Armstrong taylor debt and distortion; risks and reforms in the chinese financial system (2016)

Development of Local Government Bond Market 13812 Real Estate Market 145 Does China Have a Real Estate Bubble?. Low interest rates and gov-ernment guarantees that supported the growth in

Debt and Distortion

Risks and Reforms in the Chinese Financial System

p a u l

a r m s t r o n g

-t ay l o r

Debt and Distortion

Debt and Distortion

Paul   Armstrong-Taylor Debt and Distortion Risks and Reforms in the Chinese Financial System

Debt and Distortion

ISBN 978-1-137-53400-2 ISBN 978-1-137-53401-9 (eBook)

DOI 10.1057/978-1-137-53401-9

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Nanjing University

Nanjing , China

As China’s economy and fi nancial system have grown, so too has the tance of understanding their development Unfortunately, the Chinese fi nan-cial system is unique, complex, and rapidly changing, all of which aspects make

impor-it a challenging subject to grasp Almost every day, a new fi nancial problem is revealed, an innovative product released, or a critical reform announced Even for someone who follows these developments closely it can be hard to keep

up Surely, only a fool would write a book, a medium with unavoidable lags between creation and publication, on such a rapidly shifting subject A short-age of such fools may explain the lack of such a book

Perhaps I am such a fool because this is such a book But before you close it, let me explain why I believe that a book, specifi cally this book, can off er some-thing that other media cannot While a book cannot deliver commentary on daily events, it does off er a chance to step back and see the broader trends and forces that might be obscured by a focus on the latest news If it can’t show the trees, it can off er a map of the forest

To construct such a map, I focus on a few key underlying distortions that can explain much of the Chinese system’s uniqueness, complexity and rapid evolution Most of China’s fi nancial problems are manifestations of such underlying distortions, most Chinese fi nancial innovations are attempts to bypass or exploit these distortions, and most of China’s fi nancial reforms are attempts to correct these distortions Th ese distortions have been around for a while and, unless addressed by reforms, will not go away soon Th ey will continue to shape China’s fi nancial system and drive reform for many years Writing a book on these distortions is, I hope, not entirely foolish, and reading such a book may be of value to even a wise reader

Pref ace

Th is book should be of interest to anyone who wants to understand the broad trends in the Chinese fi nancial system Th is might include business people, fi nancial professionals, government offi cials, regulators, and those generally interested in world aff airs Even those who do not intend to work with China directly can benefi t from understanding how changes in China will impact the rest of the world, and I believe this book can provide that understanding Th e book is written at a level that should be accessible to those without specialized knowledge of China or fi nance, but even those with such knowledge will, I hope, learn something Th is book is not intended to provide practical business or legal guidance, but could provide a valuable complement

to such guidance

Finally, I would be remiss if I did not acknowledge the help of a number

of people without whom this book could never have been written A book on such a wide-ranging subject as this cannot be written without leaning on the work of others Much of what I know about China’s fi nancial system has come from reading the work of others Th ere are too many to list individually, but the bibliography should give an idea of the scale of my debt

I was fortunate that Peter Baker, my editor at Palgrave Macmillan, was willing to walk a new author through the unfamiliar process of writing and publishing a book I am grateful for his patience

Th e Hopkins-Nanjing Center has been a lot more to me than an standing employer My time at the Center has been rewarding on both a per-sonal and professional level My colleagues have helped me enormously with this book, among so many other things I have been fortunate to have had the opportunity to teach some talented and motivated students, and my discus-sions with them, both in and outside the classroom, have helped me develop many of the ideas in this book In particular, I would like to thank Antoine Cadot-Wood for sharing some diffi cult-to-fi nd statistics and Sean Linkletter for feedback on an early draft of this book

Finally, I would like to thank my family for their support from the other side of the world I fear I am not the most fi lial of sons

Of course, any errors are my sole responsibility

Nanjing, China Paul   Armstrong-Taylor

November 15, 2015

Contents

Why Can Th is Growth Not Be Sustained? 6

Minsky’s Th eory of Financial Crises 12Japan 13USA 16China 19

Why Did Investors Not Move Money from Deposits to Other

Investments? 32

Stocks 33Bonds 34

International Investment 35What Would Be the Eff ects and Risks of Liberalizing

Deposits 36Loans 37

Role of Financial System in Managing Risk 42Government Guarantees and Moral Hazard 45Eff ect of Government Guarantees on Financial Risk 47

6 Overview 63

7 Banking 67

Better Incentives for Bank Offi cials 73

Trust Companies and Wealth Management Products 84Purpose 84Risks 85

Reforms 87Informal Lending and the Wenzhou Crisis 88

9 Stock Markets 99

Volatility 101

Unlocking the Potential of the Stock Market 110

Bonds over Banks: Market Forces and Liquidity 117

Risks: Challenges to Banks and Government Control 121

11 Local Government Debt 125

Confl ict Between Central and Local Governments 125

Local Government Debt: A Nexus of Financial Risk 131

Balancing Local Government Debt Reform

Development of Local Government Bond Market 138

12 Real Estate Market 145

Does China Have a Real Estate Bubble? 145How Would a Real Estate Crash Aff ect China’s Economy? 148Households 148Local Government and Corporate Risk 150Reducing Risks from the Real Estate Sector 153

Insulating the Financial System from Real Estate Risk 155

13 Exchange Rate Liberalization 161

Renminbi: From Undervalued to Overvalued? 162Pre-2008 162

Letting Go: Moving to a Floating Exchange Rate 166Loosening Control over the Exchange Rate 166Relationship Between Exchange Rate Liberalization

15 Capital Account Liberalization 185

Treacherous Tides: Risks of International Capital Flows 186Financial Freedom and Political Commitment:

Contents xi

Tentative Steps: Progress to Capital Account Liberalization 189

Policy Laboratories: Free Trade Zones 195

16 Asian Infrastructure Investment Bank

and the New Silk Road 199

Confl icts Within the Chinese Communist Party 209

Reform and the Personal Finances of Offi cials 210

18 Strategies to Overcome Opposition to Reform 215

Anticorruption Drive and Financial Reforms 216Anticorruption Drive and Legitimacy of CCP 216Eff ectiveness of Anticorruption Campaign 217Eff ect of Reduced Corruption on Economic Growth 218

Process and Benefi ts of Centralizing Power 219

Containing the Eff ects of a Crisis 247

20 International Consequences of Reform 249

International Impact of Financial Crisis 252

Short-Term Risks, Long-Term Benefi ts 258

Appendix: Financial Decision Making

in the Chinese Government 261

Central Discipline Inspection Committee 263

National Development and Reform Council 265

Index 267

Introd uction

In 1992, Deng Xiaoping toured China’s southern provinces and committed

to opening China’s economy to the world Th is policy transformed China’s economy and aff ected almost every part of the global economy Whether

we look at British supermarkets, Peruvian mines, American universities, or French fashion houses, we see China’s infl uence

