China’s Financial Situation
China’s debt has been growing at a furious pace. As the chart below shows, since the financial crisis, China has been taking on debt rapidly in order to maintain economic growth.
What can past market crashes teach us about the current one?
Rapid debt growth has been associated with economic crises in other nations. China does have high household savings rates that, so far, have protected the country from a financial crisis. However, this rapid rise in debt will almost inevitably lead to malinvestment and a rise in non-performing loans. The key issue is how the losses are allocated. In the past, China has allocated loan losses to the household sector. We suspect that will happen again.
However, there is a concern that households and others may be worried about the assignment of losses or worse. Foreign reserves have been falling steadily for two years, although they have stabilized so far this year. They are still down almost 24% from the peak in 2014.
Late last year, the Chinese government implemented more stringent rules to prevent money from leaving China. These measures have worked to arrest the decline but are not consistent with other measures to open Chinese financial markets.
Some of China’s capital flight is coming to the U.S. Local West Coast real estate markets have become targets of Chinese investors.7 Although capital flight is a benefit for the foreign nations that receive the flows, it could destabilize China’s economy.
The Communist Party of China (CPC) is holding its annual meetings in October. This year’s meetings are of significant importance because President Xi will select a new Standing Committee of the Politburo. In China’s system, a president becomes more powerful in the second five-year term because he gets more say in the selection process of Politburo members. Xi will want to avoid major crises before October, fearing it could undermine his influence. In the long run, China needs to grow at a much slower pace, probably around 3%, to stop the rise in debt levels (China can grow at almost any level it wants as long as it can increase its debt). Cutting growth to sustainable levels will be very difficult; if Xi is going to be able to make this adjustment, he will need a solid cast of CPC members in the Politburo to support him. Thus, we expect the Chinese economy to avoid major spills until after the October meetings.
There were some thinkers who warned that ending the intellectual battle between capitalism/democracy and communism/ totalitarianism would lead to other problems.2 Samuel Huntington postulated that the world was instead heading toward a clash of civilizations. However, he saw the clash of civilizations in geopolitical terms. Instead, we are seeing it in domestic politics. The term “loyal opposition” is used to describe the party out of power. Despite being out of power, this group would remain loyal to the government and the overall path of policy. Therefore, the party that loses an election still generally believes that the policies coming from the incoming government would be different only by degrees.
In the West, the concept of loyal opposition is fading. Elections are now being seen as “zero sum games.” Losing an election appears catastrophic; voters simply don’t like members of other parties and view them as enemies.3 The following quote captures this issue:
In 1960, just 5 percent of Republicans and 4 percent of Democrats said they would be unhappy if a son or daughter married someone from the other party. In a YouGov survey from 2008 that posed a similar question, 27 percent of Republicans and 20 percent of Democrats said they’d be “somewhat” or “very upset” by that prospect. By 2010, that share had jumped to half of Republicans and a third of Democrats.4
This situation isn’t just seen in the U.S.; Europe is developing similar traits. Brexit was a shocking outcome. The fact that PM May couldn’t secure a majority in recent parliamentary elections suggests that “leave” wasn’t all that popular. Perhaps more astounding is that the opposition is led by the Labour Party, run by a “paleo-socialist” who wants to renationalize major industries and essentially reverse Thatcher’s reforms. Meanwhile, the French have elected their youngest president of the Fifth Republic and his new party now holds a majority in the National Assembly.
It appears that Western political systems are becoming increasingly disjointed. Why did this happen? The most likely culprits are globalization and deregulation. These policies were primarily responsible for taming the high inflation of the 1970s. Allowing firms to source production in the cheapest areas of the world, use immigrant labor that more easily moves into countries and introduce new technology and methods without serious regulatory restraint has greatly benefited the top 20% of the income brackets in most Western nations. The bottom 80% have missed out on the growth generated by globalization and deregulation.
This chart shows global real income growth in the two-decade period between 1988 and 2008. The developed world middle class did not participate in the global boom.
The tensions from globalization and deregulation have reached a critical point. We are seeing nations turn inward and support nationalist movements. For the world, the fact that the U.S. is deeply affected by these trends is dangerous. America, through its exercise of hegemony, has secured the sea lanes, made global commodities accessible, frozen age-old conflicts in the Middle East, Europe and Asia, and provided the reserve currency and a reliable source of export demand for developing nations. If the U.S. ends this practice, and it appears that we are, the world will steadily become a more dangerous place.
Political leaders need to create a new narrative of unity that offers hope and respect to those who have failed to participate in the globalized and deregulated world. If they cannot do so, wars will become more common. And, given the current degree of political fragmentation, working together will likely require an event to foster unity.
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