posted January 11, 2016
China: Bubbles, Bubbles, Debt & Troubles–Chapter 6 from ‘Systemic Fragility in the Global Economy’

As preceding chapters have documented, the weakest links in the global economy today—the emerging markets (EMEs)—are locked in an economic tailspin, hammered by slowing global demand for their commodities, commodity and financial asset deflation, falling currency values, capital flight, slowing real investment, rising debt and import inflation, and general economic stagnation or recession. The EME downward spiral that began to initially emerge in 2013 is now accelerating two years later. At the same time the second and fourth largest regional economies in the world—Japan and Europe—have never really recovered from the 2008-09 global crash. Today in 2015, seven years after the 2008 global crash, their economies have still not recovered to pre-crash levels. Both Europe and Japan have continued to hover between repeated recessions and stagnant growth, at best. The US economy since 2009 has done only slightly better than Europe-Japan, growing at half the normal post-recession rate and collapsing on four different occasions for single quarters since 2011 to near-zero or negative GDP growth rates, in what is best described as a sub-normal ‘stop-go’ economic trajectory.

An exception to this general scenario characterizing the advanced economies (US, Europe, Japan),and now the emerging markets as well, was China—at least up to recently. For a brief period from 2009-through 2012 China’s economy boomed, growing at double digit GDP rates for much of the period. However, beginning in 2013—and concurrent with the slowing of global trade, the collapse of world oil prices and accelerating global currency wars—China’s rapid real growth has slowed significantly since 2013. That slowing continues to gain momentum in 2015.

China’s share of world exports has been under attack since 2013 by Japan’s, and then Europe’s, de facto currency devaluations resulting from their combined quantitative easing (QE) programs. Those QE programs have driven the Euro down by 23% against China’s currency, the Yuan-Renminbi, and the Yen by even a larger 30% since 2013. Those policies, along with the general slowdown in world trade due to additional factors, have slowed China’s exports, a centerpiece of its economic growth. The exports slowdown in turn has caused China’s manufacturing sector to contract consistently since 2014. By pegging its currency to the US dollar in June 2010, its exchange rate has risen by 10% to 30% against many of its Asian competitors since 2013, as the Yuan has risen in tandem with the rising US dollar.

The slowing in China’s exports and manufacturing sector has been accompanied since 2013 by a slowing in what was another major growth source in China during 2009-2012—infrastructure investment in industrial and commercial projects and residential real estate.

China’s Successful Fiscal Recovery Strategy: 2009-2012

Much of China’s infrastructure boom of 2009-2012 was the consequence of government direct investment, which rose to more than 45% of China total GDP. Local infrastructure and industrial expansion projects contributed to the boom as well. It was financed in large part by local and regional governments’ proceeds from local land sales and ‘hot’ money inflows from offshore shadow bankers and speculators. As millions of rural Chinese moved from the countryside to the cities to provide the labor force for the industrial, manufacturing, and infrastructure expansion, residential housing also boomed after 2009, financed from many of the same sources.

So China recovered rapidly after the 2008-09 global crash, while the advanced economies remained stagnant, slipped in and out of recessions, or struggled with a ‘stop-go’ trajectory.

That different recovery trajectory for China was due to China’s different policy choices. Unlike the advanced economies (AEs)—the US, UK, Europe and Japan—China’s immediate response to the global financial and economic crash of 2007-09 was not to rely almost exclusively on monetary policies—i.e. central bank liquidity injections—in order to bail out the banks and hope thereby to generate economic growth. Unlike the AEs, China’s financial institutions at the time were mostly nationalized government banks and were not in trouble from collapsing financial asset prices caused by over-lending to speculators and shadow bankers, as was the case for the AEs. At least not in 2008-09. Moreover, there were no shadow banks to speak of in China in 2009 to drag down the traditional banking system. That would change dramatically over the next half decade, but was not yet a factor in 2009.

But for the moment, in 2009, China’s recovery policy focused on fiscal measures, at the heart of which was a massive direct government spending program aimed at rapidly expanding real asset investment and projects in industrial, commercial, infrastructure, housing and manufacturing. China’s banking system basically provided the money supply to fund the real investment boom. They had no great financial asset losses on their balance sheets that would discourage lending, as in the AEs. Moreover, since they nationalized public banks, they would lend when the government told them to do so, and to whomever the government said they should.

This fundamental policy mix difference between China and the AEs was to a great extent responsible for the different recovery outcomes. China’s financial institutions were not in insolvent due to financial asset deflation and would finance the government’s program of boosting real investment from direct government spending on real investment (infrastructure, buildings, manufacturing and industrial expansion, housing, equipment, etc.).

