Why the China Threat Is Overblown | Logan Wright

24:23It doesn't matter whether it's eight, three, five. So why don't you say, okay, potential's eight. We were at 14 at the peak. We're going to go to five at the trough. We're going to bounce from there. And we don't therefore need to expend all of this credit in order to kickstart growth at a higher rate. And he said to me, it was just one of these conversations I always remember. This was back in 2009. He says, I completely agree with you. But if we actually said it was five, everyone in the system would think that zero and they would start panicking. So his point was like, there's this internal party coherence aspect of this, that you need to be basically sending messages that show that the party leadership has this under control within among party cadres themselves.

25:08It's not really directed at the people, so to speak. It's not really directed at sort of a nationalist message that we're the first out of the financial crisis. And then externally, especially now, the importance of the narrative is basically for, in my view, first, why can't Xi Jinping admit that growth might be lower? Well, one, he probably doesn't believe it. He believes that growth might be lower than 5%, but there's no way that Logan Wright is correct and growth is zero. So it's somewhere in between. We have some things going for us. We have robotics and AI and export dominance and things are going pretty well for us.

25:45And I don't really understand what the economists are saying, but it's not nearly as bad as it was a couple of years ago when we had this sort of local government fiscal crisis. So there's that sort of view that they just don't believe it. The other is this narrative, this ideological narrative, the East is rising, the West is declining. So how can China have a problem? How can there be slower growth in the West? I mean, if I told most people in Washington, I say this all the time, by every measure, the United States has outgrown China in the last five years. I mean, official data, unofficial data, nominal, it's like in nominal terms.

26:18I mean, yes, it's because there's higher inflation in the US, but this is really what matters. It's nominal growth that repays debt and drives corporate profits and drives reinvestment. You do not want persistent deflationary pressure. And then the other part of this is the strategic messaging. If you are trying to push back against de-risking, you do not want to say domestic demand growth in China is going to be zero because then the economy is not worth arguing over. If you are trying to push back against Western sanctions and export controls, you want to say, our economy is still vibrant enough that you still want to trade with us even if we're being sanctioned and face these sort of controls.

26:56So strategic competition comes into all of this and is actually, I mean, I think a pretty critical part of unlocking some of these changes as well because China is basically coming into a set of choices where relaxing strategic competition and seeking some kind of detente with the rest of the world, especially in trade tensions, is going to become a preferred option because they really won't be able to continue this kind of model for much longer.

27:23Demetri Kofinas:I'm fascinated at the differences between the Chinese political economy and what we have in Western countries and the role that things like Xi Jinping thought seem to play. It's almost kind of like presidential doctrines. When the executive in the White House has a specific sort of vision for the country and foreign policy, that sort of diffuses throughout the cabinets within the executive branch. And people sort of use it as a point of direction to navigate because most people in government don't have regular access to the president. And it feels like, to some degree, China's economy functions in a kind of similar way, that it's more bureaucratic.

28:07Demetri Kofinas:And so I think when people look at it from a Western perspective, it's hard to really capture that. I also want to mention Joseph Torrigian's book, The Party's Interest Come First. Joseph had been on the podcast, and I think also was very helpful for me in thinking about some of the policy choices that Xi Jinping has taken, and in so far as not reforming the economy along the lines that someone like you or Michael Pettis would think is necessary. Okay. So I think we've done a good job here of establishing a base. Let's talk about where things went wrong. When did things go off the rails for China's economy in your view?

28:41It's a good question. So I mean, I think that there's a first run of disorder, so to speak, and instability that starts in 2012 to 2016. And so this is right after the global financial crisis, you have this huge credit expansion. Money supply basically doubles. I think it was up 85%, 88 % in three years.

29:00Demetri Kofinas:Because I really want to make sure that we spend quite a bit of time on their response to the financial crisis. Also, tell us a little bit about, because the financial crisis happened at the same time as the Beijing Olympics. What was the overall lesson that China's leaders took from those two events? And was it important that they happened concurrently? And then go ahead and complete your answer. Yeah. I talk about this in the book as well. So the Olympics happens and it's this enormous coming out party for China. And it's this enormous signal that China's joining the rest of the world and is committed to joining the rest of the world and has been successful in doing so as this important marker.

