It became clear last week that China has probably not dodged the financial crisis at all, after Beijing quietly agreed to bail out local government to the tune of $463 billion.
Adjusted for the size of its economy, that rescue package is one-and-a-half times bigger than the Tarp bailout. That is particularly worrying, according to Dylan Grice, a global strategist at Societe Generale. “If we calibrate the magnitude of the economic crisis with the size of the bail-out, one-and-a-half Tarps implies a financial crisis one-and-a-half times the order of magnitude of 2008.”
The bail-out is aimed at cleaning up the vast pile bad loans made to local government financing vehicles, which were responsible for stimulus spending on infrastructure and development programmes. Grice expects the government will deal with them in the same way it recapitalised its banking industry after 1998, which has led some to assume the problem has been solved.
That might be wishful thinking. To understand the possible effects of China’s actions, Grice draws on an article by Black Swan author Nassim Taleb and Mark Blythe in the recent issue of Foreign Affairs, in which the two authors draw comparisons between the global financial crisis and the uprisings in North Africa and the Middle East.
“The critical issue in both cases is the artificial suppression of volatility — the ups and downs of life — in the name of stability,” they wrote. “What the world is witnessing in Tunisia, Egypt, and Libya is simply what happens when highly constrained systems explode.”
The same goes for China’s bailouts, argues Grice. It has succeeded in stalling its own crisis for so long only because it is more effective than almost any other country at exerting control over its economy. China can keep dancing for a while longer, but at some point the music has to stop.
This is nothing new, of course. Grice argues that monetary policy committees worldwide played a huge role in the crisis by setting interest rates at artificially low rates instead of seeking to match the “natural” rate of interest — which is roughly the same level as economic growth, whereby the supply of risk capital matches demand.
A look at historic rates shows clearly that all of the countries worst-affected by the crisis maintained interest rates far below the natural rate for years. In Ireland, rates were more than 10% below the equilibrium point in the early part of the last decade, while in the US they bottomed out at about 3% below the natural rate in around 2005.
"Surely enough, their economies boomed as the demand for risk capital rose. Why would it do otherwise?” asked Grice in the report, titled China’s Great Suppression. “But since the price of capital was suppressed by these wise committees, rates weren’t allowed to rise to their natural levels, so there was no increase in the supply of capital. Who would supply the searing demand for risk capital these wise central bankers were unleashing? Why, the wizards in the financial system!”
We all know how that worked out. Governments did a good job of suppressing asset-price inflation by letting the banks create a massive round of credit inflation. None of them, however, did as good a job as China. By Grice’s reckoning, China’s natural rate of interest is roughly 11.6% higher than its actual rate today.
Suppressing rates is politically expedient in western economies, where governments tend to be judged on extremely short-term measures, but China has no such worries. Indeed, one of its great advantages has been its ability to pursue necessary but unpopular policies without having to worry about the next election cycle. But China is juggling knives.
It might not be accountable in the western, democratic sense, but China’s leaders know that an unhappy population will take to the streets and could even topple the government. The trick to avoiding that is to make sure the people are happy, which means rich. But China could be paying a huge cost for the sake of suppressing inflation.
“It has upped the ante,” said Grice. “While we can’t predict where complex systems will go, we know that the longer their volatility is artificially suppressed, the more emphatic will be its release when it does come. It is more likely that China has one-and-a-half times (and counting) the 2008 financial crisis ahead of it.”