AE’s Failed Monetary Recovery Strategy: 2009-2015

China’s fiscal direct government real investment spending for recovery approach contrasted sharply with the AEs, where the strategy for recovery has without exception focused since 2009 primarily on monetary policies by AE central banks. It has been a ‘bail out the banks first’ strategy, in the hope banks would then lend to stimulate real asset investment. That would lead, according to monetary theory, to real job creation and wage income growth to keep the growth momentum going. It would then raise real goods prices as well as stock prices, to further fuel and stimulate consumption, to drive private investment further, and so on. But the AE money injection by central banks to bail out the private banks first strategy would prove a total failure. The banks would not lend to small and medium businesses for real investment expansion.

Lending would target multinational corporations who would invest abroad or shadow banks that would in turn redirect the money flows to financial asset speculation. Stock and other financial asset prices would inflate but do little for the real economy. Lack of real investment in the AEs would keep job creation slow and in low paying service industries. Wage incomes would not grow, and therefore neither would real investment. Real goods prices would slowly disinflation and drift toward deflation, thus discouraging real investment and consumption still further. Employers would attack wages and benefits of workers unable to defend due to the massive unemployment and slow recovery. Profits from cost reduction, not sales revenue, would become the new norm. Near zero interest rates for banks, shadow banks, and speculators would have an additional perverse effect: corporations would issue record new corporate bond debt. That debt, profits from cost cutting, and the historic tax cuts benefitting businesses and investors that accompanied the monetary policies, would add still more income to businesses. But instead of directing their excess net income to real investment, it would end up redistributed to investors as record stock buyback and dividend payouts, redirected to financial asset markets where prices were booming, or remain hoarded on business balance sheets. All these coinciding factors resulted in AEs recovering at a tepid pace (US) or else stagnating long term and repeatedly slipping in and out of recessions (Japan, Europe) after 2009. The AE strategy of ‘monetary policies first’—i.e. as recovery policies primarily targeting bankers, investors and multinational corporations first—was thus a failure. This contrasted sharply with China’s ‘fiscal policy first’ approach—i.e. a massive government direct investment and manufacturing for exports strategy—which proved quite successful in generating recovery, at least initially for the 2009-2012 period.

But the two main sectors responsible for China’s double digit growth between 2009-2012, i.e. manufacturing & exports and direct government investment, have both cooled significantly since 2013.

They worked amazingly well for several years, 2009-2012, pulling up the emerging markets along with China as China demand for their commodities and semi-finished goods surged, and mitigating the effects of the 2007-09 crash on the immediate post-2009 global economy. There is little doubt that China’s policies and growth post 2009 played the key role in preventing and even weaker global recovery than occurred from 2009-2012. Without China’s fiscal-direct investment strategy, it is quite likely the entire global economy would have experienced another global contraction circa 2011-12, but it didn’t. Instead it stumbled along, with Europe-Japan in and out of recessions, the US growing at sub-historical post-recession levels, while China and emerging markets in tandem recovered.

Yet even China’s successful 200-2012 strategy began to fade by 2013, and with it faded as well the emerging markets pulled along with it 2009-2012. China’s manufacturing + exports + government direct investment strategy began to slowly unravel in 2013. And that unraveling has gained steam in 2015.

The question is why did China start to slow after 2012 in terms of real economic growth? What has that growth slowdown had to do with China’s shift in policies after 2012? With the massive liquidity and debt generated in China post-2009? And with the shadow bankers and AE finance capital inflows and the financial asset bubbles created after 2012—including the most recent China stock bubble unwind?

China’s Liquidity Explosion

Concurrent with its massive fiscal stimulus of 2009, estimated at around 15% of its GDP at the time, China opened the floodgates to money injection into its economy. At first that liquidity came from its central bank, the PBOC, and other government banks to finance industry and infrastructure expansion. To an extent this was necessary. If the record fiscal stimulus focusing on direct investment, expansion of its manufacturing and industrial production base, and buildup of supporting infrastructure was to happen successfully, a significant increase in its monetary system was necessary. Without a corresponding monetary increase, the stimulus would not result in the double digit real GDP growth that it did. But even this liquidity injection from official banking sources was in excess of what was necessary to finance real asset investment in manufacturing, mining, structures, and supporting infrastructure.

Representing just part of this official total liquidity injection, China’s M2 money supply increased by about 15 trillion Yuan, from 25 to 40 trillion, during its prior boom period, 2000 to 2008. Starting in 2009, from a M2 level of about 40 trillion, however, it doubled to approximately 80 trillion by 2012. In 2013 the money floodgates would open still further, with M2 rising to 135 trillion by mid-year 2015—a gain of 55 trillion in just a little over two years!

In dollar terms, at the 2010 exchange rate of the Yuan fixed at 6.2 to the dollar from 2010 to mid-2015, liquidity as M2 tripled, from roughly $6.5 trillion in 2009 to $19.5 trillion. That acceleration has continued, with M2 rising another $2.5 trillion in just the last nine months from October 2014 through July 2015. That’s money and liquidity growing twice as fast as the growth in China real GDP.

