Comments of Walden Bello on his new book, “Paper Dragons: China and the Next Crash”

Why China might be the trigger of the next global financial crisis is the subject of the first event in my book tour at Sciences Po in Paris, with Prof Cornelia Woll and Victor Mallet, Paris bureau chief of the Financial Times, serving as commentators. Sept 19, 2019.
Brief Remarks on State of Global Financial System and China
Paris, Sept 19, 2019
I would like, first of all, to thank Prof Cornelia Woll for organizing this event. I am also very appreciative of Mr Victor Mallet’s joining us this evening.
Let me first say that “Paper Dragons: China and the Next Crash” is about the vulnerabilties of the global financial system and not just about China. But since China is a major new source of global financial vulnerablity, we have decided to focus on it today.
The global financial system is as vulnerable, is not more so, to a financial crash today than in 2008. Let me just cite a few indicators:
First, the “too big to fail” problem has become worse. The big banks that were rescued by the US government in 2008 because they were seen as too big to fail have become even more too big to fail.
Second, the products that triggered the 2008 crisis are still being traded. This includes around $6.7 trillion in mortgage-backed securities sloshing around. US banks collectively hold $157 trillion in derivatives, about twice global GDP. This is 12 per cent more than they possessed at the beginning of the 2008 crisis.
Third, the new stars in the financial firmament, the institutional investors’ consortium made up of hedge funds, private equity funds, sovereign wealth funds, pension funds, and other investor entities, continue to roam the global network unchecked, operating from virtual bases called tax havens, looking for arbitrage opportunities in currencies or securities, or sizing up the profitability of corporations for possible stock purchases. Ownership of the estimated $100 trillion in the hands of these floating tax shelters for the superrich is concentrated in 20 funds.
Fourth, financial operators are racking up profits in a sea of liquidity provided by central banks, whose releasing of cheap money in the name of ending the recession that followed the financial crisis has resulted in the issuance of trillions of dollars of debt, pushing the level of debt globally to $325 trillion, more than three times the size of global GDP.
In other words, the grand promises to reform the global financial system made during the G 20 Summit in Pittsburgh in 2009 have remained just that: promises. Why? I think I will leave Prof Woll to answer that since she is the world’s leading expert on how what she calls the “structural power” and “productive power” of capital has been able to stymie global financial reform.
I said earlier that we may even be more vulnerable to a financial crash today than in 2008. The reason I say this is that there is a major point of vulnerability that was not there in 2008: China’s financial system. No one can predict where the next crash will take place. It can be anywhere, but what we can do is point to financial centers that can serve as potential triggers, and China’s is one of them.
When people talk about China’s vulnerability, they usually refer to the massive indebtedness of the country’s state enterprises, which are estimated by one source to be possibly as high as $12.5 trillion. That is a big problem and this made China’s economy more and more fragile, but so long as the state banks keep lending what are called zombie companies money, the day of reckoning can be postponed though probably not indefinitely.
I am talking about new vulnerabilities such as massive real estate speculation, a volatile stock market, and the spectacular rise of shadow banking. Let me take the three in turn.
Dr Naoyuki Yoshino, perhaps the leading expert on the Chinese financial system in Japan, says that there is no doubt that China is already in the midst of a real estate bubble. As in the United States during the subprime-mortgage bubble that culminated in the global financial crisis of 2007–09, the real-estate market has attracted too many wealthy and middle-class speculators, leading to a frenzy that has seen real estate prices climb sharply.
Chinese real estate prices soared in so-called Tier 1 cities like Beijing and Shanghai from 2015 to 2017. The average price of a home in Beijing has soared from around 4,000 yuan (US$578) per square metre, or 380 yuan (US$55) per square feet, in the early 2000s to the current level of well above 60,000 yuan (US$8,677) per square metre, or 5,610 yuan (US$813) per square foot. Of course, this is not of the same order of magnitude as in Japan in the late 1980’s, when the Imperial Palace East Gardens in Tokyo alone was valued as much as all the property in the state of California. But it is heading there.
However, Chinese authorities face a dilemma. On the one hand, workers complain that the bubble has placed owning and renting apartments beyond their reach, thus fueling social instability. On the other hand, a sharp drop in real estate prices could bring down the rest of the Chinese economy since real estate accounts for 15 to 20 per cent of GDP.
The problem is not just a real estate market slowdown having a domino effect on the rest of the economy owing to reduced demand; it is also that so many other industrial sectors are heavily invested in real estate. As the former chief economist of the Agricultural Bank of China writes, “Almost all big manufacturing companies have, to a certain extent, gotten involved in real estate…For many companies sales are stagnant, business is difficult, and the ability to earn a profit has sharply declined, so more and more manufacturing companies have started to subsidize their losses by getting involved in real estate or with financial investments.”
