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The U.S.’s Dangerous Miscalculation on a Chinese Debt Crisis

Aug 09, 2018
  • Vasilis Trigkas

    Onassis Visiting Scholar, Tsinghua University
  • Qian Feng

    Director of the Research Department at the National Strategy Institute


As the largest trade war in post-WWII economic history has officially launched, and President Trump is determined to escalate it, some American economists have now subscribed to the old myth pushed by Gordon Chang of an imminent Chinese economic meltdown. Their reasoning is the epitome of conventional economics and goes as follows: the debt levels of local governments and state-owned enterprises (SOE)s can only be maintained at a sustainable level while the economy is soundly growing, meaning Chinese GDP is expanding by over 6%. As a trade shock will drag growth to levels below 6%, highly indebted organizations will be unable to grow their way out of pressing liabilities. This will spark a massive debt crisis, loss of confidence, and an eventual economic meltdown. Meanwhile, pressure on the renminbi (RMB) will accelerate and China’s $3.2 trillion currency reserves will be unable to prevent a collapse of the exchange rate even with draconian capital controls fully applied. With economic trust shuttered and inflation rising abruptly due to the RMB’s free fall, the CPC’s very legitimacy would be questioned. To avoid such an ominous scenario, the CPC would have to capitulate early and offer Washington sufficient trade concessions, or so the argument goes.

As Yukon Huang of the Carnegie Endowment for International Peace put it, conventional economics however will only have minor success in evaluating the impact of a trade war on the world’s second largest economy; an economy also shaped by many unconventional factors with singular Chinese characteristics. Moreover, the unsubstantiated American strategic optimism that a trade war will provoke a Chinese economic meltdown is incentivizing President Trump to be hawkish rather than conciliatory. In international relations, accurate strategic perceptions are essential for deal making, and if one side overestimates its capacity to influence the strategic environment of its adversary, then conflict would persist where a mutually beneficial accord would have otherwise been reachable.

It is thus essential that American strategists examine Chinese economic fundamentals carefully before drawing easy conclusions on the fragility of the Chinese economy and the propensity of the CPC to submit. Three key “China specific economic dimensions” should be considered in some detail: the total information management of the CPC and its ability to control informational cascades, emergency nationalization overruling property rights, and last but not least, China’s monetary revolution in going cashless and boosting national tax revenues.

The CPC’s Control over Financial Information

Information is a key input shaping the behavior of economic agents and the overall aggregate direction of the market. A major difference between the West and China is that financial information is screened by the government. If a large state-owned enterprise or local government faces pressing liquidity constraints, the government can limit the spread of this news, hence controlling an “information cascade.” This would provide time for regulators to act and apply suitable regulatory, monetary or fiscal remedies to prevent the crisis from escalating and becoming systemic. Western capitalism cannot emulate this, as the press will immediately report a liquidity crisis or even sensationalize danger, making the government a post-hoc actor with limited capacity to contain a nascent crisis.

To be sure, the government’s ability to drastically screen information does have certain trade-offs. If used too much it creates moral hazard and does not contribute to the long term efficiency of price signaling. However, if the control over financial information is being used strategically and complemented by post-hoc accountability, then the aggregate impact upon economic activity could be positive.

CPC’s Capacity to Nationalize Systemic Economic Agents on the Spot

In China, the national interest is supreme; when the stability of the national economy is at stake, a big financial corporation or a systemic market actor can be nationalized in a timely way and liquidity fixed by an adequate capital injection under emergency procedures. The recent case of Anbang is a prime example. The company was taken under national trusteeship rapidly and its chairman arrested on the spot. In the U.S., Congress, the White House, and the Treasury would have to fight a months-long legal war with armies of lawyers and lobbyists, losing essential time. One may consider the 2008 financial crisis, Solyndra’s insolvency or the bailout of the U.S. auto industry and the time it took Congress and the Executive Branch to act.

The Cashless Revolution: A Bonanza for Tax Revenue

Technology also empowers Chinese regulators. The big data revolution and the nascent social credit system optimize private capital allocation and ease the economy’s transition to a more sustainable model. China is a global leader on cashless transactions, with its fintech outmatching the U.S.’ by a factor of 10. This provides an enormous amount of data to Alipay and WeChat Pay, allowing them to create complete credit rating profiles for over 800 million users. This is a massive efficiency boost to private capital allocation as both moral hazard and adverse selection – financial capital allocation’s two endemic problems – are minimized by credit profiling.

This does not resolve the soaring debt of local governments, but it can alleviate pressure on the national government budget because cashless transactions make taxes easier to register. If China pivots towards a totally cashless economy, the shadow economy would immediately be included in national statistics. Cashless transactions would thus lead to a future cashflow effect and boost trust in the central government’s ability to undertake a fiscal expansion and bail out insolvent institutions without a national debt overshoot. Deleveraging could thus be achieved by a present boost in state revenues capable of smoothing the process of sustainable debt reduction without constraining short-term fiscal expansion.

The People’s Bank of China (PBoC) has gone to great lengths to estimate the impact of a cashless economy on monetary policy. Macroeconomic modeling can be complex and it often misleads; however, going totally cashless is a strategic decision which China can easily implement as it already has the tactical technology platforms – the cashless ecosystem – on the ground. For instance, the government could impose a special ad valorem fee on ATM transactions to discourage people from drawing money out of ATMs and encourage the use of e-pay platforms instead. In many cases, with cash, shopkeepers do not issue receipts and thus VAT is never really paid. With cashless payments, the payment is real-time and automatic: with VAT immediately registered with national accounting systems, tax revenues would increase. In addition to the “VAT effect,” transaction data analytics would make income tax easier to estimate and would limit tax evasion (the “income tax effect.”) Even in the case of Greece, cashless transactions have achieved a miracle in normalizing the country’s fiscal environment.

To be sure, worries about the impact of a trade war on the Chinese economy have also been heard within China, with an unusual verbal confrontation between the PBoC and the Finance Ministry concerning the pace of deleveraging that China should be pursuing amidst a trade war. The PBoC officials have supported a strong fiscal stimulus while Ministry of Finance officials have opted for targeted fiscal easing through SOE’s.

Evidently, the Chinese economy is not invulnerable to global shocks, but having already amassed an enormous amount of wealth and driven by mass grassroots entrepreneurship, China’s economic vibrancy and debt deleveraging will mostly be determined by domestic politics, smart supply-side reform and sustained opening up. It is only by reform at home that productivity can sufficiently rise, boosting China’s welfare and normalizing the long-term debt to GDP ratio.

It is thus essential for American strategists to accurately evaluate Chinese economic fundamentals and not to overestimate the adverse impact of the U.S.’s trade tariffs on China’s debt sustainability, as this would motivate President Trump to escalate the trade war and push China and the U.S. down the path to conflict.

Even in the 60s, when China was much weaker, the country decisively pushed back against foreign coercion and dared to confront both the Soviet Union and America – the world’s superpowers. A miscalculation of China’s economic fundamentals and its determination to fight against commercial coercion would have grave consequences not only for America and China, but for the global economic order.

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