Despite their importance, Deng’s reforms did not liberate the fi nancial tem, and government intervention remained the norm Interest rates were suppressed to support investment, and the renminbi’s exchange rate was con-trolled to support exports Th e fi nancial system remained dominated by the state-owned banks, with foreigners largely excluded, and stock and bond mar-kets remained underdeveloped In many ways, China remained a planned rather than a capitalist economy

In 2012, twenty years after Deng, Chinese president Xi Jinping embarked

on his own southern tour Th e symbolism was deliberate Xi is planning the most radical transformation of China’s economy since the early 1990s Financial reforms are at the core of Xi’s vision Interest rates and exchange rates will be liberated, restrictions on international capital fl ows will be relaxed, and state-owned banks will face more competition from private competitors, shadow banks, and stronger markets China, he promised, will become truly capitalist at last

Th ese reforms will impact the structure of the entire economy Resources will shift from state-owned fi rms and governments to private fi rms and house-holds, leading to a shift from investment to consumption Higher interest rates will reduce capital-intensive infrastructure projects and promote service and knowledge industries that use capital more effi ciently Th e discipline of the market will dominate while the infl uence of government recedes

As China changes, many of the global trends of the last 20 years will slow or reverse, and new trends will replace them Until now, China has been a trade partner; in the future, it will be a fi nancial one – both as a source and desti-nation of capital fl ows While past reforms boosted China’s manufacturing exports, future reforms will allow service imports Emerging markets may suf-fer from China’s reduced demand for raw materials, but developed countries will benefi t from its growing demand for services

Th is book takes a systematic look at China’s fi nancial system: how it has worked in the past and how it will work in the future, why reforms are needed and what risks they bring, and how these reforms will aff ect China and what their impact will be on the rest of the world We will analyze the core forces underlying China’s transition and how these forces are manifested in a wide range of areas

Outline of the Book

Part I of the book shows how China’s existing fi nancial system supported China’s impressive growth and why, despite this, it needs to be reformed China grew through investment and, to a lesser extent, exports, and the

fi nancial system was distorted in ways to promote these High interest rates may have choked off investment, so interest rates were kept low Rapid appreciation of the renminbi may have choked off exports, so the exchange rate was managed Risk may have discouraged investment, so the govern-ment guaranteed investment In short, the distortions were not seen as prob-lems: they were part of a deliberate policy to promote growth As long as the economy was growing at 10 % per year, the costs of the distortions could be absorbed

However, there are limits to investment-led growth Previously countries have grown quickly for a period of time using a similar strategy, but none have been able to maintain the growth forever Eventually, good investment oppor-tunities start to run out, and the returns to further investment fall Maintaining growth requires ever larger investment and ever more borrowing, but servic-ing that borrowing becomes increasingly diffi cult Low interest rates and gov-ernment guarantees that supported the growth in borrowing and investment

in the past now become liabilities  – encouraging unsustainable increases in debt With no reform, widespread defaults and a fi nancial crisis are inevitable Reform, as the Chinese government has acknowledged, is necessary

Broadly speaking, those reforms involve eliminating the distortions of the existing system However, reform is also risky Raising interest rates and

Introduction xv

eliminating government guarantees increases the risk of defaults on existing debt Discouraging excessive investment, while necessary, will also lead to a slowdown in growth, which carries both fi nancial risks (it becomes harder to service existing debt) and political risks (it reduces the benefi ts going to vested interests) Reform, then, is both essential and fraught with challenges Th e rest of the book explores these themes in more detail and attempts to outline the path reform should, and hopefully will, take

Part II takes the themes of the fi rst part and applies them to particular

fi nancial sectors

One of the main points of this book is that the formidably complex web of reforms across multiple sectors becomes much easier to grasp once you see that many of these reforms are refl ections of the same basic themes Understand the themes, and most of the reforms make sense However, while the reforms across diff erent sectors may rhyme, they do not exactly repeat; applying themes requires care Furthermore, reforms in one sector aff ect other sectors For example, reforming the banking sector will aff ect the shadow banking sector and vice versa Th ese interrelations must be taken into account when considering what type of reforms to undertake and, in particular, the order

in which reforms must occur Th e correct reforms applied in the wrong order can lead to crisis

Part III looks at the international aspects of China’s reforms

International reforms, such as liberalizing the exchange rate and ing capital fl ows, will have the most direct eff ects on the rest of the world However, international reforms must be consistent with, and mostly subse-quent to, domestic reforms Premature opening of China’s fi nancial system would be disastrous Most importantly, China cannot fully open its capital markets until domestic interest rates are liberalized If it attempted to do so, capital would simply fl ow abroad to bypass the domestic restrictions, leading

free-to a loss of domestic liquidity and potential crisis On the other hand, limited opening is possible and may be helpful in increasing the pressure for reform

in domestic sectors

An understanding of the Chinese fi nancial system and reforms helps to minate several issues that have attracted attention A reserve currency requires open capital markets and a large and liquid government bond market China has neither of these things and will not have them for some time 1 Th erefore, there is little chance that the renminbi will become a reserve currency soon

illu-Th e Asian Infrastructure Investment Bank (AIIB) has been very controversial

1 It also requires a willingness to allow foreigners to accumulate large amounts of domestic assets, usually

by running persistent current account defi cits Th ere is little sign that China is prepared to do this, either

for political reasons, but its economic importance is likely to be minor China already invests heavily in overseas infrastructure projects and would do so with or without the AIIB. If anything, the AIIB, as a multilateral organiza-tion, will place additional constraints on how China directs this investment China’s commitment to foreign infrastructure investment is best seen as a way to extend its investment-focused growth model while bypassing the con-straints of diminishing returns in the domestic economy

Part IV looks at the politics of reform

Th e principal goal of the Chinese government is to maintain power In addition, and consistent with this, it is cautious and risk averse Both of these principles are refl ected in its focus on “stability.” Th ese principles combine

to create the incentive for fi nancial reform Failure to reform is likely to end, sooner or later, in a fi nancial and economic crisis Economic instability could easily lead to political instability and so is to be avoided Reform is, therefore, essential

However, fi nancial reform brings political challenges of its own Th e ing elites have benefi ted from the existing system It has brought them politi-cal power and fi nancial wealth Financial reforms threaten these benefi ts and therefore will face entrenched, powerful opposition Xi Jinping, China’s presi-dent and leader of the reforms, understands that to enact his reforms, he will need to subdue or crush this opposition His extensive anticorruption campaign is designed to achieve these goals Certain opponents, most notably Zhou Yongkang and his power base, have been publicly convicted of corrup-tion and removed from power Others may be spared as long as they do not oppose Xi’s policies Some have puzzled over why Xi is loosening control over the economic and fi nancial system while concentrating political control in his hands Properly understood, this is not puzzling at all Th e fi nancial reforms

exist-require the centralization of political control Without this, any reforms would

stall – as happened under Hu Jintao

Part V looks at the risks and eff ects of reforms, both domestically and internationally

