Trade War or Not, China Risks a 'Minsky Moment'
The transformation of China’s economy, both in terms of GDP growth rate and poverty reduction since it started its transition to the market system in the late 1970s, has arguably been the biggest macroeconomic event of the past half-century. The model that has characterized the country’s high output growth rates has followed in the footsteps of the Asian “tigers": first, its high growth rates of capital accumulation, driven by high investment-output ratios; second, a marked outward orientation through export-led growth policies; and third, the pursuit of industrialization (in particular the production and export of manufacturing goods), a key ingredient for fast growth and development. By almost every metric, China has advanced from economic backwater to the world’s second-largest GDP (and by some measures, is now the largest economy).
But in spite of signs of renewed economic activity in March, the country’s debt build-up has provoked increasing concern amongst Beijing’s policy makers, as it points to an underlying long-term financial fragility, particularly if trade war pressures intensify. Just last October during the Communist Party Plenary, Zhou Xiaochuan, then head of the country’s central bank, warned of a “Minsky moment":
“When there are too many pro-cyclical factors in an economy, cyclical fluctuations will be amplified. If we are too optimistic when things go smoothly, tensions build up, which could lead to a sharp correction, what we call a ‘Minsky Moment’. That’s what we should particularly defend against.”
To elaborate on Zhou’s statement, the economist Hyman Minsky described how once the debt “disease” goes metastatic, there will come a “Minsky moment” (a term originally coined by economist Paul McCulley) when euphoria gives way to concern and then to panic liquidation and credit revulsion. When that dynamic is in full flower, policy makers are powerless to avert it, no matter how much they want to bring the punchbowl back. Governor Zhou’s public warning was no doubt in response to recent rapid increase of debt which, according to Professor L. Randall Wray, “increased from 162 percent to 260 percent of GDP between 2008 and 2016,” and remains “a topic of discussion, if not deep concern.”
It may seem odd to warn of a Chinese slowdown, given the recent renewed surge in exports and the corresponding rise in both the manufacturing and non-manufacturing purchasing managing indices (both the manufacturing and service gauges remain above 50, and therefore indicative of robust economic activity). But these gains ought to be viewed against the backdrop of a more hostile external environment for Chinese manufactured goods. Discussing the recently imposed tariffs on steel and aluminum, the New York Times reported that Trump has already provided brief exemptions to “Canada, Mexico, the European Union, Australia, Argentina, Brazil and South Korea” (countries that “account for more than half of the $29 billion in steel sold to the United States in 2017”), which reinforces the idea that it is largely China that remains the major target of Trump’s economic nationalists.
In that context, China’s ramped-up production in March could well be interpreted as an effort to evade the tariffs by exporting products into the U.S. under the wire, suggested economist Raymond Yeung of the ANZ group. If so, that could provoke further aggressive responses from Trump’s trade hawks, especially if it results in an expansion of the bilateral trade surplus with the U.S. Adding to the pressures, Reuters reports that “Top Trump administration officials are asking China to cut tariffs on imported cars, allow foreign majority ownership of financial services firms and buy more U.S.-made semiconductors in negotiations to avoid plans to slap tariffs on a host of Chinese goods and a potential trade war.”
But how serious are these threats? Are they simply a case of “smoke and mirrors,” as the economist Dani Rodrik has suggested? China itself appears to be taking the risk of a trade war seriously, imposing retaliatory tariffs of up to 25 percent on 128 food imports from the U.S., an understandable negotiating posture given its position as a major creditor nation. But the very fact of its creditor status might presage problems for Beijing. If anything, history has shown that it is trade surplus nations, not debtors, that tend to be the biggest casualties of trade wars, as this account of America’s ill-fated Smoot-Hawley tariff imposition illustrates:
“World War I… made America the world’s creditor. The center of the financial world moved from London to New York, and billions of dollars were owed to large U.S. banks. The Smoot-Hawley Tariff threw inter-allied war-debt repayment relations into limbo by shutting down world trade. An international moratorium on debtor repayments to the United States froze billions in foreign assets, thus weakening the financial solvency of the American banks. Specifically, over $2 billion worth of German loans were obstructed by Germany’s inability to acquire dollars through trade to repay its debts. This same scenario played out in many other countries as well.”
China today occupies a creditor position comparable to the U.S. in the 1930s. Trump was certainly exaggerating when he suggested that “trade wars are good and easy to win.” But the U.S. is a largely self-sufficient economy; China is not—which is what Trump was implicitly highlighting when he made his comments (albeit, typically oversimplified and ignoring the fact that the U.S. itself still has quasi-bubbleized assets and very high levels of indebtedness).
Even if the trade war threat turns out to be more talk than action, there are other ways in which Beijing might risk a Minsky-style deflation. There is a very old idea from business cycle theory prior to the Second World War that private sector over-investment can become so unsustainably high that even without a fiscal/monetary shock, there could be a fall in autonomous investment. Once that begins, accelerator multiplier dynamics can lead to a cumulative economic contraction even if interest rates plummet and monetary conditions ease.
There are grounds for thinking this is an idea whose time has come again. Though fixed investment is very low in the U.S., it is not so globally, especially in China, which has a condition of over-investment that is historically unprecedented. A decline in global autonomous investment that threatens accelerator and multiplier dynamics should follow.
