Connecting the Dots in China

NEW HAVEN – All eyes are fixed on the dark side of China. We have been here before. Starting with the Asian financial crisis of the late 1990s and continuing through the dot-com recession of the early 2000s and the global financial crisis of 2008-09, China was invariably portrayed as the next to fall. Yet time and again, the Chinese economy defied gloomy predictions with a resilience that took most observers by surprise.

Count me among the few who were not surprised that past alarms turned out to be false. But count me in when it comes to sensing that this time feels different.

Contrary to most, however, I do not think Evergrande Group is the problem, or even the catalytic tipping point. Yes, China’s second-largest property developer is in potentially fatal trouble. And yes, its debt overhang of some $300 billion poses broader risks to the Chinese financial system, with potential knock-on effects in global markets. But the magnitude of those ripple effects is likely to be far less than those who loudly proclaim that Evergrande is China’s Lehman Brothers, suggesting that another “Minsky Moment” may well be at hand.

Three considerations argue to the contrary. First, the Chinese government has ample resources to backstop Evergrande loan defaults and ring-fence potential spillovers to other assets and markets. With some $7.5 trillion in domestic saving and another $3 trillion in foreign exchange reserves, China has more than enough capacity to absorb a worst-case Evergrande implosion; recent large liquidity injections by the People’s Bank of China underscore the point.

Second, Evergrande is not a classic “black swan” crisis, but rather a conscious and deliberate consequence of Chinese policy aimed at deleveraging, de-risking, and preserving financial stability. In particular, China has made good progress reducing shadow banking activity in recent years, thereby limiting the potential for deleveraging contagion to infect other segments of its financial markets. Unlike Lehman and its devastating collateral damage, the Evergrande problem hasn’t blindsided Chinese policymakers. 

Third, risks to the real economy, which has entered a temporary soft patch, are limited. The demand side of the Chinese property market is well supported by the ongoing migration of rural workers to cities. This is very different from the collapse of speculative housing bubbles in other countries, like Japan and the United States, where supply overhangs were unsupported by demand. While the urban share of the Chinese population has now risen slightly above 60%, there is still plenty of upside until it reaches the 80-85% threshold typical of more advanced economies. Notwithstanding recent accounts of shrinking cities – reminiscent of earlier false alarms over a profusion of ghost cities – underlying demand for urban shelter remains firm, limiting downside risks to the overall economy, even in the face of an Evergrande failure.

China’s most serious problems are less about Evergrande and more about a major rethinking of its growth model. Initially, I worried about a regulatory clampdown, writing in late July that the new measures took dead aim at China’s internet platform companies, threatening to stifle the “animal spirits” in some of the economy’s most dynamic sectors, such as fintech, video gaming, online music, ridesharing, private tutoring, and takeaway, delivery, and lifestyle services.

That was then. Now, the Chinese government has doubled down, with President Xi Jinping throwing the full force of his power into a “common prosperity” campaign aimed at addressing inequalities of income and wealth. Moreover, the regulatory net has been broadened, not just to ban cryptocurrencies, but also to become an instrument of social engineering, with the government adding e-cigarettes, business drinking, and celebrity fan culture to its ever-lengthening list of bad social habits.

All this only compounds the concerns I raised two months ago. The new dual thrust of Chinese policy – redistribution plus re-regulation – strikes at the heart of the market-based “reform and opening up” that have underpinned China’s growth miracle since the days of Deng Xiaoping in the 1980s. It will subdue the entrepreneurial activity that has been so important in powering China’s dynamic private sector, with lasting consequences for the next, innovations-driven, phase of Chinese economic development. Without animal spirits, the case for indigenous innovation is in tatters.

With Evergrande blowing up in the aftermath of this sea change in Chinese policy, financial markets, understandably, have reacted sharply. The government has been quick to counter the backlash. Vice Premier Liu He, China’s leading architect of economic strategy and a truly outstanding macro thinker, was quick to reaffirm the government’s unwavering support for private enterprise. Capital markets regulators have likewise stressed further “opening up” via new connectivity initiatives between onshore and offshore markets. Other regulators have reaffirmed China’s steadfast intention to stay the course. Perhaps they doth protest too much?

Of course, on one level, who wouldn’t want common prosperity? US President Joe Biden’s $3.5 trillion “Build Back Better” agenda smacks of many of the same objectives. Tackling inequality and a social agenda at the same time is a big deal for any country. It is not only the subject of intense debate in Washington but also bears critically on China’s prospects.

The problem for China is that its new approach runs counter to the thrust of many of its most powerful economic trends of the past four decades: entrepreneurial activity, a thriving start-up culture, private-sector dynamism, and innovation. What I hear now from China is denial – siloed arguments that address each issue in isolation. Redistribution is discussed separately from the impact of new regulations. And there is also a siloed approach to defending regulatory actions themselves – case-by-case arguments for strengthening oversight of internet platform companies, reducing social anxiety among stressed-out young people, and ensuring data security.

As a macro practitioner, I was always taught to consider the combined effects of major developments. Evergrande will pass. Common prosperity is here to stay. A regulatory clampdown, in conjunction with a push to redistribute income and wealth, rewinds the movie of the Chinese miracle. By failing to connect the dots, China’s leaders risk a dangerous miscalculation.

Stephen S. Roach, a faculty member at Yale University and former chairman of Morgan Stanley Asia, is the author of Unbalanced: The Codependency of America and China.

© Project Syndicate 1995–2021