Reform is necessary but not without risk Understanding why requires standing the role of debt Reforms are necessary to prevent new debt from build-

under-ing up by removunder-ing the subsidies that support borrowunder-ing However, removunder-ing these subsidies may increase defaults on existing debt Reform too slowly and the

debt will continue to rise; reform too fast and you could trigger a crisis

Finance is an interconnected system: changes in one part ripple through the system and may cause unintended eff ects elsewhere For example, developing

a bond market allows large companies and local governments to borrow at lower interest rates, but it leads to the loss of customers and interest income

Introduction xvii

for the banks, which may cause them to take more risk (as happened in Japan

in the 1980s) Increasing competition in banking, for example, by allowing Internet banking, might improve effi ciency However, with deposit guaran-tees, banks must compete on interest rates and may search for higher-return, and therefore higher-risk, projects Poorly regulated liberalization, therefore, could lead to increased risk

However, China does have some advantages in managing these risks First, the government retains control over most of the fi nancial system, which gives

it more tools than Western governments have at their disposal for responding

to problems Th e subprime crisis was exacerbated by the refusal of banks to lend to each other If banks cannot borrow when they need to, they are forced

to hoard cash Th is sucks liquidity from the real economy and exacerbates recessions Th e Chinese government can simply order banks to lend (to each other and to the real economy) and so avoid such a liquidity crisis Such inter-vention is counter to the direction of reform but might be temporarily justi-

fi ed to address a crisis Western governments and central banks used similar tools to intervene during the subprime crisis

If China does suff er a recession or a more serious crisis, it is not clear that the impact on the rest of the world will be severe Japan in 1990 was similar

in many ways to China now It was the world’s second largest economy and was coming off a period of rapid growth fueled by debt It ran current account surpluses and had a bank-based fi nancial system that was somewhat insulated from the rest of the world Japan suff ered a major fi nancial crisis, after which

it barely grew for 15 years, but its domestic problems did not infect the global economy On the contrary, the 1990s proved to be a time of rapid growth in many parts of the world My own research suggests that this episode illustrates some general themes: economies like those of Japan and China tend not to transmit their economic problems to the same degree that the US does While the risks of a fi nancial crisis may be overplayed, the eff ects of suc-cessful fi nancial reforms will be signifi cant Rebalancing will change China’s economy and the way it interacts with the rest of the world As China moves from investment to consumption, and from construction and manufacturing

to services, the composition of its imports and exports will change Demand for commodities will fall, which will impact economies that have grown on Chinese demand, including many emerging markets; this has already begun

On the other hand, demand for services, such as fi nance, healthcare, and cation, will increase, creating opportunities for economies strong in these areas Finally, as China opens its fi nancial system, there will be more opportunities for investment to fl ow into and out of China Recently, China’s outward foreign

edu-direct investment (FDI) surpassed its inward FDI. China as an investor will be

a theme of the next few decades

Finally, in Chap 21 , I refl ect on China’s future Much of the recent pessimism about its prospects is exaggerated While growth is certainly slow-ing and the reforms discussed in this book carry short-term risks, the long-term prospects remain bright

Despite its past successes, China’s economy in general and its fi nancial sector in particular urgently need to be reformed President Xi Jinping has committed to these reforms and, I believe, possesses the political power to overcome the vested interests that stifl ed his predecessors Many challenges remain, and the risk of some form of fi nancial crisis within the next 10 years is high However, on balance, the positive eff ects of reform will far outweigh any negative eff ects Within a decade, China could become a truly market-based economy with stable growth prospects

While some commentators have portrayed China’s rise as a threat to the West, it will bring great opportunities Th e 1992 reforms created an econ-omy based on investment and manufacturing with a vast appetite for raw materials Th is led to a commodities boom that greatly benefi ted commodi-ties exporters, including many emerging markets and Australia Th e benefi ts

to the USA and Western Europe were less clear, however, as Chinese ucts often seemed to be competing against domestic industries 2 China’s new economy will be based on consumption and services, areas where Western economies are particularly strong For the USA and Europe, therefore, the opportunities of this second wave of reforms may, therefore, be even greater than the fi rst wave

prod-2 Th ere were exceptions Germany’s strong economic performance is at least partly based on China’s demand for its high-quality manufacturing exports And, of course, consumers in all countries have benefi ted from cheap Chinese imports

Part I

Current Economic Model

How Did China Grow So Fast?

China’s growth over the last 35 years is unprecedented It has created more wealth and lifted more people out of poverty in a shorter time than any other country in history In this chapter, we explore the economic system that made this possible Th is is a necessary prerequisite for analyzing the fi nancial sys-tem for three reasons First, the fi nancial system evolved to support the eco-nomic system that brought this growth, and it is impossible to understand the fi nancial system without understanding the system it was designed to support Second, we need to understand why such a successful system needs

to be reformed and, by extension, why the fi nancial system needs to change

to accommodate that reform Finally, fi nancial reforms will undermine the existing drivers of economic growth and replace them with new drivers Th is transformation will be diffi cult and risky, and the challenges and dangers will need to be understood in advance and incorporated into the reform plans China grew by investing and exporting  – a path trodden previously by Japan, Korea, and Taiwan To grow, an economy must expand both the amount it can supply, or its productive capacity, and the demand for its prod-ucts Ideally, supply and demand need to grow at similar speeds If supply grows faster than demand, the result will be excess capacity and unemploy-ment; if demand grows faster than supply, the result will be infl ation

Investment boosts growth in two ways: it expands the productive capacity

of the economy and provides demand for inputs to the investment process For example, investing in the construction of a car factory boosts the amount

Growth Model

4 P Armstrong-Taylor

of cars that can be produced and provides demand for construction Exports provide an additional source of demand If supply grows faster than demand, the excess production can be exported

A simple example might provide further insight Consider an economy with just one person We will call him Robinson Crusoe after Daniel Defoe’s castaway To begin with, Robinson Crusoe is very poor He has limited tools

or understanding of how to survive, let  alone prosper He tries catching

fi sh with his hands It is diffi cult, and he doesn’t catch many But being a resourceful fellow, he fi gures he could catch more fi sh with a net He takes a break from fi shing to make his net from some sticks and pieces of material washed up on the beach Th is takes a couple of days, and during this time

he doesn’t catch any fi sh and goes hungry However, once the net is fi nished,

he can catch many more fi sh than he could with his hands and he will be able to eat heartily

Robinson Crusoe’s meager fi shing project may seem a long way from China’s vast manufacturing economy, but they both developed in the same way: by investing Robinson Crusoe is more productive because of the invest-ment in his net; the Chinese factory worker is more productive than his peas-ant farmer because of the investment in production lines Both had to sacrifi ce consumption in order to make this investment: Robinson Crusoe had to go hungry for a few days; the factory worker, and others like him, had to save, giving up some consumption, to fund production