Some would argue that the global capex overinvestment problem is purely a product of low interest rates, but in China’s case, it is also a product of their economic model. Although the reforms undertaken over the past few decades have given China the appearance of a market economy, it is not in many important aspects, notably in regards to the allocation of capital, which is not market-determined.
In essence, China’s economy is a historical blending of three distinct strands: First is the old Communist, command-style economy, which, on the most conservative measure, accounts for at least one-third of China’s GDP (and possibly higher, according to some studies). This sector is comprised largely of the old “white elephants,” the state-owned enterprises (SOEs).
Second is the East Asian model, whereby the government directs investment into particular areas via the aegis of private companies, but with considerable state backing. This “dirigisme” is a variant of the old Japanese “MITI administrative model,” wherein the government essentially targets priority sectors (such as agricultural products, high-speed rail, aerospace, semiconductors, robotics, AI, and civil aviation). You can see evidence of this “state-directed capitalism” in the country’s recently published "Made in China 2025" document, an explicit policy of import substitution designed to make the country largely self-sufficient in a broad range of industries by 2025. (Import substitution is a red flag for trade hawks, especially as many of Beijing’s newly designated priority sectors are areas currently dominated by the U.S., and seeking to expand exports into China.)
Essentially, here the Chinese state often acts as “loss leader” as it tries to develop national champions, mobilizing the financial resources of large oligopolistic conglomerates to enable them to make long-term investments in research. (As an aside, this used to be a model embraced by the U.S. until the anti-government attitudes of recent decades took hold; the private sector was thought to be unable to make sufficient large-scale R&D investments because no single company on its own would have the resources/longevity to exploit the potential financial returns.) China has already done this in areas such as solar power, and it is one of the reasons why global solar costs have fallen so precipitously over the past decade (as well as contributing to the bankruptcy of Solyndra here in the U.S. back in 2011).
Third, and finally, is China’s “wild west capitalism,” which has been manifested in areas such as property speculation, “wealth management products,” the shadow banking system, and the country’s comparatively young capital markets (including a newly established oil futures market). Odd that despite the Asian Financial Crisis of 1997/98 and the global meltdown of 2008 (both products of global financial liberalization), China persists in expanding this “third leg,” given the challenges the country has experienced attempting to curb its speculative excesses, while simultaneously seeking to restructure the state sector.
In any case, the challenge for China is clear: If policy makers move too aggressively in countering any one of these vulnerabilities, they risk setting in motion a huge debt deflation dynamic. This is especially dangerous, given that overall capital expenditure in China is still in excess of 40 percent of GDP. By way of comparison during Japan’s bubble years, capex as a percentage of GDP got as high as 32 percent, and that was considered bubble-like territory, while U.S. capital expenditure as a percentage of GDP has typically stood around 15-17 percent.
So China’s policy makers have a fine line to tread. In essence, they have been using the old command economy to arrest any incipient debt deflation dynamics in the free market segment. The problem is that the command economy is home to all of the white elephants, notably construction, heavy machinery, bulk chemicals, steel, coal, and shipbuilding, all of which contribute significantly to global overcapacity. As Jianguang Shen, chief Asia economist at Mizuho Securities Asia, notes:
“SOE reform, debt, overcapacity and ‘zombie companies’ are all deeply connected issues. For private companies in overcapacity industries, after several years of losses there’s no way to continue. The owner will shut them down or sell them off, but at SOEs they can keep getting bank loans or government support.”
Shutting down these companies would create mass unemployment. So the government keeps them going, via subsidies, bailouts, and low interest rate loans. Excess capacity, therefore, gets dumped on China’s trading partners, thereby imparting an ongoing deflationary bias to the global economy, while China builds up global champions at home, which will ultimately squeeze out foreign competition.
This is in effect what Trump is seeking to counter right now via his latest salvo against China. But will the threat of more tariffs prove effective against Beijing? Bear in mind that China’s political imperatives are considerably different than those of the U.S. In the U.S. (as well as most other western democracies), if a governing party screws up, it can be voted out of office. In China, the entire political legitimacy of the Communist Party is tied up with the country’s economic prosperity. They miscalculate, and the party risks losing its monopoly on power, party members get arrested, and probably a few are shot as well. There are limits to political liberalization.
Shutting down excess capacity in the state-owned enterprises in response to tariff threats, then, would likely risk a severe economic downturn in China. It would create the prospect of mass layoffs, heightening domestic turmoil, while simultaneously undermining the political standing of the ruling party. To avert this outcome, we should therefore expect that China’s policy makers will respond as they always have: continuing to guide financing to all of these white elephants, effectively exporting deflation to the rest of the world and risking a trade backlash. Hardly ideal, but understandable, given the competing domestic political imperatives. For all of today’s market chatter about “creeping inflation” in the U.S., then, this will likely prove ephemeral if China continues to dump much of its excess capacity on the rest of the world to offset the political fallout from tackling its own domestic bubbles. The resultant pressures China’s competitors will face could engender a tougher response in line with that of Trump, which is what appears to be happening right now. So while today’s political machinations may well appear to be nothing more than a high-stakes game of poker bluffs, the longer-term dynamics suggest that it could well herald the start of a dangerous dynamic in which China and the rest of the world are fated “to live in interesting times,” as the apocryphal Chinese curse exhorts.