Spectacular Growth May Be Masking Unstable Foundations.

Listener, 7 August, 2010.

Keywords: Globalisation & Trade; Political Economy & History;

The question was asked aggressively, and came from the Australian-Chinese businessman as we sat down for lunch: “Is there a bubble?”

I avoided a direct answer; I had only briefly visited China, but I knew what he was on about. The Chinese economy is trying to drag the rest of the world out of this great recession. But isn’t it vulnerable to a financial crisis, too?

Because housing is part of the root cause of the Western crash, there is much concern about the Chinese housing market, where prices are absurdly high. If that bubble bursts, some households and some lenders will be in trouble. But that is not the worry.

How sound is China’s banking system? Chinese banks’ balance sheets are flush with the deposits of Chinese households, which on some measures are saving 40% of their incomes. But what about the assets side? Are the banks overinvested in sectors that might collapse? And what are their bad debts and underperforming loans like? And I mean in real terms, not what they report in their books – does anyone trust auditors nowadays?

What about the cosy deals between banks and companies that almost wrecked the South Korean economy? Like Korea had, China has credit underpinned by entrepreneurs. Sure, most of the banks are already owned by the state, which would simplify any bailout – no mucking around, as in the US and UK, over whether they need to be nationalised. And the Chinese Government has a war chest of a couple of trillion dollars to finance the bailout, although if it used them, this would affect the rest of us: if China pulled back its funds, world interest rates would rise and nervousness would increase.

We are not talking here about the inevitable slowdown of China’s spectacular economic growth, where 8% in a year is thought low. (The reported figures may be too high, but there is no doubt the growth is above Western norms.) There are various reasons to expect a slowdown, but here’s just one example: China is increasingly dependent on oil imports. Its huge and increasing needs will drive up oil prices and weaken the more energy-intense economies, China among them.

But on top of the slowdown, one day there may be a bust. We know what happened to Japan, although it slowed down in the early 1990s for different reasons. Japanese banks that had been able to hide their non-performing loans behind the veil of revenue growth became unsteady. The country’s financial system became riddled with zombie banks – those with negative equity that could survive only with explicit or implicit government guarantees. Because the Government was unwilling to address the problem directly, the Japanese economy stumbled along for almost two decades.

Banking crises are more common than you might think. The BNZ had one in 1990, but our most serious one, with multiple failures, was over a century ago. Other countries had them more recently. China’s last one was in 1997-99, when four large state-owned commercial banks with 68% of the banking system’s assets were deemed insolvent and half the total loans were thought to be non-performing.

That failure is reported in the book This Time Is Different: Eight Centuries of Financial Folly, by Carmen Reinhart and Ken Rogoff, which brings together what we know about all the world’s financial crises. The authors’ message is that in every financial boom, mechanisms and failures eventually lead to a financial collapse.

As Marx almost said, history repeats itself, the first time as a tragedy, the second time as farce. Or in the case of financial collapse, repeated farce – eight centuries of it – although there are many tragedies as well.

That’s what I should have told my lunch-time companion; I’ll send him this column. Not that I know much about China, but history can be helpful. That day we talked about the intricacies of his business; I learnt a lot.