Even when defined narrowly, as M2 money supply, this magnitude of liquidity injection was excessive. Perhaps the injection between 2010 and 2012—from $6.5 to $13 trillion—was necessary to ensure the growth of real production and GDP. But the further acceleration of money into the system that began in late 2012-2013 would only spill over increasingly to finance more financial asset investment instead of real asset investment in infrastructure, manufacturing, and industrial production. Furthermore, around 2012, in addition to the official excessive M2 liquidity, overall liquidity was boosted still further by foreign money capital inflows that China not only welcomed but facilitated. Foreign direct investment by AE based banks and multinational corporations provided part of this. But another source was the rise and expansion of shadow banks and speculators, both global offshore as well as domestic China shadow banks.

Prior to 2009 there were virtually no shadow banks in China. As a result of a series of reforms opening up China’s financial system after 2010 to global finance capital, by 2014 shadow banks would provide 30% of all the accumulated debt in China from all sources—governments, corporations, banks. With the rise of shadow banks, ‘inside credit’ would add still further to the ‘money credit’ forms of liquidity, supplementing further the official M2 and money capital inflow forms of liquidity.
Perhaps the most important point to be made about China’s liquidity explosion is that, as liquidity has surged from various sources—official and shadow—it has not gone into real asset investment at a similar rate. As liquidity accelerated from $6.5 trillion to $22 trillion—more than doubling as a percent of China GDP—China real asset investing has continued to slow as a percent of GDP. As latest data for August 2015 now show, according to Thomson Reuters Datastream Research, China’s fixed asset investment as a percent of GDP has declined from 22% at the end of 2011 to only 11% at mid-year 2015. Industrial production has similarly fallen by half.

So where has the massive liquidity explosion since 2009, accelerating after 2012, gone if not to real asset investment, is the next big question? That amount of liquidity is created for some purpose. It was not created to sit around on bank balance sheets. The answer is it went into financial asset investing instead of real asset investments, or else was sent offshore for other purposes. But in the case of China, mostly the former during the period in question.

A central theme of this book is that the massive, excess liquidity being generated globally in recent decades is getting redirected largely toward financial asset investment and speculation. It is loaned out by banks and shadow banks to other financial institutions and financial investors, often for the purpose of speculation in financial instruments of various kinds, both traditional (equities, bonds, foreign exchange, etc.) as well as newly created (futures, options, derivatives of all kinds, etc.). That massive liquidity surge is then leveraged as debt increasingly in financial asset markets. The greater profitability it produces in financial investing in turn redirects investment capital out of real asset investing, which then slows. That slowing leads to goods deflation, as financial asset investing leads to financial asset inflation.

The Inevitable Debt Crisis

The primary indicator of excess liquidity and financial asset investment and speculation is debt. Debt—i.e. credit extended by lenders—is the mediating element between liquidity and financial asset investing. Excess liquidity is necessary for the availability of excess credit to be loaned out as debt. Debt and its leveraging is the stuff of financial asset over-investment and financial speculation that eventually leads to financial asset bubbles, instability events, and periodic asset bubble crashes. And when those crashes are of sufficient scope and magnitude, an economy-wide—or even global-wide—financial crisis results.

In parallel with China’s exploding liquidity, its total debt has also nearly quadrupled from 2007 to mid-2015. According to a recent 2015 study by McKinsey &Company, the global business research and consulting firm, China’s total debt rose from $7.4 trillion in 2007 to $28.4 trillion through mid-2014. That total represents 282% of China’s GDP at mid-year 2014, among he highest in the world.

The problem with China’s debt, however, is not just its magnitude; nor even its rate of increase. Both are impressive enough. The even greater problem is its composition, by which is meant the proportion of the debt that is private business associated debt. China national government debt is not particularly severe as countries go. But private businesses are, and especially older basic industrial companies including the many that are government enterprises.

By far the largest part of the $28.2 trillion in outstanding debt in China, as of mid-2014, was debt held by non-financial businesses. At 125% of China’s $9.4 trillion 2014 GDP, that’s about $11.9 trillion. Add another $6.2 trillion for financial institutions’ debt. That’s more than $18 of the $28 trillion, roughly two-thirds of its total debt as business-financial. Corporate debt is roughly $16 trillion in 2015 of that.

Local government debt is another problem of major dimensions in China, and should be viewed in part as wrapped up with private sector business debt. Over 10,000 local government entities in China set up ‘off balance sheet’ property investment vehicles called LGFVs, local government financing vehicles. Borrowing heavily from shadow banks, they then over-invested in local property markets. LGFV debt was approximately 18% of China GDP in 2008, or $634 billion. According to a China government survey done at the end of 2013, it rose to about $3 trillion for that year. Projections are it will rise further, to 45% of China GDP in 2015, or $4.6 trillion.

