A theory on China

Looking at credit charts makes you a China bear, and here is the one that usually scares people*.

private credit to gdp4 A theory on China

It is a scary chart! Increases of private credit/GDP of this magnitude has generally meant trouble, EM or DM. An increase of 38.0% since the lows in November 2008 screams ‘crisis’, in fact, as it is hard to imagine that much credit expansion without over-leveraged balance sheets, non-productive investments, and a possible Minsky moment, by which one has to take on debt to cover interest rate expenditures [other credit charts of China are equally scary. Here are two from Goldmanhere is one with EMs ranked, as always data is different from database to database!]

So are we going that way? My bet is no.

I wasn’t always this chipper about China. In fact go back six months and I thought the above mentioned chart spelled ‘doom’. I don’t anymore, and I can explain why with two charts.

First, as anyone who have studied the Asian Crash of 1997-8 will know, what made it close to inevitable was the combination of an overvalued currency (pegged) and huge borrowings in non-local currency denominated debt. Here is what I consider the best paper on that. This left the Tigers with the impossibility of remaining on pegged exchange rates, but if they devalued their corporate and banking systems would collapse (and they did). Can this happen in China, which also does some currency management? No.

external debt1 A theory on China

While short-term external debt has risen in dollars, as a percentage of GDP it has not (red line). This means that it is a very different beast we’re dealing with, insofar as China does not have to decide on its exchange rate on the basis of its banking and corporate balance sheets. Credit is mostly Renminbi denominated. So far so good (and absolutely nothing new here.)

The second graph that has me re-thinking my view on China is the credit/deposit ratio.

credit deposits 3mma1 A theory on China

While credit has expanded enormously since 2008, so has deposits. Why?

My theory (and I’d be very interested in opposite views) is that China’s credit story is different because of its closed capital account. China’s capital account is closed, and has arguably not been opened much since 2008. Here for example is a paper, “[studying] the renminbi (RMB) covered interest differential – an indicator of the effectiveness of capital controls. It is found that the differential is not shrinking over time and, in fact, appears larger after the global financial crisis than before. That is, capital controls in China are still substantial and effective.

In other words This Time Is Different because credit has shown up as deposits elsewhere in the system. This is both good and bad. Good because China is still a, errr, relatively authoritarian country and if the Chinese government decide to pull the plug on credit expansion, the credit can be repaid with deposits elsewhere in the system. Simple bookkeeping and China controls all entries. Bad because, well, where is that money? Is it places like here? Is it with LGFVs, which have just said, “we have done stimulus,” and then just done nothing with the money except depositing them somewhere in the banking system? If that’s the case then credit expansion has probably meant less in real life, and more in debt statistics. 

The crucial thing in my mind is just the fact that, because one cannot easily move money out of China, deposits actually have to show up somewhere when credit is created. This makes it (i) a whole new credit expansion story, and (ii) much more manageable.

This has policy implications, most notably that China should not move too fast liberalising their capital account, at least not before they are done tackling their credit situation. While money has stayed in China so far, it is not so certain that it would if China opened up. If money started to move out in spades, we could move closer to a ‘classic’ credit binge as the liability sides of balance sheets would have to be borrowed elsewhere. Nobody wants that.

[Update: I should add, as George Magnus made me aware, this does not mean that I think China will do great going forward. Their credit expansion will require a tightening cycle, and a big one, and growth will slow. I just think they have way more tools in the box than most any other countries before.]

* This theory is not at all original and you can find this kind of thinking elsewhere. This is just my write-up. Graphs are mine, though. Also again: data differs wildly in China so you can disagree with charts.

  • mojomogoz

    Hello, I am very negative China just as it does not make sense to me and it is always too complicated to see why it is okay going forward (saying they have grown a lot, are now big and extrapolating to the future is bogus IMO). Here’s a negative take on what you say…

    The amount of credit, deposits and money is not very informative but we are always dazzled by big numbers like this. In a full on fiat like China that piggy backs on the $ fiat (as, whilst not fully open, it is very dependent on its interactions with the outside world) the amount of money like stuff and its proportions is not very informative about the future. The quality of this money like stuff is entirely dependent on the aggregate beliefs of Chinese on the future potential of their economy to be productive and create a decent life for them.

    I believe that this outlook is negative. At heart the problem is the system and politics. For the money stuff to be good the average person needs to believe in their future…that they can pursue it positively….believe this and near any amount of money imbalance or excess can be overcome (with some pain of course) If not then the fiat will collapse. Does anyone believe that China can actually believe that China can give people more freedom, consumption power and resolve money imbalance and associated financially unproductive investments? Its too complicated as a command control process so they are reliant on the system already being strong enough to deal with the stress…

    The only escape is a form of default and escape to a new money set-up. I believe that China’s only escape path is to link the RMB to gold (which it has a lot of both public and private) and produces a lot of. I am no gold bug but this is the route to escape a seriously negative cycle like any other imbalanced and bloated ‘immature’ economy under the $ world order. This is the only way to prevent domestic consumption collapsing.

    mojovision out

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  • AB

    The U.S. actually had money flowing to it from the rest of the world in 2008. That is better than having a closed capital account, yet there was still a crisis.

    Credit expansion usually ends up in deposit growth. After all, credit expansion is really just the bank agreeing to give the borrower a deposit today because they feel they can make a profit on it because there is some reason the borrower can pay it back. The question is whether the loan can be paid back and if not, how much equity is their to absorb losses.

    I agree that China should be able to manage this smoothly because they have complete control in theory. However, we have already seen some unthinkable things (bank runs) and very little has gone wrong yet. Second, if they are so omnipotent, then how in the hell did they let things get to this point?

  • Simon

    AB – yes, agreed, but my point was more that China sort of controls deposits, whereas in the US if you have deposits then the gov’t can’t touch them. If China really wants to socialise loses then they probably can.

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