29:37And then at the same time, all of the borrowing from foreign influence that I discussed, all of the importance of using foreign economic models and different structures, that comes into this. The financial crisis causes Chinese officials to start questioning a lot of that logic because it looks like the system just failed and created this huge disruption. At the same time, China reveals that they're vulnerable to dollar financing constraints. Trade credit contracts globally. It impacts China's exports. The crisis in Beijing's view, notwithstanding the savings glut versus the US consumer housing debt overlap, their view is basically like, this is a Western financial crisis.

30:19How come our trade is being impacted to this extent through purely financial lenses? Then you start thinking about, okay, can we internationalize our currency? Can we drive renminbi-denominated trade credit? Zhou Xiaotuan puts that marker down for a change in the international monetary system as early as March 2009. This was a period of very significant shifts in China. I don't think I even mention this in the book, but there's also outright conspiracy theories going on about the financial crisis in China. One of the most popular books at that point was this sort of, it's like Protocols of the Elders of Zion kind of overlap with international monetary theory called Currency Wars, and written by this sort of amateur armchair historian.

31:04But I recall being at a conference with this guy on the stage and a bunch of macroeconomists and in 2008, 2009, and they were talking about the book and the macroeconomists are saying things like, Mr. Song, we've read your book, but this isn't really how the global economy works. And these are sort of the forces that you're not looking at, et cetera, et cetera. But he gets all the applause, absolutely all the applause for this sort of the West is conspiring to use currency politics to contain China in certain ways. I don't remember the exact argument. It It was kind of silly.

31:36Demetri Kofinas:Is there an important lesson we need to draw from what you just said there, or is this just a sort of general appeal to populist messaging that would also operate in Western countries? The point I would make from this is that Western models are suddenly being questioned. And so suddenly you have this idea of convergence with Western practices doesn't look nearly as attractive to critical elements of the party structure and Chinese people and the global financial crisis creates this delegitimization process. That was really the point I was trying to make. And one more quick question before you continue with your previous answer.

32:13Demetri Kofinas:Why was it so difficult for Chinese policymakers and people within the intellectual community to recognize that part of the explanation for the crisis was the structural trade surplus and the capital deficit that the United States was running and importing capital from China. Oh, I recall having this conversation with people in the PBOC. I said, well, yeah, but your savings glut is part of what's financing US corporate debt. And the responses were just like, that's impossible. No, I mean, it's US household borrowing that is driving this. We can't create liquidity, only you can create liquidity.

32:49This was straight from the PBOC. I recall having these conversations in 2007, 2008.

32:54Demetri Kofinas:Was that informed by a kind of like Puritan perspective, like the same sort of ideas that Joseph Tarrigian puts forward in the party's interest come first in terms of Xi Jinping's upbringing and the need to sort of eat bitterness? No, I think it's more fundamental. It's just like, we can't possibly be that important in terms of what was driving this. We can't possibly be the causative agent. And you still see this, like right now, China has an investment led economy, very weak domestic demand. They can only grow relative to the rest of the world by displacing others' investment because they are the largest investor in the world, unless they are actually rebalancing domestic economy.

33:32But they don't view that as a fundamental economic imbalance from their perspective. They view that as a diplomatic problem, like to make the world safer for Chinese exports. And so that's a huge risk. And so it's this sort of, you know, China became far more important in international finance relative to its importance in international politics. And that happened faster. And that empowered certain individuals within the Chinese system who had these sort of outsized roles. The other example I'll give you. So I worked as a stringer in covering the strategic economic dialogue between the U.S. and China in May 2007.

34:11And I was in D.C. and it's just this interesting sort of microcosm into the Chinese system. So like all of these ministers walk out of the room and I'm speaking, you know, bad Chinese and I'm trying to interview the head of the NDRC who at that time was Ma Kai. And so I try to ask Ma Kai a question and Ma Kai looks at me like, first, who is this foreigner speaking Chinese? Second, who the hell are you to ask me a question like in this regard? Four people later, Zhou Xiaochuan comes out, governor of the central bank. Everyone swarms around Zhou Xiaotuan. He's the lowest ranking official within this delegation, but all the foreigners just want to see what is Zhou saying about monetary policy, which makes perfect sense for a financial market audience.