Another approximate $3.8 trillion represents household debt in China as of 2014, according to the McKinsey study, about half of which is household mortgage debt. That $3.8 trillion rose from $1.9 trillion in 2010. But the amount today may be actually higher, since the $3.8 trillion McKinsey estimate predates the bubble in China stock markets that began growing rapidly after the 2014 data by the McKinsey study. As the stock bubble grew, ‘margin debt’ lending by brokers to retail stock market investors, i.e. households who constitute 85% of China’s stock buyers, rose by as much as another $.85 trillion in just one year, from July 2014 to June 2015, according to some estimates.

Extrapolating from the mid-2014 figures, China’s total debt therefore likely will exceed $30 trillion in 2015—just about three times China’s nominal annual GDP. About $26.5 trillion is private sector debt or various kinds and related off balance sheet local government, LGFV, real estate debt. The rest is general government debt of about $4 trillion. That private sector + LGFV debt represents a $20 trillion increase in private sector debt alone since the 2008 crash—an unprecedented, historic rise in debt in only five years or so.

That debt would not have been possible without the massive liquidity injection by banks, foreign money capital in-flows, shadow bank source funding, and forms of ‘inside credit’ like margin debt, most of the latter of which is reportedly provided by shadow banks as well. And debt has consequences, especially when of that magnitude and composition. It becomes particularly important when the real economy is slowing or declining and when deflation is a factor, both in financial securities prices as well as in real goods and services prices.

China’s Shadow Banks

Shadow banks as a major source of credit and debt in China are a phenomenon of the post-2009 period. A study by JP Morgan Bank in 2012 estimated that the shadow banking sector in China grew from only several hundred billions of dollars in total assets under management in 2008, to more than $6 trillion by the end of 2012. By 2013 the total had risen to more than $8 trillion, according to the research arm of Japan’s Nomura Securities company. Shadow bank total assets rose another14 percent and $1 trillion in 2014—to more than $9 trillion. A study by McKinsey research in 2014 determined shadow banks accounted for no less than 30% of China total debt.

At the center of shadow bank instability has been the so-called ‘Investment Trusts’. According to McKinsey Research, Investment Trusts today account for between $1.6-$2.0 trillion (of the roughly $9 trillion) of all shadow bank assets in China. Trusts’ assets grew five-fold between 2010 and 2013. Approximately 26 percent of the Trusts provided credit (and therefore generate debt) to local governments for infrastructure spending, another 29 percent to industrial and commercial enterprises, another 20 percent to real estate and financial institutions, and other 11 percent to investors in stock and bond markets. Local government debt in particular has risen by more than 70 percent in China since 2010. In other words, shadow bank credit has gone mostly to those sectors of China’s economy where debt has accelerated fastest and produced financial bubbles.

That rapid growth in shadow banking was the direct consequence of China leadership deciding to open China’s economic doors to foreign money capital big time around 2010. Whereas in the US and UK, and later Japan and Europe, the main engines of liquidity creation in the wake of the 2008-09 global crash were zero interest rates and quantitative easing, in China the liquidity injection was no less impressive in terms of magnitudes but the forms were more traditional central bank measures—traditional bond buying, lowering of reserve requirements, etc.— to which was added the money inflows from the advanced economies as well.

As later chapters will elaborate, the advanced economies (AEs) starting in 2008 pumped liquidity amounting to around $25-$30 trillion into their economies in the form of central bank engineered zero interest rates and QE. A significant part of this AE liquidity injection flowed out of the advanced economies and into emerging markets after 2009, including China. So China’s massive liquidity was similar in content but different in form from the US, UK, Europe and Japan which relied heavily on zero rates and QE . But shadow banks in both cases—the AEs and China—play significant roles in transmitting that massive liquidity into investors and financial markets in the form of leveraged debt. A difference was which markets. In the AEs, the liquidity and debt was directed into stock and bond markets and derivatives of various kinds.

In the China case, it initially flowed into local government financed housing, land speculation, and commercial and industrial real estate. Some also went into what are called ‘asset management products’, or WMPs. And some into ‘trust’ loans that provided refinancing funding for state owned enterprises (SOEs) that were unable to qualify for better rates from traditional bank loans. Only beginning in 2014 did the liquidity-debt flow into China equity markets. So just as shadow banks played a key role in destabilizing the financial systems in the AEs up to 2008-09, their destabilizing effect was delayed in the case of China to 2010 and beyond. And there is no way that a $9 trillion money injection in just four years could fail to destabilize and create financial asset bubbles. An important question is what role did these bubbles—in local infrastructure and housing, in WMPs, in propping up failing SOEs, and then in equity markets—play in contributing to China’s concurrent real economy slowdown? Was it merely coincidental that the slowing of China’s real economy began in earnest, circa 2012-13, as its financial asset bubbles began to grow and multiply?

