While Nanjing has many of the same problems of pollution and uncontrolled growth of other Chinese cities, it is altogether more pleasant, with abundant parks, museums, and broad, tree-lined boulevards built under imperial influence during the late nineteenth century. Nanjing lies on the Beijing-Shanghai high-speed railway line and is easily reached from both cities. It is among the most important political, economic, and educational hubs in China today.
Immediately south of Nanjing proper lies the Jiangning district, site of one of the most ambitious infrastructure projects now under way in China. Jiangning consists of seven new cities, still under construction, connected by a highway network and an underground metro. Each city has its own cluster of skyscrapers, luxury shopping malls, five-star hotels, man-made lakes, golf courses, recreation centers, and housing and science facilities. The entire metroplex is served by the Nanjing South Railway Station to the north and a newly constructed airport to the south. A visitor cannot help but be impressed with the project’s scale, the quality of the finished phases, and the rapidity with which the entire project is being completed. What struck one as odd on a recent visit is that all of these impressive facilities were empty.
Provincial officials and project managers gladly escort interested parties on a new city tour to explain the possibilities. One laboratory is pointed out as the future source of Chinese wireless broadband technology. Another skyscraper is eagerly described as a future incubator for a Chinese alternative asset management industry. An unfinished hotel is also said to be taking reservations for world-class conferences with A-list speakers from around the world.
Meanwhile the visitor stares out at miles of mud flats, with poured concrete and steel rebar footings for dozens more malls, skyscrapers, and hotels. This vision of seven new cities would be daunting enough—until one realizes that Nanjing is among dozens of cities all over China building similar metroplexes on a mind-boggling scale. The Chinese have earned a reputation around the world as master builders to rival the Pharaoh Ramesses II.
The Nanjing South Railway Station is not empty, but it also illustrates China’s deficient approach to infrastructure development. In 2009 China was reeling from the same collapse in global demand that had affected the United States after the Panic of 2008. Its policy response was a ¥4 trillion stimulus program, equal to about $600 billion, directed mainly at investment in infrastructure. The United States launched an $800 billion stimulus program at the same time. However, the U.S. economy is more than twice as large as China’s, so on a comparative basis, China’s stimulus was the equivalent of $1.2 trillion applied to the United States. Four years after the program was launched, results are now visible in projects like the Beijing-Shanghai high-speed railroad and the Nanjing South Railway Station.
The station has 4.9 million square feet of floor space and 128 escalators; it generates over 7 megawatts of power from solar panels on the roof. Ticketing and entry to platforms are highly automated and efficient. The new trains are not only fast but also comfortable and quiet, even at their top speed of 305 kilometers per hour. Importantly, the station took two years to build, using a force of 20,000 workers. If the object of such infrastructure is to create short-term jobs rather than transportation profits, the Nanjing South station might be judged a qualified success. The long-term problem is that a high-speed train ticket from Shanghai to Nanjing costs the equivalent of thirty dollars, while a journey of similar length in the United States costs two hundred dollars. The debt incurred by China to build this monumental train station can never be paid with these deeply discounted fares.
Chinese officials rebut the excess capacity criticism by saying that they are building high-quality infrastructure for the long term. They point out that even if it takes five to ten years to fully utilize the capacity, the investment will prove to have been well founded. But it remains to be seen if such capacity will ever be used.
Apart from the infrastructure’s sheer scale, China’s vision of expanding the science and technology sectors of the economy faces institutional and legal impediments. The high-tech wireless broadband laboratory in Jiangning is a case in point. The research facility has massive buildings with spacious offices, conference rooms, and large labs surrounded by attractive grounds and efficient transportation. Local officials assure visitors that fifteen hundred scientists and support staff will soon arrive, but the most talented technologists require more than nice premises. These scientists will want an entrepreneurial culture, close proximity to cutting-edge university research, and access to the kind of start-up financial mentoring that comes with more than just a checkbook. Whether or not these x-factors can be supplied along with the buildings is an open question. Another problem with building for the long run is that obsolescence and depreciation may overtake the projects while they await utilization.
China’s political leaders are aware that wasted infrastructure spending has permeated the Chinese economy. But like political leaders elsewhere, they are highly constrained in their response. The projects do create jobs, at least in the short run, and no politician wants to preside over a policy that causes job losses, even if it will result in healthier long-run outcomes. Too often in politics everything is short-term, and the long run is ignored.
Meanwhile the infrastructure projects are a windfall for the princelings, cronies, and cadres who run the SOEs. The projects require steel, cement, heavy equipment, glass, and copper. The building spree is beneficial to the producers of such materials and equipment, and their interests always favor more construction regardless of costs or benefits. China has no market discipline to slow down these interests or redirect investment in more beneficial ways. Instead China has an elite oligarchy that insists that its interests be served ahead of the national interest. The political elite’s capacity to stand up to this economic elite is limited because the two are frequently intertwined. Bloomberg News has exposed the interlocking interests of the political and economic elites through cross-ownership, family ties, front companies, and straw man stockholders. Saying no to a greedy businessman is one thing, but denying a son, daughter, or friend is another. China’s dysfunctional system for pursuing infrastructure at all costs is hard-wired.
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 pric
e 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.
The Death of Money Page 12