34:57But within the Chinese system, they're just like, what are they missing? Why on earth do they want to talk to Zhou? We're a lot more important and we're not going to talk to you, but this has to be this huge moment of cognitive dissonance. But it reflects this idea that China became far more important in international financial policy relative to where they were in international politics or in terms of trade flows as well.

35:20Demetri Kofinas:Is the understanding of the Chinese leadership to the trade restrictions placed by other nations on China similar to their understanding and perception of the 2008 financial crisis and the role that their trade surplus played in generating capital outflows and increasing credit availability in Western countries. In other words, do they see the responses as sort of anti-China being driven by fears about China's rise and attempts to contain China and less so about the manifest hollowing out of domestic industry and the political interest groups within these countries like Germany, for example, that are invested in preventing it.

36:05Right. So I think there are parallels there. I think that the current disconnect is far larger than it was back then. I mean, back then, there was a lot of concern about, if you recall, Chinese exchange, I wrote my dissertation on China's exchange rate reform. So during 2004, 2005, you had this threat of tariffs from Lindsey Graham and Chuck Schumer in the Senate. Treasury got to say, good cop, bad cop, look, if you don't do something about the currency, there's going to be this congressional pressure to do something about trade. Therefore, you need to adjust the currency. China reforms the currency in 2005, but there's this belief that, okay, this is unfair in terms of they shouldn't be pressuring China's growth model and that the China shock isn't...

36:54At that time, it was a supply shock of labor. It was about wages. And it was about currency undervaluation because productivity gains in the Chinese system weren't the same as they were later, but you had real consequences in the industrial Midwest for outsourcing of a lot of those jobs. So the first China shock was a real development, but because foreign companies were so involved in that movement, the agency wasn't really placed, so to speak, on China itself, like that this was a policy problem from China. That is very different now because the real issue is that if China cannot generate domestic demand, then trade tensions are inevitable.

37:35But how is Beijing interpreting those trade tensions? They're interpreting, I think, exactly the lens that you're talking about where this is sort of a containment-oriented approach. They're just trying to stop China's rise. I like to frame it this way. We think about global economic imbalances as temporary problems to be alleviated with policy so that you don't have these dramatic adjustments in a crisis, right? China thinks as global economic imbalances is the deliberate objective of their policy. They want to expand global export share and global value added, and they are not in position to expand domestic demand at the same time.

38:14So that is a far different sort of state of affairs, I think, relative to the past. But I do think that the global financial crisis, as we go back, was this pretty important kind of inflection point for thinking about foreign influence in China's economy. And you start seeing, first, it's harder around this time. I mean, it's not 09, 10, but it's 11, 12. It's harder to get meetings. It's harder to have forthright conversations. There's more investigations into foreign influence. And in part, this is because of the Bo Xilai incident and all sorts of things that were happening in the US-China relationship at the time, which are sort of beyond the scope of the book.

38:55But the start of this is really during the financial crisis itself.

38:59Demetri Kofinas:All right. So put the scale of China's post-GFC credit expansion perspective. How large was it relative to anything that the world had seen before? Larger than anything that's happened in at least a century in a single country. So $24 trillion between 2008 and 2016,$27 trillion by 2017, depending on how you cut it off, relative to only about$6 trillion in GDP during that time. Credit to GDP multiples expand about 80 percentage points during that timeframe. I mean, depending on how you measure, but it's in that kind of range. And that is equivalent at the time to about a third of global GDP. So I urge people to just sort of grapple with this.

39:38You're saying that Chinese state banks and local government banks basically extended credit the size of Germany or Japan's economy every year for eight years and increasingly had less and less control about where it was going. And the idea that all of this lending was productive is just impossible to sustain, if you think about that in that context.

