The Chinese Humpty Dumpty

I’ve opined for over two years that China’s economy is very fragile and deceptively robust: I characterized it as a “Michael Jackson economy” kept functioning by doses of artificial stimulants, which postpone the ultimate adjustment, but which make that reckoning all the more harrowing when it comes–as it must. There have been other advocates of this view, notably short sellers like Jim Chanos, but until relatively recently the consensus was that China would slow gently, and experience a “soft landing”.  In recent weeks, however, the consensus is clearly shifting towards the alternative view that China is increasingly vulnerable to a big fall.

This is best illustrated by the fact that nearly polar ends of the opinion spectrum, from the WSJ to Krugman, have agreed that China’s situation is increasingly fraught.

The previous optimism by some was actually the primary reason for my pessimism.  The Tom Friedman School of Sinology, which has far too many adherents (including many corporate types here in the US), argues that China’s centralized policymaking system will allow it to respond to crises in a forceful, technocratic way unhindered by the political messiness that has interfered with economic policy in the US, and particularly Europe.

Alas, fascism always has its admirers, not least among the smart set opinion makers and the board rooms of large corporations, where it is all to common to think of economies like companies run by managerial fiat, rather than as spontaneous orders coordinated via the price system and other forms of market contracting.

To me, this centralization is a bug, not a feature.  Centralized resource allocation invariably leads to substantial distortions.  In China’s case, the extreme orientation towards investment in driving GDP growth should be a clear signal of misallocation.  In 2008 and 2009, China responded to the crisis by dramatically easing credit and encouraging investment in infrastructure and housing.  A lot of money got spent, and a lot of measured GDP was created, but it is increasingly doubtful that the true market value of these investments, which would represent the actual value created, is anywhere near the amount invested.  The decline in housing prices is one symptom of that.  The fact that many big infrastructure projects, like the glittering high speed rail systems that Obama marvels over like an 8 year old watching a Lionel whiz around the track on Christmas morning, are unable to cover even variable costs, let alone generate a return on investment, is another.

Governments can spend, or distort prices to encourage spending.  Creating actual value from the spending is something else again.

Moreover, China’s supposedly wise planners have created a financial system that would make Rube Goldberg proud, and which exhibits all the pathologies and brittleness of past systems that have collapsed in ugly crashes.

The Chinese have constructed a system that is intended to (a) channel savings via big banks for lending to the kinds of companies and projects that the government wants to support, and (b) generates spreads for banks to help them generate income to overcome the consequences of past bad investments.  This system involves paying very low rates to depositors who have limited investment alternatives.  Most Chinese depositors actually earn negative real returns.

But these price controls–like all price controls–encourage efforts to circumvent them.  In China’s case, investors looking for higher returns are circumventing the formal banking sector by directing capital to the informal shadow banking system. This system utilizes a crazy quilt of products like wealth management products, letters of credit, and bank acceptances.

Much of the capital raised via the shadow banking system has been channeled into real estate, loans to companies rationed out of the formal banking system as the result of government policies to try to rein in inflation and speculation, and to lending to local governments with extremely dodgy finances (being heavily dependent on real estate sales for funding).  Thus, the asset side of the balance sheets of these entities is extremely risky.  The liability side is, moreover, very fragile and prone to runs–just like the shadow banking system in the US was in 2007-2008.

Put this together and you have a very big financial Humpty Dumpty teetering on the verge of a very big fall: risky assets funded with run-prone liabilities, and all that operating in the financial shadows.  Those who marvel at the wonders of a state dominated system (e.g., the Tom Friedman China cult) are not worried.  They are serenely confident that all the Party’s horsemen and all the Party’s men will be able to put Humpty Dumpty back together again.  This optimism is passing strange, given that CCP policies are primarily responsible for Humpty Dumpty’s existence, and his parlous state: policies that encouraged the rapid expansion of a shadow banking system, and which stimulated extremely investment-intensive growth with little regard to the economics of the projects this stimulus spawned.

What could give Humpty a push?  Well, given China’s export-orientation, the most obvious candidate is a slowdown in Europe which appears increasingly certain.  The main open question here is how severe the contraction will be.  That depends on the wildly unpredictable (because it is primarily politically-driven) outcome of attempts to address its sovereign debt crisis.  But it is also possible that Humpty could fall purely due to internal factors, without an external push.  The existing balance is very precarious.

As I’ve mentioned before (mainly in the comments), it is very difficult to predict the timing of these things.  But it is plain to see that Humpty is teetering, and that the odds of a fall are appreciable.

This helps explain why open interest in very low strike crude oil puts is increasing dramatically: if Humpty does fall, it will be extremely bearish for commodities.  (Deep-out-of-the-money-calls on crude are also quite popular now, reflecting the situation with Iran.)

So I remain pessimistic on China.  It is interesting to have much more company in that view.  Interesting, and at the same time a little unsettling: having Krugman on the same side is always reason for a rethink!

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About Craig Pirrong 238 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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