Forget the trade war. China already in crisis with failing companies and gutted banks

Once again, global investors are turning their worried eyes to China. And for good reason. Economic growth in the third quarter fell to 6.5%, the slowest pace since the depths of the global financial crisis in 2009. Car purchases fell last year for the first time in more than two decades. Apple’s warning in early January that iPhone sales in China were collapsing alerted the world to how a slowdown in the Middle Kingdom would lead to lower global growth and corporate profits. But locals figured that out some time ago. Even after a recent rally, the Shanghai stock market has still plunged more than a quarter from its 2018 peak. The outlook is no rosier. Tariffs on Chinese exports to the United States imposed by President Donald Trump are beginning to pinch the country’s factories. A steep and unexpected fall in imports in December showed just how much the economy is slowing down. This led Beijing to lower the volume of its bravado and negotiate with Washington to defuse the conflict.

A trade pact, if it materializes, can appease investors and perhaps even stimulate economic growth, at least temporarily. But that won’t end China’s woes. While the tariffs are a nuisance, the real problems lie deeper, rooted in China’s financial structure.

What goes largely unnoticed is that China is already in crisis. No, this is not the kind of cost-of-living crash the US experienced in 2008 or the startling and ferocious collapses the Asian Tiger economies experienced in 1997. Nonetheless, it is a crisis, with gutted banks, bankrupt businesses, and government bailouts. Since the Chinese call their model of state capitalism “socialism with Chinese characteristics,” let’s call it a “financial crisis with Chinese characteristics.”

This crisis is not just about the current slowdown in growth. It’s been going on for a while and it looks like it’s not going away any time soon. At first glance, the very idea that China is in crisis may seem ludicrous. Growth has slowed, but it remains relatively strong, assuming you believe the government figures. Banks do not descend into large-scale insolvency. While concern over the state of the economy has grown, leading Chinese buyers to pull back, the mood in China has not escalated into the gloom that usually accompanies financial turmoil. It is true that China may never experience the panicked fiasco that emanated from Wall Street in 2008. This financial crisis is not following the same course as most others. Rather than a sudden explosion that destroys banks and jobs, the Chinese version is prolonged, moving so slowly it can be hard to notice.

A few years ago, some China watchers predicted that the economy could slide into a 2008-like meltdown. All the warning signs of disaster were flashing bright red: a housing bubble, excess capacity in industries ranging from steel to solar panels, and most disturbing of all, an accumulation of debt of gargantuan proportions. Total debt relative to domestic output jumped to 253% in mid-2018, from just 140% ten years earlier, according to the Bank for International Settlements. No emerging economy since the 1990s has experienced such an expansion in debt and escaped some sort of financial calamity. China should defy history to dodge a debt disaster.

We watched and waited for the Lehman Brothers China moment, and then we waited for even more. It never happened. Some analysts have come to believe that this will never be the case – that indeed China is too big to fail. The Chinese government, the new argument goes, has so many levers of control — over banks, big business, and capital flows — that it can suppress the kind of crisis that a more liberal economy cannot prevent. This superpower emerged in 2015 after the bursting of a stock market bubble, fueled by unstable loans and bureaucratic incompetence. Money poured in from the country as the currency faltered. What would likely have brought other emerging markets down was just another day’s work for powerful Chinese mandarins. The government staged a stock bailout and clamped down on capital outflows. Crisis averted. This approach is representative of Beijing’s overall strategy in dealing with its debt problem. The government, obsessed with social stability, does not let the debt bomb explode. Lehman moments can be terrifying, but they are also purifying, an opportunity for the market to weed out bad things and make room for new ones. Beijing, by preventing this from happening, is allowing the waste to rot and fester, likely increasing the costs of the inevitable cleanup.

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