The main financial vehicles closely associated with China shadow bank lending include ‘trust accounts’ offered by Trust institutions that invest on behalf of high end investors, both in China and abroad. Another is the ‘wealth management products’, the WMPs, which are financial assets of various kinds sold to mid to high end investors—many of whom got rich initially from the local land, real estate, and local government infrastructure bubble and moved on, taking profits, and reinvesting in the WMPs. Another is ‘entrusted loans’, in which financing is provided for companies to lend to each other, inter-company, including many state owned enterprises, or SOEs. Many of the old-line industrial companies have loaded up on ‘entrusted loans’ in particular, which amount to China’s version of AE ‘junk bond’ corporate financing.

Shadow banks can be defined either by the financial instruments or markets, as per above, or In terms of their institutional forms. Shadow banks in China include traditional forms like hedge funds and private equity firms. Reportedly there were 4000 Chinese hedge funds and private equity firms launched in the first half of 2015 alone, no doubt spawned by the then escalating bubble in China stock markets. But China’s shadow banking system includes many new forms of shadow banking that have recently arisen in the AEs, like peer to peer lending companies, finance companies, etc., as well as forms relatively more prevalent in China, like microcredit companies. However, ‘Trust’ companies are a particularly important form of shadow bank in China.

According to McKinsey Research, Investment Trusts today account for between $1.6-$2.0 trillion (of the roughly $9 trillion) of all shadow bank assets in China. Trusts’ assets grew five-fold between 2010 and 2013. Approximately 26 percent of the Trusts provided credit (and therefore generate debt) to local governments for infrastructure spending, another 29 percent to industrial and commercial enterprises, another 20 percent to real estate and financial institutions, and other 11 percent to investors in stock and bond markets. Local government debt in particular has risen by more than 70 percent in China since 2010.

Trusts in China have served as the conduit for loans to local governments that in turn fed the real estate bubble. They also function as intermediaries between companies and wealthy investors to raise funds for many non-financial in desperate need of credit to remain in operation. Trusts are therefore a kind of ‘junk bond’ agent for corporations unable to obtain credit on normal banking terms but willing to pay a higher interest rate for credit in order to buy time to remain in business. And they also serve as aggregators of retail investors money capital directing their investments into stocks and other derivative financial instruments.

China’s Triple Bubble Machine

Thus far China has faced three financial bubbles since 2013 which are in various stages of collapse and therefore financial asset deflation. The first is the local government property and infrastructure bubble. The second, the corporate junk bond and refinancing bubble involving older industrial companies and SOEs. In both cases, China’s central government has been intervening to prevent a rapid collapse of the bubbles and financial assets, trying to slow them down, prevent contagion, and extend the period of unwinding. The third bubble, in its two major stock markets, Shanghai and Schenzhen, began to form late summer 2014. In a year’s time, the stock markets surged 120%, clearly a bubble, and then began collapsing in June 2015. Since June 2015 the central government has been desperately intervening on an unprecedented scale to prevent the stock collapse from gaining momentum, just as it has been since 2013 to contain the deflating of the previous housing-local infrastructure bubbles that continue to be a problem.

The first bubble, in local real estate property, was driven by local governments, their off balance sheet financing vehicles, the 10,000 or so LGFV funds, and shadow bank financing (domestic and foreign) providing the liquidity and debt that fueled financial speculation in real estate from 2011 to 2014. Real estate prices rose to record levels in 2013. That bubble finally began to deflate in 2013-14. The collapse of the over-investing in housing and local infrastructure meant that a major stimulus to China’s real economy was thus removed after 2013, or at least significantly reduced. It has been estimated that housing constitutes 10% of China’s GDP. So it’s collapse and retreat has taken away a major underpinning to China’s real economy. In other words, the collapse of financial asset prices, and their subsequent deflation, has direct effects on a real economy GDP.

The effect of the housing bubble as it expanded also impacted the real economy. China’s central government intervened several times to slow the housing bubble before 2014 but without much effect. Each time it intervened by raising interest rates it simultaneously slowed the real economy as well as the real estate sector. As this happened, China then lowered rates again and introduced fiscal mini-stimulus packages to get the real economy back on track. This in turn restarted the real estate bubble. This see-saw policy to try to tame the shadow banks and keep the economy growing at the same time happened several times before 2014. Thereafter, China adopted a more targeted approach to attacking its shadow banks, speculators, and their local government official allies feeding the bubble in local real estate and infrastructure. By 2014 real estate prices began to moderate. However, the speculators and the profits they made from the real estate bubble then moved on—to investing and speculating in the new financial asset opportunity associated with the WMPs, the ‘asset management fund’ securities.

The WMPs fueled the continuing bubble in what other economists in the past have called ‘ponzi’ finance, providing high interest loans from ‘trust accounts’ managed by Trusts and other shadow banks to enterprises becoming increasingly fragile. A parallel development in the boom in ‘high yield’ (junk) bonds was occurring simultaneously in the US and AEs. But as China’s real economy has continued to slow, fragile enterprises are increasingly unable to repay even these high cost WMP (junk) loans. On several occasions since 2014, the China central government has had to bail them out and absorb the losses. As China’s real economy slows more rapidly in 2015-16, it is questionable whether the central government can continue to bail out ever-wider potential debt payment defaults by these enterprises. Should it not do so, the market value of the WMPs will also deflate rapidly, just as housing has.

