The liquidity crisis recently experienced by one of the largest developer companies in China, Evergrande, is the fruit of the long journey of socialism-style capitalism in China or in Carl E Walter and Fraser J. T Howe’s terms “Red Capitalism“. The policy of financial distortion and repression carried out by the Chinese monetary authority to stem the negative impact of the 2008 global financial crisis not only has an impact on increasing the portion of credit to China’s GDP (more than 200 percent), but also give birth to new vulnerabilities in the country’s financial system due to the growing role of the party and the government (central and local) in determining credit allocation. As a result, banking financing decisions actually move away from the principles of financial professionalism which increase the potential for damage to China’s financial system
On the one hand, the 2008 global financial crisis caused the capital market and other financial products less attractive to Chinese domestic investors. Meanwhile, on the other hand, the capital control policy implemented by the monetary authority has made it very difficult for financial institutions and investors to place their capital in various investment opportunities abroad. As a result, property become an easy target not only for conventional banks, but also for household investors, financial institutions, and shadow banking, even for local governments who are always required to increase their contribution to state revenues by means of land transfers to developer companies.
Not enough with that, the local government has finally participated in issuing various types of debt securities to obtain an abundance of capital and are directly involved in various construction projects so that sources of regional income are increased. Even though they offer yields below the profitability level, the majority of these bonds have to be purchased by banks (mostly SOEs), both local and national, with the guarantee of the central government with concessions that debt securities from local governments can be used to obtain loans from the Central Bank of China or the PBOC.
The impact on the property and real estate market is a drastic increase on the demand side. Inevitably, contractors and developers work hand in hand with conventional banking plus shadow banking to exploit the construction and property sectors. As a result, China’s national banking system, which is dominated by state-owned banks, suddenly entered the ranks of the world’s giant banks with very fat asset values, but little opportunity to capitalize on assets in the domestic financial market due to the financial repression policies implemented by the monetary authorities. Distorted low interest rates, the trauma of the capital market due to the Suprime Mortgage crisis in US, and the less liquid state debt market have proven to have narrowed investment opportunities to the construction and property sectors, which has been causing the property and housing bubble bigger on the one hand, but boosting its contribution on the Chinese GDP on the other hand, which is around 25-30 percent of GDP
As Hyman Minsky reminded, debt-based capitalism is capitalism that is supported by boom and bust dynamics. In the early days of the bubble, demand will increase, the value of the asset will increase consistently, until the upper limit where the price is no longer representative of the underlying asset, which then makes all market participants aware that the bubble is ready to burst. What happened today in China is not without precedent. Japan experienced it first in the 1990s, namely the corporate debt bubble and falling property values ​​that made Japan’s economic fortunes shrink by more than 1500 trillion yen and Japan’s aggressive economic growth suddenly stopped. However, the recession in Japan did not immediately become endemic at the regional, let alone global level, because as Richard Koo (2014) wrote, firstly, the market for products made by Japanese companies at the global level was not disrupted, in fact the prospects were getting bigger aka the business was still very promising. And secondly, because of that, companies could immediately adjust their balance sheets by maximizing profits on the one hand and reducing debt burdens on the other.
As a result, the Japanese financial market suddenly froze because the number of borrowers fell drastically, while banking liquidity continued to increase due to increasing installment payments and decreasing loans. The only way for Japan to avoid freezing its financial markets is to bombard the financial markets with sovereign bonds. This is the reason why Japan has a huge debt to domestic savers. Japan owes its debt to its people not because Japan lacks income, but because Japan must implement countercyclical policies to keep the real sector running. The state must use abundant (but unproductive) banking liquidity to build infrastructure and various social service facilities so that GDP does not decline negatively due to the freezing of financial markets. In other words, government debt securities are a transmission channel from banks to the real sector via the government’s countercyclical policies. Thus, banks can continue to lend funds to customers (the government) and get yields from the abundance of liquidity they have.
So, for China, which has a less liquid financial market, the question is what if the Evergrande’s default actually makes banks withdraw from providing risky loans based on property and housing projects which causes China’s financial markets to freeze too? Will China flood its financial markets with sovereign debt or government bond like Japan and United States? There is no sign of which direction China will move yet. Chinese banks have been willing to bet risks in the property sector because of guarantees and encouragement from the government and the China Communist Party (CCP). If the government and political party still want China’s national banking sector to penetrate and manipulate credit into the construction sector, then that is what will happen, aka the financial market will continue to move, of course in an increasingly fragile financial system. Even though Xi’s government has imposed strict restrictions on the property and construction sectors financing from the start, Xi still seems very cautious for two reasons. First, the role of construction in China’s economic growth is still large and second, there are still many party elites involved in determining the disbursement of bank credit to the construction sector (party’s elites vast interest).
However, there was a precedent that proves that in 2008, China did not follow the steps of developed countries such as United States, Japan, and the European Union which poured stimulus (tax money) into the financial system, but instead further undermined the policy of financial repression in order to strengthen banking penetration to investment sector, especially construction and property. It’s just that this policy is risky for China’s economic growth. China’s intention to rebalance its GDP structure could be disrupted. Allowing massive credit flows will make it difficult for the household consumption sector to grow because the level of public saving must be mediated by banks to return to investment, not consumption. And again China will be stuck in the status quo position of economic growth which is supported by investment and exports, not consumption. In other words, China or Xi Jinping’s administration should choose whether to continue with the style of “party pet capitalism” or Red Capitalism in financial system in which the party will intervene based on the political risks that will be experienced by the party or instead calculate economically and financially the continued risk of the property and hausing sector debt bubble crisis for the sustainability of China’s future economic growth? If China chooses the former, then future economic growth will be at stake. But if choosing the second one and reform the financial system, then the CCP must be willing to accept the diminution of its role in determining China’s economic movements, aka accept the full role of the market. Let’s see
