The U.S.-China trade war may hasten a Chinese financial crisis that has been bubbling up for some time. Public and private debt has been ballooning upward even faster than the fast-growing economy. Debt-financed development is not itself necessarily a problem, except when it inevitably spills over into ever-rising asset prices. Asset prices can ascend as long as credit expands faster than real economic growth, but when creditors become more wary about issuing new loans to heavily-leveraged speculators, a crash will soon follow.
Exactly when an asset bubble will finally burst is hard to tell. Like over-inflating a toy balloon, you can never be sure when the next breath of air will stretch a fatal weakness to the breaking point and burst it. What is inevitable is that it cannot expand forever. Asset speculation first became infamously rampant in the Netherlands during the 17th century when the Dutch, appropriately, called it “the wind trade.”
In China, as in the U.S. and other countries during the 2008 financial crisis, all assets tend to rise with expanding credit, but real estate is the leading asset bubble. Real estate, like stocks and bonds, has no natural price based on cost of production because its value depends on desirable location more than cost of construction. As credit expands, more and more people can afford to buy pricier homes; businesses can buy bigger offices and fancier malls. If credit keeps expanding fast enough, asset prices keep going up with no natural upper limit other than the eventual wariness of increasingly bearish creditors. When major creditors lose confidence in further price increases, they start to restrict credit to the most debt-leveraged speculators, and panic selling begins.
Whereas ordinary people buy homes mostly as residences, speculators care only about their value as assets. Real estate prices have been shooting up in China for a couple of decades, but recently have begun to plateau. Speculators do not even have to see a drop in prices to begin panic selling. Even slower growth can raise alarms. Nearly all speculation is based on debt. The more debt leverage, the more the speculators can magnify profits. If asset prices are going up 10% per year and loans cost 6%, the more you can borrow the more you can profit. However, if price growth slows to only 3% a year, then the leveraged speculator may soon be “under water” because the annual gain from the asset is less than the cost of borrowing. Then it pays to sell quickly because losses will be leveraged too.
Once price growth slows, speculative buyers quickly disappear and sellers proliferate. This is why bubbles tend to burst much more quickly than they inflate. Speculators need to sell before the price falls below the amount they borrowed — or they lose money. When a bubble starts to burst, the quicker you sell, the less you lose. However, the need to sell quickly also makes it a buyers' market as sellers are willing to cut the price to sell quickly, before it is too late.
Governments can influence asset prices in any country, but the authorities are especially active in China. Not just the central government, but local governments all over China are in the real estate business, much like Donald Trump and other private developers in the U.S. Given China's hot property market of recent years, a principal source of revenue for many Chinese local governments has been real estate development. Government agencies buy (or already own) land, build infrastructure to make it more valuable, and then sell it at a profit to private developers, who themselves hold it to sell at even higher prices to householders, businesses, and speculators. The merry-go-round continues to enrich all participants as long as the credit flows freely.
China's rich real estate circus creates a tension between local governments, the primary real estate developers, and the central government in Beijing. Unlike local governments, Beijing is also responsible for managing the value of the Chinese currency, the RMB, and overall economic performance. The faster debt expands, the more there is price inflation – both asset and consumer prices. Local governments are not troubled, but the central government has a problem. Inflation means the purchasing power of the RMB is falling, which tends to weaken it relative to foreign currencies.
China's enormous export boom plus its attractiveness for foreign investment tended to increase the value of the RMB for about a decade until 2014. Since then, China's debt-fueled inflation and slowing export growth have tended to weaken the relative value of the RMB to the dollar, euro and other major currencies. The main way to staunch the falling value of the RMB is to restrict credit, but restricting credit tends to pop the asset bubble. This painful dilemma leads Beijing officials to a “saw-toothed” credit policy. They put the brakes on credit to prop up the RMB, and asset prices fall. Then they panic and expand credit again. This stop-and-go credit policy has been roiling Chinese markets in recent years. Beijing's temperamental credit management has so far averted a crash, but debt continues to pile up, which increases the potential size of the panic when credit tightens significantly.
I have been to at least a dozen Chinese cities, large and small, during the past year and observed the effect of the debt and real estate bubble. Everywhere frenetic construction continues even though forests of completed high-rise apartment buildings are largely empty, and glittering mall after mall stuffed with expensive financed merchandise have relatively limited foot traffic and even fewer shoppers with bags of merchandise. Young people go to malls to window shop and to eat, but increasingly they buy online. When I see underutilized real estate I perceive non-performing loans. Owners will lose their shirts when the music stops and the credit frenzy abates.
Last year Beijing was in the mood to restrain the credit bubble to bolster the RMB. This was in part to placate Trump who complained loudly that Chinese “currency manipulation” was depressing the RMB value and thus unfairly competing by making Chinese goods cheaper in dollar cost. But it was not enough. Now that Trump has unleashed a trade war in earnest, China is reacting as I expected and once more reversing direction, letting credit flow freely to counter the otherwise depressive effect of Trump's tariffs on Chinese exports to the U.S. This will tend to weaken the RMB again and thus reduce the dollar cost of Chinese exports, though not likely enough to counteract the cost of the tariffs.
China seems determined to avoid a serious financial crisis, but as a result, credit continues to expand at an unsustainable rate. A reckoning must eventually come. Yet exactly when will be influenced by the unstable twists and turns of public authorities in the U.S. and China plus the concerns of creditors who might be uncomfortably exposed to insolvent borrowers. The U.S.-China trade war adds new pressure to an already stressed system.
