The Death of Money (14 page)

China can continue its infrastructure binge because it has unused borrowing capacity
with which to finance new projects and to paper over losses on the old ones. But there
are limits to expansion of this kind, and the Chinese leadership is aware of them.

In the end, if you build it, they may not come, and a hard landing will follow.

■
Shadow Finance

Behind this untenable infrastructure boom is an even more precarious banking structure
used to finance the overbuilding. Wall Street analysts insist that the Chinese banking
system shows few signs of stress and has a sound balance sheet. China’s financial
reserves, in excess of $3 trillion, are enormous and provide sufficient resources
to bail out the banking system if needed. The problem is that China’s banks are only
part of the
picture. The other part consists of a shadow banking system of bad assets and hidden
liabilities large enough to threaten the stability of China’s banks and cause a financial
panic with global repercussions. Yet the opacity of the system is such that not even
Chinese banking regulators know how large and how concentrated the risks are. That
will make the panic harder to stop once it arrives.

Shadow banking in China has three tributaries consisting of local government obligations,
trust products, and wealth management products. City and provincial governments in
China are not allowed to incur bonded debt in the same fashion as U.S. states and
municipalities. However, local Chinese authorities use contingent obligations such
as implied guarantees, contractual commitments, and accounts payable to leverage their
financial condition. Trust products and wealth management products are two Chinese
variants of Western structured finance.

The Chinese people have a high savings rate, driven by rational motives rather than
any irrational or cultural traits. The rational motives include the absence of a social
safety net, adequate health care, disability insurance, and retirement income. Historically
the Chinese counted on large families and respect for elders to support them in their
later years, but the one-child policy has eroded that social pillar, and now aging
Chinese couples find that they are on their own. A high savings rate is a sensible
response.

But like savers in the West, the Chinese are starved for yield. The low interest rates
offered by the banks, a type of financial repression also practiced in the United
States, make Chinese savers susceptible to higher-yielding investments. Foreign markets
are mostly off-limits because of capital controls, and China’s own stock markets have
proved highly volatile, performing poorly in recent years. China’s bond markets remain
immature. Instead, Chinese savers have been attracted by two asset classes—real estate
and structured products.

The bubble in Chinese property markets, especially apartments and condos, is well
known, but not every Chinese saver is positioned to participate in that market. For
them, the banking system has devised trust structures and “wealth management products”
(WMPs). A WMP is a pool or fund in which investors buy small units. The pool then
takes the aggregate proceeds and invests in higher-yielding assets. Not surprisingly,
the assets often consist of mortgages, properties, and corporate debt. In the WMP,
China has an unregulated version of the worst of Western finance. WMPs resemble the
collateralized debt obligations, collateralized loan obligations, and mortgage-backed
securities, so-called CDOs, CLOs, and MBSs, that nearly destroyed Western capital
markets in 2008. They are being sold in China without even the minimal scrutiny required
by America’s own incompetent rating agencies and the SEC.

The WMPs are sponsored by banks, but the related assets and liabilities do not appear
on the bank balance sheets. This allows the banks to claim they are healthy when in
fact they are building an inverted pyramid of high-risk debt. Investors are attracted
by the higher yields offered in WMPs. They assume that because the WMPs are sponsored
and promoted by the banks, the principal must be protected by the banks in the same
manner as deposit insurance. But both the high yield and the principal protection
are illusory.

The investors’ funds going into the WMPs are being used to finance the same wasted
infrastructure and property bubbles that the banks formerly financed before recent
credit-tightening measures were put in place. The cash flows from these projects are
often too scant to meet the obligations to the WMP investors. The maturities of the
WMPs are often short-term while the projects they invest in are long-term. The resulting
asset-liability maturity mismatch would create a potential panic scenario if investors
refused to roll over their WMPs when they mature. This is the same dynamic that caused
the failures of Bear Stearns and Lehman Brothers in the United States in 2008.

Bank sponsors of WMPs address the problems of nonperforming assets and maturity mismatches
by issuing new WMPs. The new WMP proceeds are then used to buy the bad assets of the
old WMPs at inflated values so the old WMPs can be redeemed at maturity. This is a
Ponzi scheme on a colossal scale. Estimates are that there were twenty thousand WMP
programs in existence in 2013 versus seven hundred in 2007.
One report on WMP sales in the first half of 2012 estimates that almost $2 trillion
of new money was raised.

The undoing of any Ponzi scheme is inevitable, and the Chinese property and infrastructure
bubbles fueled by shadow banking are no exception. A collapse could begin with the
failure of a particular rollover
scheme or with exposure of corruption associated with a particular project. The exact
trigger for the debacle is unimportant because it is certain to happen, and once it
commences, the catastrophe will be unstoppable without government controls or bailouts.
Not long after a crackup begins, investors typically line up to redeem their certificates.
Bank sponsors will pay the first ones in line, but as the line grows longer in classic
fashion, the banks will suspend redemptions and leave the majority with worthless
paper. Investors will then claim that the banks guaranteed the principal, which the
banks will deny. Runs will begin on the banks themselves, and regulators will be forced
to close certain banks. Social unrest will emerge, and the Communist Party’s worst
nightmare, a replay of the spontaneous Taiping Rebellion or Tiananmen Square demonstrations,
will then loom.

China’s $3 trillion in reserves are enough to recapitalize the banks and provide for
recovery of losses in this scenario. China has additional borrowing power at the sovereign
level to deal with a crisis if needed, while China’s credit at the IMF is another
source of support. In the end, China has the resources to suppress the dissent and
clean up the financial mess if the property Ponzi plays out as described.

