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  • Writer's picturePavel Kohout

The Dirty Little Secrets of China

Almost all advanced economies experience financial crises at certain stages of their development due to excessive credit growth. America suffered its first major crisis in 1837. Germany and Austria experienced the so-called Gründer crisis which began in 1873. Another crisis of similar proportions occurred in America and Europe in 1931 - in Germany it led to the rise of National Socialism.

The American crisis of 2007 and the European crisis of a year later are still vivid in the minds of many of us. These crises were caused by excessive credit expansion, too. Each economy offers only a certain volume of profitable projects at any given time, for which the probability of credit default is very low. Once the volume of money (in the sense of creditworthy funds) exceeds a certain critical limit, this money flows into loss-making projects. A banking crisis is imminent.

Within the euro area, the volume of liquid money grew at a double-digit rate during the period July 2007 to June 2008.In the five years prior to the crisis, the euro area experienced an average of 9% monetary inflation per year; in the five years that followed, money grew at just under 2.9% per year. It is thus clear that the European Central Bank practised an expansionary monetary policy before the crisis and monetary restriction after the crisis. The exact opposite of what a central bank should do.

Expansionary monetary policy in the pre-crisis period was tailored to the needs of Germany, which was then considered the sick man of Europe. It was too loose for a large part of the euro area, which has subsequently been confirmed. Let us look at Ireland, whose artificially overheated economy -- the result of a common monetary policy in the euro area -- plunged into a crisis that threatened at one point to completely destroy the Irish banking sector.

In the context of the credit crunch (i.e. for a number of years starting in October 2008), the European Central Bank failed to ease monetary policy even further because it was simply not possible. It was simply not possible to order a credit boom at a time of tightening credit criteria.

Let us now make the leap to China. This economy pretended that it was unaffected by the crisis in the Western banking systems. In fact, without much attention from the world, Beijing has carried out a monetary expansion of monumental proportions: in the five years since the third quarter of 2008, credit to China's private non-financial sector has increased 3.16 times. As of the first quarter of 2021, China's credit volume was seven times that of 2008 (in nominal local currency terms).

This is the secret to China's economic growth: credit. Meanwhile, in the Eurozone, credit volume remains almost exactly at 2008 levels. (Also in local currency, in nominal terms.) Not surprisingly, the EU is not experiencing any economic spurt, gallop, or even trot. Indeed, the volume of credit was already so large in 2008 that there was a shortage of quality projects. Bank lenders simply had a shortage of sound loan applications.

In short, the Chinese leadership is solving the financial crisis by having the state-controlled banking system pump credit into the economy under pressure, whether it makes economic sense or not. To some extent, it even works, since "pumping" credit can make more sense in some circumstances than the decisions of frightened lenders who are afraid of making another mistake. But how do we know when those "certain circumstances" have occurred?

Expressed in relative terms, China's credit has grown from 112 percent of GDP (2008) to 220.5 percent of GDP (Q1 2021). This puts China well above the Eurozone level (178.5 per cent of GDP.) The Chinese economy is thus "leveraged" very thoroughly.

China has also surpassed Japan's record set in 1993, when credit reached 217.5 percent of GDP. Remember that during the first half of the 1990s, Japan experienced a severe crisis when all the country's major banks failed. This was mainly due to lending to the real estate sector.

During September 2021, news of the possible default of Evergrande, one of China's largest property developers, attracted attention. Evergrande failed to pay part of its interest payments on time, but managed to buy time and avert a formal default and the legal procedures that would follow in such a case. In the meantime, however, the troubles of several other Chinese developers have bubbled to the surface: Fantasia, China Properties Group, Modern Land and Sinic Holdings.

China is beginning to look very familiar to those who remember the Japanese developments of the late 1980s and early 1990s. The Nikkei stock index peaked in December 1989, and to this day has not yet managed to reach the highs of that time. Chinese stock markets may have already anticipated similar developments several years ahead, as most stock indices there are still below their all-time highs. The Shanghai SSE Composite index, for example, is almost 40 percent below the peak reached in October 2007: according to Chinese stock market operators, the crisis is still ongoing.

Chinese stock exchanges have therefore long been pricing in the possibility of a financial crisis in stock prices. What could be its impact on the world? If the Chinese economy slows down significantly, we can expect shortages of various products, semi-finished goods or raw materials originating in China. The result could be stagnation coupled with inflation. Perhaps it is time to dust off the textbooks describing the development of the world economy in the 1970s. By the way, you probably do not want Chinese shares in your pension fund.

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