Nassim Nicholas Taleb coined the term “black swan” to describe high improbable events that none consider but that in the long run, they turn out to be the events that shape our financial and economic system. It goes without saying that the last economic crisis in 2008 could have been described as a black swan event. On the contrary, some coined the term “gray rhino” to describe a widely known systemic financial risk that is ever-present but never realized, so it becomes increasingly unimportant.
China’s economy fits especially well in the term “gray rhino” as the potential bust of its economic system may well trigger an economic downturn across the board and at the same time, everyone knows about the huge systemic risks that China’s economy poses for the global economy.
In this article, we aim to investigate (i) the evolution of the well-known financial risks in China, (ii) the long-term prospects of China’s economy when it comes to economic prosperity and (iii) the likelihood that the financial risk could materialize in the foreseeable future.
- One party rule
Much has been discussed about the long-term economic consequences of a non-democratic government. The evidence suggests a direct link between the quality of the institutions and the level of living standards in the long-term. Good institutions that guarantee freedom of speech, separation of powers, rule-of-law and a system of check and balances that prevents the government from owning too much power, create a structure of incentives that make possible a path towards high economic prosperity.
In China, according to rule-of-law indicators of the World Bank, the quality of the institutions is very low, corruption is still driving economic life, internet control is rampant, and the financial system is still controlled by the state, both creating credit allocation inefficiencies and distorting the private ownership principle of individuals by forbidding the free competition among banks.
However, China’s companies and individuals at the same time can benefit from the intellectual capital from foreign companies and from high quality institutions placed in Hong Kong. Also, Chinese society has a rich culture and social values that come from Confucian and Taoist traditions still present in China. These facts provide a cushion for private companies and individuals to thrive despite the one-party rule and low-quality institutions in China.
For these reasons, we believe that China will never achieve a high level of economic prosperity unless its institutions will guarantee economic freedom, social and political freedom, rule-of-law and limited-power government. Currently, the GDP per cápita in China is below 9,000 dollars, considered to be a middle-income country or even a low-income country. By contrast, Taiwan GDP per cápita is almost 3 times higher, close to 25,000 dollars.
China experimented with communism during the Mao era, resulting in a GDP per capita of 614 dollars in 1950, even below Republic Democratic of Congo. After Mao’s death, Deng Xiaoping created an economic revolution, allowing foreign companies, joining to the World Trade Organization, increasing the legal certainty and reducing the planification of the economy as well as allowing individuals to freely set prices. Since then, China’s GDP per capita advanced quite rapidly being already in the 181th position in the world by GDP per capita.
Nonetheless, after the Tiananmen Square protests in 1989 the speed of the economic reforms was reduced significantly as the party seen jeopardized its one-party rule and decided to give more room to State-Owned Enterprises (SOEs) over private enterprises, increase the degree of social control and censorship and increase the level of taxation. Since 1989, the GDP per cápita in China was advancing at a slower pace. It took 27 years to overtake 81 countries in the world. In 1990, China was the 181th richest country in the world per GDP per capita; in 2017 it is the 99th richest country in the world. In conclusion, China will never join the club of rich countries unless China has high-quality institutions and eliminate the one-party rule. This is according to our opinion, the biggest threat to economic prosperity in China.
- Economic slowdown despite easing measures
China as a dictatorship under the Chinese Communist Party rule, still controls a wide range of issues in the country. According to research, the size of the Chinese government is 400% of the GDP, a percentage much larger than other economies, such as the US. Recall that China own all the land in the country, the biggest companies are state-owned and that all major commercial banks are also nationalized, being a branch of the Ministry of Finance.
In addition, China imposes capital control measures along with a fixed-exchange-rate regime. This means that China’s government attempt to maintain the currency exchange rate within a set range. This gives an additional layer of economic control. China could devaluate its currency to foster net exports and shore up its economic growth. In addition, China can restrict the free movement of capital, so that malinvestments in China are shored up since the money is captive in China. Due to this fact, big Chinese companies that could otherwise invest in more profitable projects in other countries are forced to invest in low-quality projects in China. This may explain why China has lingering doubts about its economic soundness, being dubbed as “gray rhino”. China may be facing several financial bubbles, but they are shored up by captive money and government controls. Evidence suggests that after the financial crash in 2015 in China, the money flew to real estate in tier 2 cities like Shenzhen.