Let’s move to the stock market. Financial repression—keeping the interest rates on deposits low to subsidize China’s powerful alliance of export industries, the infrastructure lobby and governments in the coastal provinces—has been central in pushing investors into real-estate speculation. However, growing uncertainties in that sector have caused many middle-class investors to seek higher returns in the country’s poorly regulated stock market. The unfortunate result: a good many Chinese have lost their fortunes as stock prices fluctuate wildly. As early as 2001, Wu Jinglian, widely regarded as one of the country’s leading reform economists, characterized the corruption-ridden Shanghai and Shenzhen stock exchanges as “worse than a casino” in which investors would inevitably lose money over the long run.
At the peak of the Shanghai market in June 2015, a Bloomberg analyst wrote that “No other stock market has grown as much in dollar terms over a 12-month period,” noting that the previous year’s gain was greater “than the $5 trillion size of Japan’s entire stock market.”
When the Shanghai index plunged 40 percent later that summer, Chinese investors were hit with huge losses—debt they still grapple with today. Many lost all their savings—a significant personal tragedy (and a looming national crisis) in a country with such a poorly developed social-security system.
Chinese stock markets, now the world’s second largest, according to some accounts, stabilized in 2017, and seemed to have recovered the trust of investors when they were struck by contagion from the global sell-off of stocks in February 2018, posting one of their biggest losses since the 2015 collapse.
A third source of financial instability is the strong lock on credit access held by export-oriented industries, state-owned enterprises, and the local governments of favored coastal regions. With a significant part of the demand for credit from a multitude of private companies unmet by the official banking sector, the void has been rapidly filled by so-called shadow banks.
The shadow banking sector is perhaps best defined as a network of financial intermediaries whose activities and products are outside the formal, government-regulated banking system. Many of the shadow banking system’s transactions are not reflected on the regular balance sheets of the country’s financial institutions. But when a liquidity crisis takes place, the fiction of an independent investment vehicle is ripped apart by creditors who factor these off-balance-sheet transactions into their financial assessments of the mother institution.
The shadow banking system in China is not yet as sophisticated as its counterparts on Wall Street and in London, but it is getting there. Ballpark estimates of the trades carried out in China’s shadow banking sector range from $10 trillion to more than $18 trillion.
In 2013, according to one of the more authoritative studies, the scale of shadow banking risk assets—i.e. assets marked by great volatility, like stocks and real estate—came to 53 percent of China’s GDP. That might appear small when compared with the global average of about 120 percent of GDP, but the reality is that many of these shadow banking creditors have raised their capital by borrowing from the formal banking sector. These loans are either registered on the books or “hidden” in special off-balance-sheet vehicles. Should a shadow banking crisis ensue, it is estimated that up to half of the nonperforming loans of the shadow banking sector could be “transferred” to the formal banking sector, thus undermining it as well. In addition, the shadow banking sector is heavily invested in real estate trusts. Thus, a sharp drop in property valuations would immediately have a negative impact on the shadow banking sector—creditors would be left running after bankrupt developers or holding massively depreciated real estate as collateral.
Is China, in fact, still distant from a Lehman Brothers–style crisis? Interestingly, Sheng and Ng point out that while “China’s shadow banking problem is still manageable…time is of the essence and a comprehensive policy package is urgently needed to preempt any escalation of shadow banking NPLs [nonperforming loans], which could have contagion effects.” Beijing is now cracking down on the shadow banks, but these are elusive, and unless there is a fundamental reform in its national credit system to end the lock on the banking system by the export-oriented economic complex, there will always be a strong demand for these sub rosa entities.
Finance is the Achilles’ heel of the Chinese economy. The negative synergy between an overheating real estate sector, a volatile stock market, an uncontrolled shadow banking system, and the mounting massive corporate debt could well be the cause of the next big crisis to hit the global economy, rivaling the severity of the Asian financial crisis of 1997–98 and the global financial implosion of 2008–09. While it is true that the exposure of foreign speculative investors in China’s financial system is limited, the collapse of China’s real economy will have a massive global impact owing to the centrality of China in the global trading system.
Is this a fanciful scenario? I don’t think so, especially if you place it in a bigger context.
For one, China is no longer a rising dragon but a troubled economy whose growth rate has plunged from 10 per cent a decade ago to around five per cent, and many consider the latter figure an overestimate.
Second, China is now engaged in a full-scale trade war with the United States, that will certainly result in a massive downturn in its export earnings.
Third, China suffers from massive industrial overcapacity, which is making investment in the productive economy unprofitable, leading to more and more speculative investment in the financial sector, thus increasing the dangers of a financial implosion.
Fourth, the military balance of power in the East Asian region is increasingly volatile, and the impact of this on investor confidence in China must not be underestimated.
To conclude, I am not saying that China will be the locus of the next global financial crash. All I am saying is that it is a prime candidate, and this must not be underestimated. Thank you.