China’s third clear financial bubble has been the acceleration in its stock markets. China’s stock bubble of 2014-15 and its current collapse has several roots. First, it is the outcome of a conscious shift in policy by China made in 2014, to redirect the massive liquidity and deb that had been destabilizing its internal financial system—i.e. in housing, local government investment, real estate, and desperation financing of failing enterprises—into the stock markets. In 2013 a major policy ‘turn’ was decided by China leadership, of which the encouragement by the central government of the stock bubble was one element.

That major policy turn was to move toward encouraging more private investment and private consumption as major drivers of the economy, and to therefore shift away from the prior heavy reliance on direct central government investment and export sales, as was the previous case. That direct investment plus exports growth strategy began to lose momentum by 2013. Future growth based on exports was about to become more difficult, as both Japan and Europe had entered double dip recessions and US growth showed no signs of accelerating. Japan introduced its QE program, designed to drive down its currency exchange rate and make it more competitive in export markets. Europe introduced its own liquidity version, a kind of ‘pre-QE’ called Long Term Refinancing Option (LTRO), with the same objective in mind. The US signaled it would raise interest rates which meant emerging markets would be severely economically impacted at some point and thus reduce their demand for China exports as well. Global trade showed signs of initially slowing. An export-driven strategy was therefore less reliable, China apparently decided. At the same time, it was also growing clear there were limits to China’s government direct investment stimulus to growth. China apparently therefore decided at an important Communist Party conference in 2013 to ‘restructure’ by shifting to more private sector driven growth. That is, to encouraging more private business investment and private consumption. Boosting the stock market was viewed therefore as the solution to enable the transition to more private investment and consumption.

Stimulating the rise of stock prices was also considered to have a double beneficial effect. It would divert money capital out of the over-heated local housing and real estate-infrastructure market, which it did. Higher stock prices would in theory also provide an important funding source for SOEs and other non-financial enterprises in trouble. If their stock price rose, it would reduce their need to borrow more debt at higher rates with more stringent terms of repayment. Debt would be exchanged for equity, reducing their financial fragility. Higher stock prices also meant, in theory at least, that enterprises in general would realize higher capital gain income, from which they could and would invest in expansion. Real asset investment would result, providing jobs and income for more workers and thus more private consumption.. Rising stock prices would also have a positive ‘wealth effect’ on high end retail investors in the market, and also promote more private consumption. Higher stock prices would assist in the strategic shift to more private sector investment and consumption as the key drivers of economic growth.

It appeared a stock market boom was therefore the answer to several strategic challenges: first, the stock boom enabled plans to restructure toward more private investment and consumption; second, it addressed the need to tame the shadow banks and the bubbles they were creating by redirecting money flows into stocks; third, the new investment and consumption would get the China economy back on a faster GDP growth path—a path that was clearly slowing as the slowdown in global trade promised to negate an export driven growth strategy.

So China’s government undertook a series of measures in 2014 to rapidly expand stock values. However, the timing was inopportune. Emerging markets were already under growing pressure and slowing. Their income from commodities exports was declining. The domestic real economies of Japan and Europe economies were not recovering as planned and their demand for China exports was not rising sufficiently. Then, in June 2014, the collapse of global oil prices commenced. To boost the markets, China’s central bank, the Peoples Bank of China (PBOC) began lowering interest rates in late 2014, the first of what would be five consecutive cuts. It further injected liquidity into the markets by lowering reserve requirements of banks to get them to lend even more. In mid-November 2014 it introduce several changes to open the economy and markets further to foreign money capital. And, as a clear signal as to where the additional liquidity should flow, it introduced measures to encourage even more aggressive buying of stocks on margin. A flood of ‘retail’ investors came into the market in early 2015 as a result. The margin buying by retail investors was especially getting out of hand. Measures were introduced to slow the trend, to no avail.

After rising 120% in a year, the damn broke in China’s two major equity markets in June 2015. Stock prices crashed by 32% in just two weeks on the Shanghai exchange and by 40% on the Schenzen. Just as it had intervened to help create the stock boom, China policy makers quickly intervened again, this time to try to quell the collapse. Various measures were introduced to prevent selling of stocks, including suspension of trading at one point of nearly three-fourths of all the listed companies on the exchanges. Short selling of stocks was banned. Major shareholders (more than 5% of total shares) were banned from selling. Other measures were initiated to get buyers back into the market to buy stocks. SOEs were required to buy their stock, even if it meant raising more debt. State investment funds were ordered to buy. The PBOC provided more liquidity to brokerages to buy stock. And in another 180 degree turnaround, margin buying terms were again loosened and encouraged. In other words, a return to massive liquidity injections to try to resolve the problem that excess liquidity had helped create in the first place. That additional liquidity would translate into yet more financial debt earmarked for financial asset investment and speculation. The long run problem—too much liquidity and therefore too much leveraged debt feeding financial markets—became the short run solution. But the solution would again add to the long run problem.