Th is is the key feature of the Chinese growth model: high investment funded by savings and low consumption Since 1978, China has invested 35

to 50 % of its gross domestic product (GDP) (the USA invests about 20 %

of its GDP) 1 Th is level of investment over such a long period is edented Even more remarkably, this investment rate has continued to climb

unprec-In 2013, China invested 49 % of its GDP – the highest rate of investment

by a major economy in history Th is investment has built factories, roads, railways, buildings, even entire cities

But it is not just investment in things that can boost productivity Investment in skills can help, too Robinson Crusoe could catch more fi sh by learning how to fi sh better During this learning process, he might catch fewer

fi sh because he has to try lots of mostly ineff ective techniques to fi nd the right one However, over time, he learns the best techniques and catches more fi sh

Th is is also a process of investment: sacrifi cing some current consumption for higher future productivity

1 World Bank

Th e Chinese have traditionally valued education Under the emperor, the civil service examination provided one of the few opportunities for the poor to improve their prospects Th ese days, the National Higher Education Entrance Examination, known as the gaokao , serves the same role In 2014, almost 7

million Chinese graduated from college, up from 1.1 million in 2001 2

Chinese productivity Workers get paid their productivity, more or less, so the increase in productivity can be tracked by tracking wages According to the Economist Intelligence Unit, average hourly earnings in the manufac-turing sector increased from $0.40 in 2000 to $2.10 in 2012 – an annual growth rate of 14.6 % 3

Aside from investment, exports also played an important role in China’s growth To see why, let us return to Robinson Crusoe At some point, his nets and fi shing skills will be so good that he will be able to catch more fi sh than he needs When that happens, there will be little point in continuing to get better

at catching fi sh Investment can continue to expand supply, but there is not much point in expanding supply if there is no demand Crusoe could continue

to become more productive at other things (maybe getting better at building shelters), but this has drawbacks He loses the advantages of specialization and economies of scale that he could have had in fi shing If only he could sell the

fi sh to other islanders Th e proceeds of these sales could be used to consume something other than fi sh or for further investment in productivity

Suppose you own a Chinese television factory in 1992 You have invested

in a production line, so your workers are productive You are ready to produce thousands of TVs a day But there is a problem: to whom are you going to sell? Th ere aren’t enough Chinese rich enough to buy your products You have solved the supply problem but still face a demand problem Th e solution, of course, is to export to developed countries where there are many people who can aff ord your televisions

In 1980, Deng Xiaoping designated Shenzhen as a special economic zone,

an area in which market reforms and openness to international trade could

be tested At the time, Shenzhen was a small village, but it had an important advantage: it bordered Hong Kong Foreign investors, attracted by tax breaks and low wages, began to invest In 1992, Deng Xiaoping toured Shenzhen and reaffi rmed his commitment to economic reforms and China’s engagement

in international trade Growth in foreign investment in and exports from Shenzhen accelerated By 2012, Shenzhen was exporting $271 billion worth

2 Lynch ( 2014 )

3 Economist Intelligence Unit ( 2014 ); all monetary values are given in US dollars unless otherwise noted

Why Can This Growth Not Be Sustained?

Much of China’s investment has been funded by debt Th is growth has brought benefi ts to more than a billion Chinese and indirectly benefi ted many others around the world While it is true that China’s investment has grown quicker than consumption, consumption has also grown very fast If a country can grow both investment and consumption, why shouldn’t it continue to do so? Isn’t an economy based on debt-funded investment more sustainable than one based on debt-funded consumption (as many Western economies seem

to be)? With investment, at least the rise in debt is matched by a rise in assets

Th ese are important questions that strike at the heart of why China needs

to reform In this section, I will explain why China’s current growth model is unsustainable and why it needs to be reformed

Debt-funded investment can create sustainable growth If a company rows money to invest in a factory, this produces growth Th e new factory will allow the company to produce more output and employ more people than it did before Is this growth sustainable? To know this, we must know whether the profi tability of the factory will be suffi cient to pay back the interest on the loan Suppose a fi rm must pay 10 % interest on its loan, and the factory earns

bor-a return of 15 % Th en the interest and, over time, principal of the loan can

be paid back from the profi ts of the factory Debt levels will be stable or falling while the company is growing Th is type of debt-funded investment can lead

to sustainable growth

Th e same principle is true in the case of the macro economy As long

as investment returns are higher than interest rates, 5 borrowing to fi nance growth is sustainable Th is may have been the case in much of the developed world following the 2008 fi nancial crisis Interest rates in the USA, Japan, and much of Europe were historically low, so even investment projects with very modest returns could produce sustainable growth Indeed, borrowing for such investment will actually reduce debt-to-income levels in the long run Th is is

4 Department of Foreign Trade and Economic Cooperation of Guangdong Province

5 Th e interest rate must be adjusted for risk Some projects are much riskier than others, and so the ment return on such projects must be suffi ciently high to compensate lenders for that increased risk

invest-one of the key arguments against the austerity policies that were pursued in many countries after the crisis

Unfortunately, debt-funded investment can also create unsustainable growth Returning to our company, suppose that it can still borrow at an interest rate of 10 %, but now the return on its investment in the factory is only 5 % It could still borrow to build the factory (provided someone would lend it the money), and so it could still grow its output and employment However, now the profi ts from the factory would be insuffi cient to pay back the interest on the loan, let  alone the principal Th e factory owner faces a tough choice He could pay back the loan from the profi ts of other factories However, if this money is used to repay the loan, it cannot be used for further investment, and so the fi rm’s growth would be slower than it otherwise would

be Alternatively, the owner could take out another loan to pay back the fi rst loan and potentially to make further investments as well Th is would allow the

fi rm to grow However, the owner would soon fi nd himself back in the same situation of having debts he cannot pay and having to either cut investment (and growth) or take out still more debt to cover the old debt Eventually, the second option will become impossible because no one will be willing to lend

to him At this point, the growth of the fi rm will have to slow sharply in order

to pay off past debts In an extreme case, the fi rm may go bankrupt and have

to shut down completely

Th e same principle that we applied to the company also applies to an entire country’s economy Investment will always lead to growth in the short run, even if its returns are very low However, only investment with high returns will lead to sustainable growth If returns are too low, growth must eventually slow: the only choice is whether the growth starts slowing early and gradually

or late and suddenly

In the 1980s and 1990s, investment returns in China were high and interest rates were low Investment funded by borrowing could generate rapid and sus-tainable growth Since around 2010, however, returns have fallen below interest rates Despite this, investment has remained high, which has generated unsus-tainable growth, overcapacity and bad debt