But the blow to confidence will be incalculable. Ironically, savings will increase,
not decrease, in the wake of a financial collapse, because individuals will need to
save even more to make up their losses. Stocks will plunge as investors sell liquid
assets to offset the impact of now-illiquid WMPs. Consumption will collapse at exactly
the moment the world is waiting for Chinese consumers to ride to the rescue of anemic
world growth. Deflation will beset China, making the Chinese even more reluctant to
allow their currency to strengthen against trading partners, especially the United
States. The damage to confidence and growth will not be confined to China but will
ripple worldwide.

■
Autumn of the Financial Warlords

The Chinese elites understand these vulnerabilities and see the chaos coming. This
anticipation of financial collapse in China is driving one of the greatest episodes
of capital flight in world history. Chinese elites and
oligarchs, and even everyday citizens, are getting out while the getting is still
good.

Chinese law prohibits citizens from taking more than $50,000 per year out of the country.
However, the techniques for getting cash out of China, through either legal or illegal
means, are limited only by the imagination and creativity of those behind the capital
flight. Certain techniques are as direct as stuffing cash in a suitcase before boarding
an overseas flight.
The Wall Street Journal
reported the following episode from 2012:

In June, a Chinese man touched down at Vancouver airport with around $177,500 in cash—mostly
in U.S. and Canadian hundred-dollar bills, stuffed in his wallet, pockets and hidden
under the lining of his suit case. . . . The Canadian Border Service officer who found
the cash, said the man told him he was bringing the money in to buy a house or a car.
He left the airport with his cash, minus a fine for concealing and not declaring the
money.

In another vignette, a Chinese brewery billionaire flew from Shanghai to Sydney, drove
an hour into the countryside to see a vineyard, bid $30 million for the property on
the spot, and promptly returned to Shanghai as quickly as he had arrived. It is not
known if the oligarch preferred wine to beer, but he preferred Australia to China
when it came to choosing a safe haven for his wealth.

Other capital flight techniques are more complicated but no less effective. A favorite
method is to establish a relationship with a corrupt casino operator in Macao, where
a high-rolling Chinese gambler can open a line of credit backed by his bank account.
The gambler then proceeds deliberately to lose an enormous amount of money in a glamorous
game such as baccarat played in an ostentatious VIP room. The gambling debt is promptly
paid by debiting the gambler’s bank account in China. This transfer is not counted
against the annual ceiling on capital exports because it is viewed as payment of a
legitimate debt. The “unlucky” gambler later recovers the cash from the corrupt casino
operator, minus a commission for the money-laundering service rendered.

Even larger amounts are moved offshore through the mis-invoicing of exports and imports.
For example, a Chinese furniture manufacturer can
create a shell distribution company in a tax haven jurisdiction such as Panama. Assuming
the normal export price of each piece of furniture is $200, the Chinese manufacturer
can underinvoice the Panamanian company and charge only $100 for each piece. The Panamanian
company can then resell into normal distribution channels for the usual price of $200
per piece. The $100 “profit” per piece resulting from the underinvoicing is then left
to accumulate in Panama. With millions of furniture items shipped, the accumulated
phony profit in Panama can reach into the hundreds of millions of dollars. This is
money that would have ended up in China but for the invoicing scheme.

Capital flight by elites is only part of a much larger story of income inequality
between elites and citizens in China. In urban areas, the household income of the
top 1 percent is twenty-four times the average of all urban households. Nationwide,
the disparity between the top 1 percent and the average household is thirty times.
These wide gaps are based on official figures. When hidden income and capital flight
are taken into account, the disparities are even greater.
The Wall Street Journal
reported:

Tackling inequality requires confronting the elites that benefit from the status quo
and reining in the corruption that allows officials to pad their pockets. Wang Xialou,
deputy director of China’s National Economic Research Foundation, and Wing Thye Woo,
a University of California at Davis economist, say that when counting what they call
“hidden” income—unreported income that may include the results of graft—the income
of the richest 10% of Chinese households was 65 times that of the poorest 10%.

Minxin Pei, a China expert at Claremont McKenna College, states that
corruption, cronyism, and income inequality in China today are so stark that social
conditions closely resemble those in France just before the French Revolution. The
overall financial, social, and political instability is so great as to constitute
a threat to the continued rule of China’s Communist Party.

Chinese authorities routinely downplay these threats from malinvestment in infrastructure,
asset bubbles, overleverage, corruption, and income inequality. While they acknowledge
that these are all significant
problems, officials insist that corrective actions are being taken and that the issues
are manageable in relation to the overall size and dynamic growth of the Chinese economy.
These threats are viewed as growing pains in the birth of a new China as opposed to
an existential crisis in the making.

Given the history of crashes and panics in both developed and emerging markets over
the past thirty years, Chinese leaders may be overly sanguine about their ability
to avoid a financial disaster. The sheer scale and interconnectedness of SOEs, banks,
government, and citizen savers has created a complex system in the critical state,
waiting for a spark to start a conflagration. Even if the leadership is correct in
saying that these specific problems are manageable in relation to the whole, they
must still confront the fact that the entire economy is unhealthy in ways that even
the Communist Party cannot easily finesse. The larger issue for China’s leadership
is the impossibility of rebalancing the economy from investment to consumption without
a sharp decline in growth. This slowdown, in effect the feared hard landing, is an
event for which neither the Communists nor the world at large is prepared.

Understanding the challenge of rebalancing requires taking another look at China’s
infrastructure addiction. Evidence for overinvestment by China is not limited to anecdotes
about colossal train stations and empty cities. The IMF conducted a rigorous analytic
study of capital investment by China compared to a large sample of thirty-six developing
economies, including fourteen in Asia. It concluded that investment in China is far
too high and has come at the expense of household income and consumption, stating,
“
Investment in China may currently be around 10 percent of GDP higher than suggested
by fundamentals.”