40:06Demetri Kofinas:How much of that was driven by domestic savings and how much of that was driven by foreign capital? Right. So at first, I mean, China's savings rates are high, still 40 % overall, but it's not that it's all funded by this expansion household deposit. So for years up until about 2011, until the European debt crisis, actually, you had this very steady inflow of new deposits into the system because China was running trade surpluses that were very large starting in 2003, 2004. And so the challenge for banks was, how do we lend out all these new deposits that are generated? Because you're intervening in the currency markets, therefore PBOC is buying the dollars, generating new renminbi liquidity.

40:45The concern is inflation and the concern is too much credit growth, which they try to control with quotas. When they put controls on those with quotas, that leads to the growth of the shadow banking system, which then starts to have this own self-fulfilling logic from 2012 to 2016, which we can talk about in terms of where that goes. But there's this strong external component to funding China's credit expansion at that point. Then in 2012, you shift from a system that was broadly characterized as financial repression, in which you have no opportunities as domestic savers to really invest outside the banking system.

41:20And you're forced to put deposits on at low rates in the state banking system, and they lend them out to state-owned enterprises. And you shift to sort of a system of subsidized moral hazard, because suddenly there is no net inflow. In fact, you have an outflow of capital. And so some banks are actually scrambling for funding. And they have to bid against other banks to attract this funding and maintain their loan books, because there's still credit demand from local governments to keep these projects going. So this introduces new funding stress and introduces this new problem of wealth management products, these shorter term deposit-like instruments that have to be rolled over.

41:58You fast forward by between 2012 and 2016, you've completely changed the structure of China's financial system. 2012, you had a system that was deposit funded, made loans inefficiently, but made loans to state-owned enterprises, and had a pretty stable funding base because there was this steady sort of inflow of new deposits in the system so it could grow. By 2016, marginal growth in funding is from a non-deposit instrument, a wealth management product. Marginal growth in lending is via a shadow bank, a trust company, something else that's largely lending to property developers, margin financing for equities, local government financing vehicles, you name it.

42:41Then there's huge volatility in balance of payments conditions as there's these enormous capital outflows from China that happened in 2015. It's a totally different system and this happens very, very quickly. Suddenly, you have a far more unstable system, but the actual pace of credit growth is still large. And why? Because there's this implied moral hazard, like no one thinks that anything can default. And it can't default as long as more and more credit goes out to roll over existing loans. And so the financial system serves as the shock absorber for the political system. It insulates individual investors from losses, and it insulates companies from bankruptcies and provincial leaders from unemployment until it can't.

43:28and it stops really in late 2016, but by 2018, it's pretty apparent. I don't want to get too far ahead of your questions here, but I can tell you the whole narrative of the deleveraging campaign if that's interesting.

43:41Demetri Kofinas:I should mention before we continue, for anyone that heard those sirens, we're actually recording this on September 23rd, and you're in Washington DC. So we're anticipating the arrival of Xi Jinping this evening for the Trump-G summit. So I think this is quite apropos. There's just so many questions I want to ask you, and you've sort of addressed a lot of them in pieces in your previous answer. I guess before you continue on with the narrative, what is important for us senators? First of all, why is it important that this lending happened through the banking system and then eventually increasingly through the shadow banking system as opposed to the central government?

44:16Demetri Kofinas:How should we think about the role that local governments played? And just put this all within the context of how China's political economy operates, which is so foreign to the Western mind. Sure. And we'll step back a little bit to the immediate post-crisis environment. So the G20 looks at the global financial crisis and that the mandate that goes down is basically everyone, let's find 10 % of GDP and stimulus. And so China comes up with a 4 trillion yuan quote unquote stimulus plan. And everyone's just like, well, how are you actually funding that 4 trillion yuan. Is that direct fiscal spending?

44:50It's not. It's funded indirectly through the banking system. Why is that? Because fiscal spending takes time. You have a periodicity to government bond issuance, and then you have to transfer those resources to local governments, and then you have to find projects for them. But you've actually been just controlling local governments borrowing for a long period of time. The easiest thing to do to stimulate lending is just to let the local governments borrow as much as they can and to get this kickstarted where loans create deposits and then that facilitates new credit growth at the same time. So that's really how this gets started in 2009.