Why did this happen? First, making a lot of investments itself tends to reduce investment returns Suppose that the company from our previous example began with a range of possible investments it could make What investment would it make fi rst? If it was trying to maximize its profi ts, it would invest in the project that promised the highest return fi rst Th e next time it had (or bor-rowed) some money, it would invest in the next-highest- return project and so

on Each successive project would have lower returns than the previous one

Th e more investing the company does, the lower its returns

8 P Armstrong-Taylor

Similarly, a country that does a lot of investing over an extended period

of time (such as China) is likely to have fewer high-return projects left than

a country that has had a lower rate of investment (for example, India) Th e low-hanging fruit is gone If investment rates are relatively low, new tech-nology may create new high-return opportunities at the same rate as invest-ment eliminates existing ones Such economies can continue to grow slowly However, it is unlikely that technological progress in China is fast enough to create enough new opportunities to absorb investment of 50 % of GDP

Development Commission, the state planning agency, estimated that the incremental capital output ratio (ICOR) rose from 3.3 between 1990 and

2008 to 4.2 between 2009 and 2013 6 An increase in ICOR means that more investment is needed to generate growth or, equivalently, that investment returns are lower

Second, China’s nominal growth rate (real GDP growth plus infl ation) has fallen, which tends to lower investment returns To see this, consider a con-struction fi rm building an apartment block Th e fi rm must borrow money now to cover construction costs but will not sell the apartments until con-struction is complete several years later 7 If growth and infl ation are high, income levels will increase over that time, and the price people are willing and able to pay for the apartments will also increase Th is will increase the return

of the investment in the apartment block Conversely, lower growth and infl tion reduce returns Nominal GDP growth averaged 15 % between 2000 and

a-2011 Th is fell to 10 % per year between 2011 and 2014, leading to a sharp drop in investment returns

Th ird, while investment returns were falling, fi nancial liberalization was allowing interest rates to rise Th is further reduced the sustainability of debt- funded investment We will talk about this more in what follows

Despite the fact that investment returns have fallen relative to interest rates, China has continued to invest heavily We might think that investing in projects where the return is lower than the interest rate would reduce the wealth of the investor, and so nobody would actually do such an investment Th erefore, if the investment occurs, it must be a high-return investment 8 Th is would be true

in a free-market economy with no distortions China is not such an economy

6 Economist, Th e ( 2014 )

7 Many Chinese construction fi rms sell apartments years before they are completed However, this fact does not undermine the argument here because the buyers of the apartments are willing to pay a high price based on expectations that the price will be even higher when the apartment is completed

8 Or at least it is expected to be a high return investment

Th e following chapters will outline some of the ways in which the fi nancial system is distorted to encourage the continuation of unsustainable invest-ment Chinese fi nancial reform is largely about removing these distortions

If the incentives are not removed, then investment and even growth can continue for a while However, this can be achieved only by taking on increas-ingly large amounts of debt Debts incurred by previous low-return invest-ments must be rolled over, and debt for new low-return investments must be added to them Debt will therefore grow exponentially Clearly this cannot

be sustained forever At some point, China must pay down the debt incurred from its previous overinvestment Th e only decision is when to pay

If the government begins to pay back the debt early, the debt can be paid down gradually Investment and growth would be slower than it otherwise would have been (and much slower than during the high investment growth phase), but there need be no crisis If the payment of the debt is delayed, the risk of sudden debt crisis increases

References

labor costs in China Th e Economist Intelligence Unit

Lynch, D. J (2014, April 16) Grads remake China workforce as high-end threat to

grads-remake-china-workforce-as-high-end-threat-to-u-s-.html

on such dynamics was Hyman Minsky His work, relatively unknown during his lifetime, has received a great deal of attention since the subprime crisis

Th e basic idea is that debt tends to amplify both booms and busts During a boom, borrowing increases profi ts, encouraging the buildup of debt; during the bust, it exacerbates losses, leading to a rapid reversal in economic perfor-mance Th e next section provides a more detailed explanation of how this happens and why it can be hard to manage

A couple of other factors often contribute to fi nancial crises: changes to regulation and government guarantees Deregulation is the most common type of regulatory change that contributes to crises (though other changes can also cause problems, as we will see in the subprime crisis) Individually, these factors are not necessarily problematic Deregulation in a fi nan-cial system in which the government credibly commits never to bailout a bank might be safe Th e investors in the bank would limit the risk it took because they would pay for any losses Similarly, government guarantees with tight regulation could also be safe – the regulation would prevent excessive risk-taking However, a deregulated system with government guarantees is dangerous Deregulation allows banks and other fi nancial entities to take more risk; government guarantees for these entities, by covering losses from bad risks, encourages risk-taking Th is pernicious interaction between deregu-lation and government guarantees has played a role in many crises

Financial Risks

Th e next section discusses Minsky’s theory of fi nancial crises Using this, we will see how debt, deregulation, and government guarantees can interact with brief studies of crises in Japan and the USA Finally, we will use this theory to understand the risks in present-day China

Minsky’s Theory of Financial Crises

Debt amplifi es returns, both positive and negative When asset prices rise, the most indebted investors are those that make the most money; when prices fall, those same investors suff er the worst losses and possibly face bankruptcy Figure  2.1 illustrates this process

Minsky’s central insight is that debt is destabilizing at the level of the omy as well: it tends to amplify both booms and busts To see this, consider

econ-a fi rm When the economy is growing, investment returns econ-are high bececon-ause demand is high, and demand is high because other fi rms, households, and the government are also borrowing to spend Th e fi rm does not think it is borrowing recklessly: all its investments earn returns greater than the interest rate it must pay to borrow Other fi rms (and other types of borrowers) think the same way To lenders, the fi rm looks like a sound borrower – after all, its

Fig 2.1 How debt amplifi es business cycles ( a ) No leverage: if there is no debt,

then equity (net wealth) moves in line with asset prices If asset prices double during a boom and then fall back to their previous value in the subsequent bust,

investor will be back where they started ( b ) 2:1 Debt-to-equity ratio: if investors

can borrow up to twice the value of their equity, they can buy three times the assets, and their equity will increase three times faster during the boom If inves- tors increase their debt up to the 2:1 limit during the boom, then during the bust, the value of their assets will fall to less than their debt during the bust (when asset prices half), and investors will go bankrupt During the boom, leverage is rewarded; during the bust, it can lead to bankruptcy In this way, debt amplifi es business cycle swings and fi nancial risk

2 Financial Risks 13

investments are profi table and it has repaid past debt At the level of vidual borrowers and lenders, everyone appears to be behaving responsibly However, at the level of the economy, these high returns are themselves dependent on debt If other fi rms, households, and the government could not borrow, then they could not buy as many of our fi rm’s products and its investment returns would be lower – possibly below the interest rate If this happened, some fi rms would be unable to repay their debts and lenders would respond by raising interest rates Th is would decrease the growth in debt still further and lead to yet lower investment returns Many investments that looked sound when returns were high and interest rates low during the boom are unsustainable when returns are low and interest rates high during the bust

Th e key insight is that a debt-fueled boom that continues too long will come to rely on a circularity: debt can be repaid as long as it continues to increase (fueling higher demand), and debt continues to increase as long as

it can be repaid However, once debt levels stabilize or start to fall (as they must at some point), the process reverses, so debt that appeared sustainable becomes unsustainable Debt allows faster and more prolonged growth dur-ing a boom, but at the cost of a more severe recession when the boom ends