China’s strategic policy shift in 2013—away from direct government investment, manufacturing and export driven growth, and monetary policy in service to that real investment and exports approach—amounts in retrospect to a strategy for recovery not unlike that failed approach adopted by the advanced economies from the beginning of the crash of 2008-09. That AE strategy relied primarily on monetary measures that accelerated liquidity in the system. Fiscal policy was token at best (or negative in Europe and Japan), assuming forms of austerity. AE central banks believed that massive money injections would flow into real asset investment as banks resumed lending to non-financial enterprises. Real investment would bring back jobs, and therefore income and consumption. Wealth effects from rising financial asset values would add to consumption. More consumption would stimulate more real investment in turn. But nothing like that happened. The liquidity flowed into financial asset investing and financial markets, boosting stocks and bonds but little else.

China differed from the AEs in the initial period of 2008-10. Fiscal policy came first, and monetary policy and liquidity was primarily accommodative. But that began to reverse as a result of a series of measures, first in 2010 and then in 2013. The liquidity and debt explosions in China thus came later, well after the AEs, and in different forms. The eventual financial asset bubbles occurred in different markets as well. But China’s experience, especially after 2013, shows the same problems with AE recovery strategies that focus on liquidity injection that ultimately lead to excessive debt leveraging that tends to flow into financial asset markets. They lead to financial asset bubbles, to the need for still more liquidity to prop up the financial asset deflation that inevitably occurs when bubbles unwind and prior debt cannot be repaid. Excess liquidity leads to debt leads to more liquidity and yet more debt. It is a vicious circle leading to financial fragility and instability. A vortex. A whirlpool that sucks up money capital that might otherwise have gone into real investment, to create jobs, real incomes, consumption and finally more real investment and economic growth. But instead goes into the black hole of financial asset speculation, to disappear forever at some point as financial asset deflation sets in and drags the real economy with it.

China’s Real Economic Slowdown: 2013-2015

The experience of China since 2009 shows that the real investment and financial asset investment are causally related in important ways—contrary to mainstream economic theory that tends to view them as determined by their own more or less independent set of forces.

As financial bubbles grew in China over the period in question, accelerating in intensity, number and form, China’s real economy has continued to slow in terms of its GDP growth rates. From double digit annual growth rates in the immediate post-2008 period, China’s latest growth is officially 7%. However, almost no independent sources believe that figure is accurate. The most optimistic alternative sources estimate its latest growth at 6.2%, and others range in the 4.5% to 5/5% range. At the very low end, some suggest growth is occurring at a mere 3.1% annual rate.

Whatever the GDP estimate, which are unreliable for many reasons, other key indicators in China strongly suggest the real economy is growing much slower than official forecasts for 2015. China industrial production hit a 15 month low in July 2015, growth rates falling by half in the last eighteen months. A more accurate indicator of overall economic growth compared to GDP, electricity consumption, has declined from a 10% annual growth rate to 0% by mid-year 2015. Railway freight traffic, new home construction, and imports have all turned negative since mid-2014, a year ago. Auto sales have fallen nearly -7% for the past year. The manufacturing sector in China has consistently contracted over the past year month by month. And when measured in terms of gross fixed capital formation, real asset investment in China is slowing rapidly. In 2009 its annual rate of growth was 25%. That fell to 10% in 2013 and only 6.6% in 2014. 2015 figures will no doubt record less.

In short, various indicators of China’s real economy show it is not only slowing, but is doing so rapidly. For reasons explained in prior chapters, GDP as the key indicator of growth tends to overstate that growth, and is becoming increasingly inaccurate as governments redefine and manipulate the GDP statistic to bolster growth figures.

China Global Contagion Effects

If China’s shift to relying more on monetary policies creating excess liquidity, debt, and financial bubbles has had a negative effect on China’s real domestic growth, then China’s slowing real growth is clearly having a negative effect in turn on the global economy.

China’s declining demand for commodity imports is exacerbating an emerging markets slowdown also in progress and accelerating. Slowing China demand for commodities and semi-finished goods is having a significant impact on imports from Latin American countries like Peru, Chile, Venezuela and Brazil. While not an emerging market, Australia provides natural resources in large volumes to China, and its economy is slowing as China slows as well. Many Asian and South Asian economies that are tightly integrated with China are slowing in tandem with China. China’s slowing economy is also having an impact on China demand for imports from Europe and Japan, thus offsetting those countries recent QE policies attempting to devalue their currencies to boost their exports and stagnating or declining growth rates. Despite massive QE money injections and currency exchange rate declines for the Yen and Euro, their exports to China have not risen appreciably.