45:28And so the expansion in credit happens very, very rapidly. And then that starts to filter into inflation by 2011, but a lot of infrastructure investment, a lot of property investment. I mean, I recall in 2009, state-owned companies were just like, well, what do we buy? Let's just speculate in some commodities. So they just started buying stockpiled commodities and things like that because they had so much money at hand. And this is where none of this was strategic. People were arguing at the time that this was the opportunity to rebalance the economy. This was the opportunity in which you could have come up with a different form of economic management.

46:04You could have changed the fiscal system to prioritize transfers to households. But the priority was, let's get out of the crisis first, and let's clean up the consequences later. And the banking system was the tool to do that. What that means is that none of these loans that were extended were ever really intended to be repaid by the ultimate borrowers. There was an assumption that these were to state owned companies and that there was a government guarantee behind them. And so basically, as I kind of pithily noted, moral hazard wasn't a problem. It was a strategy. The idea was that everything could continue to expand because everyone assumed that the government was on the hook for one part of this lending one way or the other.

46:48So therefore, everyone's just happy to continue to generate more money creation. And so the constraints become rolling over the loans, the actual funding of the system in terms of wealth management products themselves, and then inflation. And so you have an inflation pickup in 2011, and you haven't really had any significant inflation in China since that time, since basically the summer of 2011. And that just shows you how inefficient the lending has become even after the shadow banking activity continued expanding. You instead got bubbles in the equity market, you got bubbles in the property market, you've got bubbles in commodity trading, because that's where the money started to flow under these sort of shadow banking, shadow lenders.

47:32Demetri Kofinas:God, this was such a good book. And in this portion of the book, I kept thinking to myself, wow, this is like Hayek's worst nightmare. I mean, the convoluted intervening to fix a previous intervention becomes so messy that you just kind of feel like they're caught in this situation where anything they do to try to fix the problem just ends up making the problem worse. But if they step away, it's obviously going to be way worse in the short term, which is kind of the dilemma that policymakers find themselves in today. And we're going to have a chance to talk about that too. We discussed the consequences and the aftermath of the bubble.

48:05Demetri Kofinas:Just one more question before we move to the second hour. So you mentioned the implicit guarantee. How widely held was this assumption? How important was it in helping to fuel the expansion? And how similar is it to the widely shared belief that the US government won't allow, for example, money market funds to fail, whereas maybe a better analogy that the US government won't allow the stock market to go down. So is it comparable in any way to that, or is it just on a much bigger scale? It used to be far more specific. And so this is important to understand is that financial risk was ground up in political risk in general.

48:41Why did people think that their assets were going to retain their value? So you always believe that even if there were problems, as long as everyone was taking the same risk. The government was basically on the hook for stabilizing these asset markets. You might not have got 100 % of your investment back, but there would have been some sort of compensation that extends to the stock market, the bailout in 2015. But for wealth management products in particular, I remember these conversations very distinctly. So in 2013, in June, the government tries to break the shadow banking system. The PBOC tries to break the shadow banking system.

49:19And they conduct this experiment where they basically say, you have this asset liability mismatch. You have short-term funding. You have long-term assets. You need to solve this problem. And we're not going to help you. And you need to do this. So basically, in about five days, the entire financial system started screeching to a halt. And the reason was that banks were buying wealth management products from one another. And so, in other words, if you're a smaller bank, you're funding yourself with this 5 % wealth management product that you're basically issuing on the interbank market. And if you're a larger bank, you can't really find a borrower for that.

49:54So you're actually buying that wealth management product, but then the interbank rate goes to seven. So therefore it makes more sense to lend that money on the interbank market. So I therefore force maturities of the wealth management product from the other bank that I'm already holding. Holy cow. Then the smaller bank has to come up with additional money in the interbank market. And so the interbank rate rate goes from seven to nine. Then the interbank rate goes to 20 and 30. The overnight rate, basically on June 20th, 2013, the overnight rate hits 30%, which basically means there's no lenders left in the system as a whole.