Th is process is at the heart of almost all fi nancial crises Th ough the debt may take diff erent forms, it almost always follows this basic pattern To illus-trate this, let us consider a couple of examples: Japan in the 1980s and 1990s and the USA before and after the subprime crisis of 2008 I will focus on how the fundamental forces in both economies followed Minsky’s process, though much more could be said

Japan

Following its recovery from the Second World War, Japan grew rapidly through exports and, especially, investment Between 1960 and 1990 it was the fastest growing economy in the world at 6.1% a year However, following the bursting of real estate and stock bubbles in 1990, the next ten years saw the economy grow at less than 1% per year Since China has followed a similar growth strategy, it is helpful to understand what when wrong in Japan

In 1985, the governments of the USA, Japan, West Germany, the UK, and France signed the Plaza Accord, in which they agreed to coordinate policy to depreciate the dollar relative to the Japanese yen and German deutsche mark Over the next two years, the yen appreciated by 50% against the dollar Th is weakened demand for Japanese exports and led Japan to loosen monetary

policy to off set the contractionary eff ect on its economy 1 Low interest rates boost asset prices because future cash fl ows are discounted at a lower rate While low interest rates alone are insuffi cient to explain the scale of Japan’s bubble, they probably did contribute to the initial increase in asset prices Once asset prices started rising, certain features of the Japanese system pro-vided incentives for debt-fi nanced investment in those rising assets I will consider three: speculation by fi rms to boost profi ts, tax distortions, and bank incentives

During the period of rapid asset price increases, fi rms could obtain higher returns on speculative investments in real estate or stocks than productive investment Th e practice of zaitech became common during this period

Zaitech involves a fi rm borrowing money to speculate on real estate or stocks 2 and booking the resulting gains as profi ts By some estimates, almost half the profi ts of Japanese fi rms during this period came from such practices

Th e process was circular: higher stock prices led to higher profi ts, which in turn led to higher stock prices Because fi rms that engaged in such practices appeared to be more profi table than those that did not and were consequently rewarded with high share prices, there were strong incentives for managers to pursue such strategies Th is increased the demand for real estate, leading to higher prices and even stronger incentives to speculate

Tax distortions also encouraged borrowing against, and speculation in, real estate Two particular features contributed to this First, some taxes (e.g., the inheritance tax) treated debt at face value while land evaluations for tax purposes lagged their market value Th is meant that tax could be reduced

by borrowing money against appreciated land values Second, while interest payments were tax deductible for companies and, in some cases, individuals, capital gains taxes did not have to be paid until an asset was sold Again, bor-rowing money to invest in real estate came with tax benefi ts Th e combina-tion of these tax eff ects was to boost demand for real estate, particularly when prices were rising rapidly Incidentally, Japan is not unique in having a tax sys-tem that favors debt Most countries allow interest payments to be deducted from profi ts before paying taxes, which creates a strong incentive for fi rms to borrow Th is may contribute to fi nancial instability

Prior to the 1980s, Japanese banks had been tightly regulated and vative in their lending Similar to China 20 years later, Japanese banks in the 1970s were protected from competition by regulation that fi xed interest rates

conser-1 Th is might be compared to China’s stimulus package after the 2008 crisis, which was also aimed at off setting falling exports

-2 Japanese fi rms are often part of a conglomerate group known as keiretsu During the boom, fi rms within

a keiretsu often held stock in other members of the group

2 Financial Risks 15

on deposits and loans and guaranteed a profi table spread between the two However, from the end of the 1970s, Japan began a series of deregulations that changed bank incentives Aside from liberalizing interest rates, Japan also liberalized the fi nancial markets – in particular the bond market Firms that had been dependent on banks for their funds could now obtain competi-tive fi nancing in the bond markets High savings rates continued to provide banks with large deposits, but they increasingly struggled to fi nd fi rms who wanted to borrow from them Instead, they increased lending for real estate investment

Another eff ect of these deregulations was to increase the competition for banks both among themselves and against the bond market Profi ts fell and banks came under pressure to improve their performance At the same time, banks, particularly those considered too big to fail, continued to have a close relationship with the Ministry of Finance, and there was a belief that they would be bailed out if they got into trouble Th is combination of pressure to increase profi tability and an implicit government guarantee created a strong incentive to take risks Risky loans generated higher returns during the boom and helped grow the banks On the other hand, the risk was borne, in part

at least, by taxpayers Furthermore, loans secured against real estate appeared safe because, as long as real estate prices were rising, the value of the asset backing the loan exceeded the loan 3

Th e zaitech strategy and tax distortions boosted demand for loans for real estate and stock market speculation, while the incentives faced by banks encouraged lending to support such risky strategies Unsurprisingly, debt increased rapidly As Minsky explained, this process worked well during the boom As long as asset prices were rising, borrowers and lenders all benefi ted from debt-fi nanced speculation However, it was also unsustainable: asset prices could not continue to rise forever At the peak of the bubble, com-mercial land in Tokyo was worth about 6.5 million yen ($45,000) per square meter and the price-to-earnings ratio of the Nikkei index reached almost 70

At one point, Japan’s land alone represented 20 % of global wealth, and its stock market capitalization was over 40 % of the world’s total Clearly, such prices were not based on fundamentals

When prices of real estate and then the stock market began to fall, the tors that had contributed to rising prices and rising debt went into reverse First, the zaitech strategy that had boosted profi ts now subtracted from them,

fac-3 Th e deregulation and subsequent instability of the Japanese banking system during the 1980s were lar to those of the savings and loan associations in the USA at the same time Th ey too experienced a series

simi-of deregulations that allowed and encouraged them to take risk, and they too experienced a crisis

so demand for real estate fi rms collapsed Some fi rms sold off assets to pay off debts, increasing asset supplies Second, the tax distortions that had favored borrowing to buy appreciating assets did not similarly encourage buying depreciating assets Finally, banks no longer had the ability or the incentive

to lend for real estate speculation Bad debt write-off s during the 1990s were approximately double bank capital in 1990 To keep their capital ratios in line with regulations, banks were forced to raise capital and cut loans Th e combination of these factors drove asset prices down as rapidly as they had increased

Th e bursting of the asset bubble had serious eff ects on the real economy Richard Koo 4 has developed the concept of the balance sheet recession to explain

these eff ects After the bubble burst, asset prices fell, but debt remained Th is created a balance sheet problem because for much of the economy the debt owed now exceeded asset values: fi rms owed more on their loans than the real estate that was bought with those loans was worth, and banks owed more to depositors than their loans were worth after subtracting bad debts In this situation, fi rms and banks try to repair their balance sheet by reducing debt Any income that fi rms receive is used to pay down debt rather than on new investment, and any income banks receive is used to cover bad debts rather than being lent out to others who would spend it Th e result is a collapse in demand With no demand, fi rms cannot sell their products, thereby reducing investment and employment Th e economy gets stuck in a depression, which lasts until the debt is repaid In Japan this took at least 15 years

