The world has two superpowers once again: the People’s Republic of China, the rising power, and the United States of America, the empire in decline. Not quite. These descriptions may represent an increasingly popular sentiment but they remain far from certitudes. What if the path of the rising power was to meet a sudden obstruction? Despite an ascension of historic proportions, the Chinese growth story today stands at risk with the possibility of a catastrophic financial crisis looming. While this is a controversial point, particularly given the dubious nature of predicting financial crises, there are enough apparent distress signs to consider the possible consequences.
Generating headlines and headaches today is the bursting of the “Chinese stock market bubble.” In the last year, the Shanghai Stock Exchange gained 150% only to fall by nearly 40% in July and August. While China boosters have rushed to point out the stock market’s insulation from the larger financial system and Beijing’s readiness to intervene to stabilize them, this fails to recognize several more significant financial risks. Credit Suisse analyst Andrew Garthwaite references China’s triple bubble in housing, credit and investment. The housing risk is well documented: construction continues to outpace sales in what is described as a dual economy. In primary Chinese cities like Shanghai, exorbitant demand has fueled speculative pricing. Yet in peripheral cities, there is an abundance of supply leading to high vacancy rates, most notoriously in “ghost cities” like Ordos. Corporations are over-levered with debt estimated at 125% of GDP. Municipal debt is also unsustainably high at 40% of GDP and is dependent on property sales and shadow banking - the multi-trillion dollar, unregulated financial boogeyman - for funds. Finally, investment remains the poison to cure China’s thirst. Investment has fueled much of its storied rise and a $1.1 trillion investment plan in January was used to drive this year’s shining 7% growth rate. However, state sponsored investment comes with further debt accumulation and severely diminishing returns. While there have been reform efforts by Chinese leadership towards more market and consumption led growth, their commitment and pain tolerance will certainly be tested during the impending economic slowdown.
If any of Garthwaite’s “bubbles” were to burst, it could freeze credit in the financial system, cause a massive loss in wealth and bring the broader economy to a halt. Not to worry, some argue, as implicitly guaranteeing much of the existing debt, including the banking sector, municipalities, shadow-banking system and state owned enterprises, is the Chinese government. But while Beijing has previously proven capable of plugging holes to steer the ship to safety, in the midst of a tempest all bets are off. Nonetheless, many insist that the state’s power to intervene with trillions of dollars and forcibly dictate market behavior is sufficient to stave off financial peril. I have two responses. First, assuming the government can keep the financial system afloat and move in earnest towards liberalizing reforms, virtually identical political risks, admittedly less dramatic, remain under the anticipated lower-growth regime. Second, the outstanding debt presents potentially systemic risk and represents liabilities an order of magnitude greater than the government’s mobilizable assets. Thus, there is more than just Western dogma behind the conviction that, as in the physical world, in the economy, natural forces always dwarf the designs of men. While the timetable may be delayed, in statist China, all steps taken by the government to prevent financial ruin other than structural reforms will only create more moral hazard and moral hazard will only heighten risks of a greater crash. As former Treasury Secretary and China-ist Hank Paulson wrote in reference to a Chinese credit crisis, “It's not a question of if, but when.” Brace yourselves: we may be in for a hard landing in China and the geopolitical ramifications would be staggering.
While the entire global economy will suffer from a large-scale Chinese financial crisis, the tumult will be felt first and hardest by states most dependent on China’s economy. In its rise, China has developed supreme economic importance to several regional and resource rich states. According to the World Trade Organization, China is the lead trading partner to Angola, Sudan, Yemen and Cambodia. Beyond their trade with China, these countries have another essential common factor: they are all Least Developed Countries (LDCs). In fact, among the states to which China is the principal export or import partner, nearly a third are on the UN’s list of LDCs. This excludes the likes of Democratic Republic of Congo and Equatorial Guinea, which have highly publicized economic ties to China but unpublished trade statistics. Aside from being generally poor, LDCs are also often decentralized, highly corrupt and prone to conflict. And political power, particularly among the resource-rich rentier states, is almost always held narrowly at the top. To borrow language from Nassim Taleb, these states are fragile. This point was made particularly clear to me on recent visits to Myanmar and Cambodia - two countries with tragic histories of political violence and uncertain political futures - where both the jade market in Mandalay and the booming real estate market in Phnom Penh were all dominated by Chinese businessmen. Their suitcases full of cash superficially fuel economic growth but in actuality line the pockets of a cabal of kleptocrats.
To consider the geopolitical consequences of a Chinese financial crisis on these dependent and underdeveloped states, consider the extreme but analogous case of Latin America during the Great Depression. During the early 20th century, America was an industrializing nation en route to global pre-eminence and had unmatched influence in Latin American states. The region was underdeveloped, had tremendous economic and political inequality and was highly dependent on commodity exports to the U.S. and Europe. During the Great Depression, it was likely the hardest hit region in the world. There were precipitous falls in exports and foreign investment and by Depression’s end, fifteen out of twenty Latin American countries had defaulted on their debt. Of course, the suffering spilled over into politics as well. Numerous states, including Argentina, Brazil, Chile and Peru experienced military coups. In the case of Brazil, the fall in coffee prices, which was paramount to the state’s revenue generation, brought the 1930’s military dictatorship of Getulio Vargas. Vargas’ reign began the state’s efforts to diversify into industrial production and ultimately became the model for import substitution. To say nothing of its economic efficacy, Brazilian import substitution was an obvious political condemnation of American political and economic dependency.
