Is China Crisis-Prone Or Crisis-Proof?

FORBES - Sara Hsu AUG 1, 2016 @ 08:51 AM

There is a debate behind China’s negative economic news about whether China is really crisis prone, or whether it is crisis proof.  Those who make the case that China is primed for a financial or economic crisis include famed investors George Soros and Kyle Bass, while those who believe it is unlikely to impossible include celebrated investor Mark Mobius and IMF Managing Director Christine Lagarde.

First of all, those who say China is headed for crisis focus on China’s credit-fueled growth and debt stock.  George Soros, of Soros Fund Management (and short-selling infamy), stated at the Asia Society in April, “There is an eerie resemblance to what’s happening in China to what’s happened here leading up to the financial crisis in 2007-2008 and it is similarly fueled by credit growth.  It’s eventually an unsustainable extension of credit. But it feeds on itself and it has a lot to do with real estate.”  Soros made the case that China’s crisis may happen later because the economy is staying afloat with a cycle of credit creation and real estate construction that provide employment, but that the nation is consuming an increasing amount of credit in order to produce the same amount of growth.

Kyle Bass, founder of hedge fund Hayman Capital Management, wrote in a letter to investors in February of this year, “The unwavering faith that the Chinese will somehow be able to successfully avoid anything more severe than a moderate economic slowdown by continuing to rely on the perpetual expansion of credit reminds us of the belief in 2006 that US home prices would never decline.  Similar to the US banking system in its approach to the Global Financial Crisis, China’s banking system has increasingly pursued excessive leverage, regulatory arbitrage, and irresponsible risk taking.”  Bass writes that all other financial analysts and experts are wrong to believe that China will emerge from the current slowdown and debt malaise, and that China is already experiencing a hard landing, since the numbers of migrant workers have declined, commodity prices have dropped, and exports have declined.  He also states that China’s government will struggle to cover banking losses in the facing of a deteriorating RMB.

Bass’ doomsday prediction that China will suddenly require a $3.5 trillion fund injection due to mounting debt doesn’t seem plausible under China’s command economy.  This is because the government is essentially bailing out underperformers in real time, preventing a sudden stop of the economic and financial systems.

Soros’ argument makes sense, since he believes China is kicking the can down the road with government intervention. He points out that China has got to pull growth from other sources, other than credit, and fast, or growth will lag.  Its reform agenda is moving along, but its transition to a service-based economy is slow.  When and if the services sector will open up significantly to competition and market forces remains in question.  However, while the credit cycle is unsustainable, as Soros states, it is unlikely to result in a US-style crisis because of government control of its financial sector.  This means that the dominoes can be substantially righted before knocking down the rest of the financial system.  Indeed, Mark Mobius, Executive Chairman of Templeton Emerging Markets Group notes that China owns the four largest banks which comprise over half of the banking sector, and that the nation can remove non-performing loans from the banks’ books to its asset management companies, which have carried out the same task in the past.

Finally, the debate may come down to a matter of how one defines crisis.  Is a crisis defined by credit risk, even when the government has put a floor (via asset management companies) on the amount of risk banks actually have to absorb?  Is it a stock market meltdown in a system where fund injections and halted trading are a given?  Anne Stevenson-Yang of J Capital Research states, “…what the world defines as crisis is the Chinese government’s admission of crisis, and there’s no reason that should happen at all. What would be the value to the government of saying that growth is negative or the banks can’t open their doors?” Maybe China’s leadership is just cushioning or staving off a hard landing, or maybe, as Christine Lagarde said at Davos in January, the Chinese “will deliver” on growth and reform.

While preventing full-on economic fallout, government intervention does pose a big challenge for the reform process, as the government tries to marketize some aspects of the economy while simultaneously hovering over it.  The services sector needs to experience more competition and less control to become China’s new engine of growth, but freeing many of these industries from government control is an arduous political and economic task, as it turns out.  China may not be in a Western-style crisis, but it is in a catch-22 about whether to maintain government control or truly install market reforms.  We’re still holding our breath.