Japan illustrates the features of fi nancial crises outlined in the introduction Debt played a pivotal role in the bubble and its aftermath It exacerbated the increase in asset prices during the boom, contributed to their rapid crash after the bubble burst, and forced the economy to go through an extended period

of depression before it could fi nally recover Deregulation of the banks and bond markets, combined with implicit government guarantees of the banks, created incentives for the banks to make the risky loans that fueled the bubble

USA

While the Japanese crisis was mainly driven by excessive borrowing by fi rms, the US subprime crisis was driven by excessive borrowing by households In the early 2000s, the USA experienced a housing boom Th is boom was caused

by and the cause of a rapid expansion in mortgage lending While house

4 Koo ( 2003 )

2 Financial Risks 17

prices were rising, home buyers were rewarded for borrowing money to buy the most expensive houses they could Th e more expensive the house, the larger the gains when it appreciated Th erefore, demand for houses and mort-gages was strong

Meanwhile, the supply of mortgages also increased Rising house prices encouraged lenders to extend mortgages even to those with questionable credit While house prices were rising, borrowers were unlikely to default

As long as houses were worth more than the money owed on the mortgage, even homeowners who could not repay the mortgage (as a result of a job loss, for example) should not default Instead, they should sell the house, repay the remainder of the mortgage from the proceeds, and keep the rest As a result, default rates were exceptionally low during this time  – even among so-called subprime mortgages Th is was the central reason lending to home-owners expanded

Th e securitization of mortgages may have helped to expand lending With securitization, mortgage lenders sell off the cash fl ows from mortgage repay-ments to investors as mortgage-backed securities (MBSs) Th is allowed the mortgage lenders to increase their lending because the credit risk was passed

on to investors Investors were willing to buy the MBSs because they believed default rates would remain low, and so the securities were low-risk 5

Th e combination of rising demand for and supply of mortgages led to a rapid increase in mortgage lending and, consequently, in demand for houses Potential homeowners, who otherwise would not have been able to borrow

to buy a house, could now do so Homeowners who previously could only aff ord a small house could now buy a big one Th is increase in demand could not be immediately matched by an increase in supply (houses take time to build), and so house prices rose Th e rise in house prices fueled the growth in mortgages, and so on Th e housing boom was a cycle of rising asset prices and rising debt along the lines outlined by Minsky

Eventually, house prices became unsustainably high and began to fall Now the cycle was reversed: debt exacerbated the fall in house prices We saw that when house prices were rising, even borrowers who could not repay their mortgage would not default – they would sell the house and use the proceeds

to repay the debt Now, with house prices falling, such borrowers may have to default if their houses are worth less than they owe Even borrowers that could

5 Because this book is about China, I will refrain from going into too much detail on the subprime crisis, but there were other reasons for the increase in mortgage lending Th e Federal Reserve kept interest rates low in order to help the economy recover from the dot-com crash and subsequent recession Th e major surplus countries around the world (China, Japan, OPEC) reinvested most of these surpluses in US capi- tal markets, expanding the capital available for lending

repay their mortgage had incentives to default A homeowner with a mortgage

of $200,000 whose house was only worth $100,000 has a diffi cult choice If she commits to repaying the mortgage, she will end up paying $100,000 more than the house is worth If, on the other hand, she defaults on the mortgage, she can rid herself of a $200,000 debt by giving up a $100,000 house Th is saves her $100,000 Th ere are costs to default – her credit rating will suff er and she will have to move out of her home – but for some homeowners these costs may be less than $100,000

As a consequence, defaults rose sharply, causing lenders to cut back on the supply of mortgages Th e demand for mortgages also fell as fewer peo-ple wanted to buy a house, particularly a big house with a big mortgage, when prices were falling than when they were rising As a result, lending and demand for housing dropped At the same time, distressed sales and sales of foreclosed properties increased the supply of housing Th e combination of lower demand and higher supply further reduced prices Th e cycle of rising mortgage debt and rising house prices that had driven the boom now went into reverse

Changes to fi nancial regulations may also have played a role in the crisis During the early 2000s, the US Securities and Exchange Commission (SEC) made a series of changes to fi nancial regulations that provided incentives for banks and brokers to buy MBSs

Th e fi rst pair of changes related to the amount of capital that banks were required to hold Th e basic business of a bank is to borrow money at low interest rates and invest it at higher rates Th e risk is that investments the bank makes fail and the bank is unable to repay the money it borrowed – in other words, the risk of bankruptcy To protect against this, regulators require banks

to fund some of their investment with equity (or capital) from shareholders

If the investments lose money, the equity holders absorb the losses so that the bank does not default on its borrowing Banks generally want to avoid hold-ing too much capital because this reduces the return they can off er to share-holders Th e amount of capital that must be held depends on the riskiness of the bank’s investments: a bank can reduce its capital by reducing the riskiness

of its investments in the eyes of regulators

In 2001, the SEC implemented the Basel II approach to calculating the capital that commercial banks had to hold In 2004, the holding companies

of broker-dealers (essentially investment banks) became subject to the same capital rules Basel II treated MBSs as low-risk By reducing other invest-ments and investing in MBS, the banks could reduce the capital they needed

to hold Th is provided a strong incentive for banks to buy MBSs, which is exactly what they did

2 Financial Risks 19

Th e impact of this regulation was amplifi ed by another change made by the SEC in 2003 Brokers are allowed to borrow securities from their custom-ers as long as they post collateral to ensure that the customers are not put at risk Prior to 2003, securities borrowing had to be collateralized with cash, Treasury bonds, or equivalently safe assets In 2003, the SEC allowed MBSs

to be used as collateral Since MBSs off ered higher returns than Treasuries or cash, brokers had a strong incentive to acquire MBSs for use as collateral Th e combination of these two regulatory changes increased the demand for MBSs from the banks and contributed to the ease with which homeowners could borrow and, consequently, to the housing bubble 6

Government guarantees also played a role in encouraging fi nancial risk-taking Large banks recognized that they were too big to fail and so would

be bailed out by the government in the event of a crisis, which gave them an incentive to take more risk Lenders to these banks also recognized this and

so were willing to lend at lower interest rates Th is encouraged borrowing but also acted as a subsidy to large banks, which allowed them to grow at the expense of smaller ones that did not have an implicit government guarantee

Th e concentration of the banking sector in a few giant banks backed by ernment guarantees created additional systematic risks

Th ough the Japanese crisis and the US subprime crisis happened at ferent times and in diff erent countries and involved diff erent processes, both

dif-of their boom–bust cycles were amplifi ed by debt, regulatory changes, and government guarantees Th ese factors provide a framework through which we can view risk in China’s fi nancial system