China’s slowing has resulted in a shift in its own currency strategy that is further impacting other Asian economies. In a major policy shift, China began to allow its currency to slowly drift lower this past August 2015, in what will no doubt be a long term trend. That is adding more impetus to Asian currency declines and the emerging global currency war reignited by Japan and Europe in recent months . As Asian emerging markets’ currencies plummet in reaction to China’s, further economic instabilities are growing in their own economies.

China’s slowdown has also exacerbated the global oil price deflation trend. As China demand for oil declines, oil producing economies compete more intensely by lowering prices in order to encourage sales and revenues elsewhere from other buyers. Also on the financial side, China’s current stock market collapse is clearly spilling over to other equity markets worldwide. The collapse will almost certainly mean less real investment, and therefore less consumption, in China, further reducing China demand for imports and thus other economies. And if China’s market collapse spills over to other AEs, then a similar negative effect on investment and consumption in those other economies will almost certainly occur as well. Declining stock prices create a negative ‘wealth effect’ on consumers who reduce spending in turn; equity deflation also discourages real investment as non-financial companies move to the economic sidelines and conserve cash.

Only in those emerging market economies where their currencies are collapsing is inflation on the rise. But that is only because of their falling currency exchange rates make import prices rise. Elsewhere in the AEs, and wherever currency exchange rates change moderately, goods deflation has become a real problem. Like the AEs, China’s currency has been one of the most stable for more than a decade. Because its currency, like the major AEs, remains more or less stable there is little import inflation occurring in China. Not so for goods deflation, however.

The slowing of real investment in China is steadily translating into deflation for real goods and services as well. China’s producer prices have fallen for 40 consecutive months, by nearly -6% in the past year. Import prices are down by 10% year to date. And its consumer price index has declined from a 2% annual rate a year ago to a mere 0.18% most recently. In other words, with declining real investment comes real goods deflation. Conversely, with rising financial asset investment, comes financial asset inflation. The parallels are not accidental.

Goods deflation is a strong indicator of the failure of monetary policies relying heavily on liquidity injections as the primary recovery tool. Conversely, the same monetary tools generate excessive financial asset inflation. Could it be therefore that the one (financial asset inflation) is related causally to the other (goods deflation)? Or, to say the same, could it be that the determinants of both forms of investment—financial asset and real asset investment—might therefore somehow be causally related?

The overall impact on the global economy of a China, responsible for 15% of the world’s GDP, that is slowing in real terms, and simultaneously struggling to contain financial asset bubbles that are multiplying in number and growing in magnitude, cannot be underestimated.

China & Global Systemic Fragility

The trends and relationships in China—between excess liquidity and accelerating debt, real v. financial investment, real investment and goods deflation, financial asset speculation and financial price bubbles, etc.—is not unlike what is happening globally in Europe, Japan, and even the US. Financial bubbles and asset inflation have been growing, as real investment and economies have been trending down long term and drifting steadily toward deflation. As liquidity, debt and financial asset investing rises, creating financial asset inflation and bubbles, real investment slows or declines, depressing earned income growth by households in turn and resulting in further real investment slowing. The eventual outcome is deflation in goods and services prices, as financial asset bubbles continue to grow.

Occurring unevenly and at different paces, these trends are happening across the global economy today. In no place or economy is the example of these processes clearer than in China today—i.e. slowing real growth v. frothing financial bubbles, financial investing and speculation v. real investment, financial asset inflation v. the drift toward goods deflation. Among all the major economies of the world, the trends and processes are at their most developed stage in China. China is the instability canary in the global economic coalmine—both real and financial. China’s economy today is a clear indication that something has fundamentally changed in the global capitalist economy in the 21st century—something not very well understood yet by mainstream economists; and even less so by central bankers and government policy makers.

The chapters that follow will therefore address the very same trends raising the fundamental questions—how are financial asset and real asset investing related? How does each determine the other? Which relationship and causal determination is perhaps stronger in today’s world of 21st century global capitalism? What are the implications for Systemic Fragility and instability for the global economy in the months and years immediately ahead? In Part Two that follows, each of the nine key variables that are fundamental to rising Systemic Fragility in the global economy are examined. Part Three then considers why contemporary economic analyses have failed to understand the key relationships between these 9 variables that lead to Systemic Fragility. The final Part Four provides this writer’s explanation and theory how the variables produce Systemic Fragility in the global economy today, and how that is leading to more instability and an eventual crisis worse than that experienced recently in 2008-09.

NOTE: For a description of the current condition of the rest of the global economy at year end 2015, the 9 basic causes of rising fragility and instability globally, why economists keep getting it wrong, and the author’s own theory, purchase the book, ‘Systemic Fragility in the Global Economy’ from this website at discount using Paypal or go to Click on the book jacket icon for ordering.

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