech industry, wiped more than a trillion dollars off the value of publicly traded Chinese firms, and shows no sign of slowing down. As a piece in the Wall Street Journal by Lingling Wei explains:

Underpinning Mr. Xi’s actions is an ideological preference rooted in Mao’s development theories, which call state capitalism a temporary phase that can help China’s economy catch up to the West before being replaced by socialism.

An ardent follower of Mao, Mr. Xi has preached to party members that the hybrid model has passed its use-by date.

A 2018 article in the party’s main theoretical journal, Qiushi, or Seeking Truth, laid bare his belief: “China’s practice shows that once the socialist transformation is completed, the basic socialist system with public ownership as the main body is established...[and] state capitalism, as a transitional economic form, will complete its historical mission and withdraw from the historical stage.”

China is, on some measures at least, the world’s most dominant economy. It is a country on which many of the West’s biggest and most important firms rely: for supplies of essential goods and equipment, for a hefty share of sales and profits, or both. Do the executives of these firms think it’s just for show when Xi puts on a Mao suit, stands behind a hammer and sickle and declares his intent to make capital serve the people? Are they expecting this whole campaign to remake the Chinese economy to just peter out? Or are they substantially underestimating the risk to which they’ve left themselves exposed?

I don’t know how this will play out. It may be that the Chinese government announces a package of measures to resolve the Evergrande problem tomorrow, stocks jump, and China grows at bang on 6% per year for the next 30 years. Or maybe big firms with heavy exposure to China have thought this all through and won’t miss a beat if the Party suddenly kicks them out of the country. But on the other hand, it could be the case that the warning lights are flashing and we’re refusing to notice. Maybe big American firms just can’t fathom that a political leadership might tolerate tumbling share prices and are in for a very rude awakening.

I don’t know. But it’s hard for me to reconcile the state of financial markets with the difficult position China faces and the profound changes Xi seems determined to see through. It may all work out. But there’s a not insignificant chance that it won’t and a hefty downside if it doesn’t.

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