No Sugarcoating It: A Hard Landing Is Likely
China's asset bubble increasingly depends on financing from the shadow banking system. The carry trade – borrowing dollar loans at low interest rates offshore and converting the loans into yuan, either disguised as foreign direct investment or export revenue, for lending at a high interest rate – has become a significant source of funding in the shadow banking system. The recent surge of land prices in big cities may be due to it.
The rising share of unstable financing for the country's asset bubble threatens a chaotic ending. If the bubble suffers a confidence crash or a receding tide of liquidity, the unwinding of speculative holdings would be chaotic, causing a hard landing.
The carry trade drove the property bubble in Southeast Asia before 1997. The rising U.S. interest rate triggered its collapse. China is under the influence of the same force but on a much larger scale. The Fed's massive quantitative easing has driven up China's money supply, partly through the carry trade. If the Fed unwinds the QE, China's bubble will burst.
Real reforms may increase investment on a better economic outlook, which may offset the negative impact from unwinding the bubble. However, as all of the country's economic problems stem from spending and investment maximization by local governments, the only meaningful reform is major curtailment of government power. That seems distant.
Hard vs. Soft Landing
Japan had a soft landing in 1992. South Korea had a hard one in 1998. Soft or hard is not the same as good or bad. The outcome ultimately depends on how a country responds to challenges. My bias is that a soft landing is not good in general, and a hard landing is likely to lead to a better outcome and faster.
I believed for a long time that China would have a soft landing. When its economy began to descend in 2012, fear of a hard landing permeated financial markets for several months. My view on a soft landing was based on the dominance of bank loans in credit creation. The country's banks are government-owned. When property developers face a liquidity crunch, the banks are likely to reschedule their loans. A hard landing is a consequence of the snowball effect from creditors liquidating delinquent borrowers. When there is a big bubble funded by debt, as is usually the case, its bursting would lead to a hard landing if the credit agreements are stuck to. Hence, a soft landing is usually due to either an inability or unwillingness of creditors to enforce debt contracts. Japan, for example, was in such a situation in the 1990s.
The Asian Financial Crisis was such a hard landing, because short-term dollar debt was a major part of the financing for the investment-cum-property bubble. When the money was pulled out, it happened at such a speed that most Asian economies experienced banking collapses and maxi devaluation. The ensuing chaos froze all normal economic activities.
The hard landing in the Asian Financial Crisis did not lead to the same outcome everywhere. At one extreme, South Korea went through a rapid process of consolidation and recapitalization of the financial sector. It allowed bad companies to go bust and dramatically cut the government's role in the economy. On the other extreme, Thailand is dealing with the consequences of the crisis 15 years later.
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