China

Figure  2.2 shows that Chinese debt has increased sharply since 2008, and,

by 2013, credit to the nonfi nancial sector had reached almost 200 % of GDP. Including government debt would bring this number closer to 250 %

of GDP.  Th is level of total credit is high for a developing country, and its rapid growth is a concern In this section we will evaluate the risk in China’s

fi nancial system based on the dynamics of debt, regulatory change, and ernment guarantees

Minsky’s fundamental insight was that growing debt can cause asset price infl ation, which provides incentives for both lenders and borrowers to increase debt still further Th is cycle from debt to asset prices can create an unsustainable

6 For more on these SEC rule changes see Carney ( 2012 )

bubble that ultimately bursts, resulting in a fi nancial crisis Th ough such cycles can impact any asset, bubbles in larger asset classes pose greater risks Major

fi nancial crises are usually preceded by bubbles in real estate, the stock market,

or both Although the Chinese stock market is prone to spectacular bubbles, stock ownership remains low in China – around 10 % of household wealth – and so the eff ects of a crash are likely to be contained A crash in China, such

as the one in 2015, is unlikely to trigger a fi nancial crisis on its own However, Chinese households have more than 70 % of their wealth invested in real estate,

so a real estate crash would be a much more serious problem 7

Much Chinese debt is linked to real estate Construction fi rms are major borrowers: they borrow money to buy land and fund construction and hope

to pay it off when a project is sold Other borrowers (e.g., steel or cement

fi rms) are also linked to the real estate market Local governments (via local government fi nancing vehicles) 8 borrow money for infrastructure projects

Th ese projects often do not produce suffi cient cash fl ow to pay back loans, so the cash fl ows are supplemented with income from land sales We review the real estate market in more detail in Chap 12

In addition, evidence suggests that some loans intended for other purposes have been redirected to the real estate market In the city of Wenzhou, for

7 Figures on the composition of household wealth are from Xie and Jin ( 2015 )

8 Local government fi nancing vehicles are fi rms set up to enable local governments to bypass regulations that prevent them from borrowing directly Th e local government decides on the project and provides guarantees and claims on future cash fl ows to the fi nancing vehicle Th e fi nancing vehicle borrows money and carries out the project and pays back the loan from the cash fl ows provided by the government Th is will be discussed more subsequently in the chapter on local government debt

Credit to Private Non-Financial Sector (% GDP)

Fig 2.2 China’s growing debt

Notes : Data from the Bank of International Settlements and the International

Monetary Fund Quarterly data for GDP interpolated from annual data

2 Financial Risks 21

example, borrowers with access to bank loans would relend this money at a premium to borrowers who used it to speculate on the real estate market 9 Firms also lend to each other through channels such as entrusted loans With

an entrusted loan, one fi rm lends to another via a bank Th e channeling of excess cash to borrowers willing to pay a high return can have benefi ts In theory, it could ensure the cash is used to fund the highest return investment While traditional banks could, and should, be able to fulfi ll this function, if some borrowers are shut out from the formal banking system, such a shadow banking system might be a workable substitute However, it makes it harder

to track the total debt in an economy and, in particular, the uses of that debt

It appears that these informal channels are often used to channel funds toward speculation in real estate and the stock market, which would increase the pos-sibility of the formation of a Minsky bubble 10

Th ese practices are similar to the zaitech practices seen in Japan in the 1980s Th e Economist , for example, reported on a fi rm, Yangzijiang Shipbuilding, that earned

one-third of its profi ts from entrusted loans rather than its core business of building 11 Th is fraction is similar to those in Japan Th e risk is that a crisis in the real estate market could spread to the rest of the economy through the web of credit Much of the demand for real estate in China comes from the growing middle class Th e demand by members of the middle class for real estate in China has remained strong despite rising prices because of the lack of alternative invest-ments Interest rates have been suppressed, and the stock market has experienced extremely high volatility, including two massive bubbles in a decade Th erefore, real estate has been the investment of choice 12 While down payments in China are usually higher than in Western countries (government regulations require a minimum down payment of 30 %), mortgage debt still reached $1.8 trillion in

ship-2014 according to the McKinsey Global Institute 13 More worrying are signs that property developers are bypassing the down payment restrictions by off ering some buyers down payment loans of almost a quarter of the value of the home If borrowers could borrow 70 % of the value of their home from a mortgage lender and 25 % from the developer, they would only have a down payment of 5 % – very similar to the numbers leading up to the US subprime crisis 14

9 See the chapter on Wenzhou for more details

10 Indeed, in January 2015, the China Banking Regulatory Commission circulated draft rules to curb entrusted loans that were believed to be creating a credit-fueled stock market rally (Reuters 2015 )

11 Economist, Th e ( 2014 )

12 Th ere is also an argument that cultural forces exist to support housing demand For example, a young man needs to own a house in order to attract a bride I am skeptical of such explanations until they have survived a period of falling house prices Th e simpler explanation for Chinese demand for houses is that they have been the best investment available If the Chinese continue to buy houses for cultural reasons, even when they are losing money by doing so, then I might reconsider

13 McKinsey Global Institute ( 2015 )

14 CNBC ( 2014 )

Both borrowers and lenders benefi t from these transactions as long as the real estate market remains strong Borrowers can boost their profi ts by bor-rowing to invest in real estate; lenders can lend at relatively high interest rates

to real estate investors, and the loans are backed by assets whose price is rising

Th is was a feature of the real estate bubbles in Japan and the USA, and it is also a feature of the recent debt growth in China

If debt continues to grow, then China is likely to experience a crisis at some point Th is would likely involve a cycle of falling real estate prices and rising fi nancial distress Th e falling real estate market would lead investors

to sell properties, increasing the declines in prices Th ose who have rowed against the value of real estate or land (including construction com-panies and local governments) would face bankruptcy Investment would slump Construction companies would not invest in projects that they could not sell Without income from land sales, local governments would have to cut back on infrastructure investment Workers connected with these activities would face unemployment or lower pay and so would cut back on consumption All of this would reinforce the economic contrac-tion and slumps in asset prices

To avoid a crisis, the government must slow the growth in debt and accept that this will mean less investment and slower economic growth Much of the rest of the book will discuss the details of how this can be achieved through reforms of the fi nancial system In essence, the various distortions that favor borrowing and investment must be removed  – in particular, interest rates must be set by the market, not artifi cially suppressed to allow cheap borrow-ing, and the government must refrain from bailing out failed investments

so that investors learn to avoid taking excessive risks Th e next two chapters explore these issues in detail

References

www.cnbc.com/id/46808453 Accessed 24 Sept 2015

Business http://www.cnbc.com/id/101846786 Accessed 27 Feb 2015

Th e Economist

and its global implications Singapore: Wiley

2 Financial Risks 23

Reuters (2015, January 18) China issues draft rules restricting entrusted lending

Reuters http://www.reuters.com/article/2015/01/19/china-banks-loans- idUSL4 N0UY0N120150119 Accessed 26 Feb 2015

47 (3), 202–229