50:27Suddenly, interbank rates are skyrocketing. This is the critical part of the story. Everyone assumed that this is a financial crisis. The short end has collapsed. there is no liquidity, but everyone assumes the government's going to step in. So if you are a regular depositor and a bank is offering you a wealth management product at 10%, ordinarily we'd think that's risky, but there's a flight to risk, a huge flight to risk. I know very intelligent Chinese financial analysts who literally took their life savings and put them in these wealth management products at 11 % for this month. This is also how Baal for Alibaba started for Alibay because suddenly they had these deposits and they could then start offering people higher returns than they could get by the banks.

51:19So there's a flight to risk because everyone assumes the government's going to bail out the system. Well, what happens when that flight to risk, why is there a flight to risk? Because people assume the government is weak. And if you think the government is weak, they're going to basically respond with this to financial instability and protests by just paying compensation. I like to joke, if you've ever been in a delayed flight in China during this time, you had to all gather around and chant at the ticket counter if you were going to get repaid for your flight, because otherwise they wouldn't pay attention to you.

51:51So everyone has to act collectively. Same thing happens six years later, five years later in Beijing in 2018. There's defaults on peer-to-peer lending networks. About 10 ,000 people organize a protest. First, they protest in front of the banking regulator, which is hilarious because the banking regulator... Who protests in front of the banking regulator? Everyone protests in front of the stock regulator because they're concerned about the stock market going down. But the idea that you'd protest banking regulation is kind of silly, so they're not even prepared for this. So they organized this on WeChat, but because they've organized it on WeChat, security forces are prepared.

52:27Because security forces are prepared, they just sort of bust everyone and get them out of here. And so they're not repaid. So you went from this notion of the communist party is weak and therefore they're going to, there's a collective leadership and therefore they're going to repay me if I face these financial defaults. And this is my expectation to Xi Jinping a centralized power. And if he's not interested in the potential consequences of these protests, then I'm not going to be repaid. And so suddenly, when you get defaults of peer-to-peer lending networks in 2018, smaller banks in 2019, trust companies in 2020, property developers in 2021, individual mortgage loans in 2022, local government financing vehicles need to bail out in 2023, free, credit demand just collapses because suddenly there's a flight to quality, not a flight to risk.

53:22That transformation that happens during the rise and fall of the shadow financial system is critical to understand why China's constrained today. Because you can't go back and say, oh, we're just going to guarantee all these shadow lenders again. First, they don't want to. Second of all, no one believes it. There's been a collapse in confidence. Yeah, exactly. Sorry, long story, but that's the way this has evolved.

53:43Demetri Kofinas:Brilliant setup. Brilliant setup. So let's move it to the second hour. I want to give people an idea of what we're going to discuss. We're just going to go into much more detail as it relates to the consequences of the credit bubble and the things that I think are most important based on having read the book, as well as the implications. So obviously we'll talk about the property market. I also want to talk about the concentration of power under Xi Jinping, zero COVID, the tech and education crackdown, which I think also has its own sort of confidence crisis type downstream implications? And then what does this mean going forward, both in terms of policy implications for Beijing and for Washington?

54:20Demetri Kofinas:And how does this fit into the US-China strategic competition? And what are the primary risk categories that you identify in the book? For anyone new to the program, Hidden Forces is listener supportive. We don't accept advertisers or commercial sponsors. The entire show is funded from top to bottom by listeners like you. If you want to access the second hour of today's conversation with Logan Wright, head over to hiddenforces.io slash subscribe and sign up to one of our three content tiers. All subscribers gain access to our premium feed so you can listen to the rest of today's conversation on your mobile device using your favorite podcast app, just like you're listening to this episode right now.

54:57Demetri Kofinas:Logan, stick around. We're going to move the second hour of our conversation onto the premium feed. If you want to listen in on the rest of today's conversation, head over to hiddenforces.io slash subscribe and join our premium feed. If you want to join in on the conversation and become a member of the Hidden Forces Genius community, you can also do that through our subscriber page. Today's episode was produced by me and edited by Stylianos Nicolaou. For more episodes, you can check out our website at hiddenforces.io. You can follow me on Twitter at Kofinas, and you can email me at info at hiddenforces.io.

55:38Demetri Kofinas:As always, thanks for listening. We'll see you next time.