In 2008, China’s government implemented a credit binge through its 4 trillion RMB stimulus package, via local government debt and ordering a credit spree to commercial banks. As a result, China entered the club of the most indebted emerging economies in the world. In 2016, the total debt of China reached 166% of the GDP. In consequence, the Chinese government implemented several measures to deleverage the economy, including the following ones:
- Tighter monetary policy
- Cleaning zombie companies
- Increase discipline to State-Owned-Enterprises (SOEs)
- Control of Local Government Financing Vehicles (LGFVs)
- Prevent banks from lending to sectors with overcapacity
- Restriction of shadow banking activities
In 2018, China’s economic slowdown deepened as shown by weaker than expected figures in industrial production, retail sales, auto sales and fixed-asset investment. At the same time, China is facing uncertainty regarding trade negotiations with the US, after US administration decides to impose higher tariffs to Chinese products. In the meantime, both administrations are negotiating a new trade deal, that may include Chinese concessions to the US.
Because of this economic slowdown and high debt, the capacity of the Chinese government to implement new easing and stimulus measures through credit is rather limited. Therefore, the government decided to continue clamping down local government debt while decided to loosen its monetary policy. The Chinese government decided to reduce the reserve requirement ratio for commercial banks, thereby increasing the overall liquidity in the financial system. Moreover, the government also announced a decline in payroll taxes for both individual and companies, the reduction in the VAT tax and import tax, an attempt to foster the economy without increasing the debt levels of the country.
Despite the high level of debt in China and the economic slowdown, we consider that China’s government still have the capacity to handle this economic downturn, due to the following factors:
- The saving ratio of China’s economy is still very high, as China’s economy does not have a fully developed welfare state. This means that individuals need to save to cope with uncertainties about retirement and health, but also that the expenses of the government are lower and having less deficit and debt.
- China’s control over the whole economy is very high. China can control its currency and capital flows, the interest rates and most of the credit that flow through its banking system. Also, China’s government -as happened in the past- may ban the sale of stocks or assets to prevent the price to drop.
- RMB devaluation
At the same time most of the economist recognized China’s economy as a “gray rhino”, namely, a well-known flawed economy whose risk never materialized, the RMB registered two waves of steep devaluation, shoring up its economic growth.
During the stock market crash in August 2015 in China, the RMB registered a significant devaluation (from August 2015 to January 2017, -13.7%) and during the recent economic slowdown, it is registering its steepest devaluation since 1994 (from April 2018 to November -10.5%).
This devaluation of the Chinese currency is caused by several factors:
- Strong USD due to a strong US economy and rising interest rated in the US
- Uncertainties regarding trading relationships between China and the US
- Loose monetary policy in China to cope with a slowdown in China
- Weaker economic growth
- In long-run China will never be a developed country with a high-income GDP per capita unless China will improve its institutions and abandon its one-party rule.
- China’s GDP growth is slowing, and the debt is mounting. However, China’s government still have the capacity to cope with financial hurdles.
- Trading negotiations with the US are the biggest risk to China’s economy. If China’s economy makes ambitions concessions to the US opening its economy to US imports and competition, it may mean higher living standards for both US and China, but lower control of the Chinese Communist Party over China’s economy.
- China is increasingly facing a trade-off between its citizen’s prosperity and China’s Communist Party control over China’s economy. This trade-off is especially obvious in the trading relations with the US.
 The Black Swan: The Impact of the Highly Improbable. Nassim Nicholas Taleb
 The gray rhino: How to Recognize and Act on the Obvious Dangers We Ignore. Michele Wucker
 Law, Finance, and Economic Growth in China. Franklin Allen, Jun Qian Meijun Qian, The Wharton School
 Law, Finance, and Economic Growth in China. Franklin Allen, Jun Qian Meijun Qian, The Wharton School
 International Monetary Fund, 2017