In the event of a Chinese financial crisis today, dependent LDCs will also face political and economic ruin. To see how shocking that could be, consider a special case: North Korea. While North Korea may be the state closest to autarky, the regime’s dependence on China is unquestioned. Dating back to the Chinese military rescue during the Korean War, North Korea has been existentially reliant on China. Today, China represents 60% of the country’s trade, providing the majority of its food – often in direct aid of the military - and 90% of its energy. However, Beijing’s feelings towards North Korea are reportedly divided, with the Hermit Kingdom falling out of favor with some after its first nuclear test in 2006. If belts tightened in China due to massive credit and economic constraints, the squeeze would certainly be felt in North Korea as well. Unfortunately for its neighbors, the DPRK’s typical means of blowing off political steam is by blowing up rockets. Long-term however, in a regime tightly controlled by a small group of the elite, it wouldn’t take much dissatisfaction for the regime to fall. A few key defections could bring down the entire enigmatic house of cards. The geopolitical consequences of such a regime change are worthy of much more than lip service, but certainly such a transition, generally assumed to reunification with South Korea, would be profound.
The threat to regimes are posed today to the LDCs and the myriad other states (if only I were bold enough to say Russia), to which China is benefactor. Most of these are rentier states with iron-fists keeping it all together. When the money dries up, some may find the resources to weather the storm and keep their elite clients and soldiers happy. Others may not. These regimes at their core are unstable; a loss of financing or an economic downturn could easily sway the allegiances of an avaricious political elite, prompting a wave of systematic policy or regime changes.
Beyond dependent states of either the US or China, lie pivot states - nonaligned states in a position to benefit from the successes of either. Their allegiances are variable, falling along a spectrum of degrees of influence between the two poles. Unlike during the Cold War, when overt security threats between the two superpowers put a premium on loyalty, today’s spectrum is relatively fluid. In the event of a large-scale Chinese financial crisis, we may see an across-the-board movement of these states towards American embrace. While there are various present benefits to alignment with China, it remains the growth stock in a pivot state’s portfolio. A shock to the perceptions of its growth potential would justify a large shift in America’s favor.
To make this a bit more concrete, consider the founding members of the topical Asian Infrastructure Investment Bank (AIIB). The China-led financial institution includes 57 member states from five continents - North American representation being noticeably absent. Interestingly, of these 57 states, 25 have, or are in negotiations to sign, free trade agreements with the United States. These overlapping states, many of which are involved in the ongoing Trans Pacific Partnership (TPP) and Transatlantic Trade and Investment Partnership (TTIP), can be convincingly labeled pivot states, juggling American and Chinese ties. David Dollar, Senior Fellow at the Brookings Institution, has pointed out the complementarity in Asia of the AIIB and TPP, analogizing them as the hardware and software, respectively, of economic integration. The AIIB would provide funds for infrastructure development across Asia and the TPP would provide markets and trade regulations. However, in the face of massive credit constraints in China, this picture looks quite different. Chinese financing of future infrastructure projects may take a hit and its power as an essential economic partner will diminish. Asian pivot states will be further pushed towards American patronage and western markets for growth. States like South Korea, Vietnam and Malaysia will be encouraged to complete the TPP and gain greater access to U.S. consumers. Similar movements would be seen in Europe and Latin America which have been edging closer towards China despite or, perhaps more appropriately, because of their historic relationships with the U.S.
At the end of the day, what does a large-scale financial crisis mean for China and geopolitics? As I’ve already proposed, it would most fundamentally mean a strengthening of American power. Many have argued that long-term we are moving, to borrow Ian Bremmer’s term, towards a G-Zero world with an absence of global leadership. Though this is a useful paradigm, it lacks necessary nuance. Chiefly, an economically integrated world necessitates a global leader. International commerce, for example, will always have a primary reserve currency and benchmark for trade and financial standards. If choosing a global leader was a multiple-choice question, America may no longer be the obvious choice but by process of elimination, it remains. And, given a Chinese financial crisis, it will maintain this status as sole superpower for the foreseeable future.
What of China’s trajectory? Following massive financial crises, consider the FDIC after the Great Depression and Dodd-Frank after the 2008 Financial Crisis, there is always a policy push to correct for the past system’s shortcomings. It is important to consider what policy changes in China would follow from such a financial crisis. Would the scalpel only correct financial regulation or larger issues of governance too? The abrupt bursting of asset bubbles is often described in terms of widespread and dramatic losses in confidence, i.e. panics. Unlike in western systems, in China’s heavy-handed, state capitalist model, no logical barrier separates a loss of confidence in the financial system from a loss of confidence in the state. Internationally, China would certainly lose credibility. The question remains whether China is destined to be a global counterweight or just a regional heavyweight. Faith in its global prospects would surely sour. However, more damning are the potential domestic ramifications. With enough time for it all to stew, just as in its dependent states, a large enough financial crisis, with vast economic repercussions could threaten the regime. Consider the possibility of unrest throughout peripheral China due to reeling municipalities, a countrywide recession due to a broken financial system and a massive loss of wealth among the country’s elite due to a collapsed housing market and underwater enterprises. In such an environment, the wheels of a repressive government, held together ostensibly by a growth imperative, may come off. Predicting the demise of the Communist Party in China is fairly extreme and more than likely a financial crisis or economic slowdown, regardless of their magnitudes, would be disruptive not destructive. But regime change is a risk. Many pundits would argue that China’s present economic and state structures are not sustainable. At a talk several years ago with Fareed Zakaria, when it was still provocative to debate Chinese versus Indian growth prospects, he offered that there is near certainty of what Indian government will look like in ten year. Yet in ten years in China, only God knows. Stay tuned: with the future of international power hanging in the balance, a Chinese financial crisis will only add to the mystery.
- Josh Poretz, A'15