China's Growth Bubble

China has made incredible economic gains over the past two decades, modernizing much of its economy. However some portion of those gains only exist on paper. In a variety of ways, China has created artificial growth, an economic bubble or even multiple bubbles, which must eventually be recognized and resolved.

When a firm invests in a new business line, it is recorded as an asset in their financial statements, and is recognized as economic growth. But it is not yet growth. The new business line needs to gain revenues and profits, and finally bring in profits sufficient to overcome the investment amount. Then we have real growth. Along with this investment often the firm will seek a loan from a bank. This too leads to paper growth, as the bank now has an asset on its books. So the firm now must make enough profit to service the loan and repay its own internal investment.

Certainly if a factory is built with the funds, we have real economic growth. In past years, the loans and investment money would be turned into physical facilities, but this has led to over-capacity in multiple industries already. In light of that reality, at some point in the system people are balking. Someone (hopefully someone) will delay construction, recognizing the futility and waste involved. In the present climate, no one will check whether the investment has been implemented or not.

In a market economy there are thousands of such investments. Some fail, some succeed. If banks do their job effectively, then loans that have gone sour will be declared as losses relatively quickly, and attempts will be made to recover those losses. Lawsuits will be filed; assets will be seized and sold. Firms that have unreliable outcomes will be shunned, and will see their cost of borrowing increase significantly. This is obviously an oversimplification of very complex economic processes, but as we will see, if the banks are at least fairly efficient in declaring these losses, the result will be more economic growth, more tax revenues and more employment.

The banks may also choose to restructure or roll over these loans, in an attempt to recoup their investment. Sometimes the borrower just needs a bit more time, or a bit more capital, to reach profitability. They also may be more willing to delay recognition of a loss, depending on their balance sheets. Losses can be used to offset profits and lower taxes, so during profitable times declaring a loss is advantageous. Conversely in times of low profitability declaring losses will be less attractive, and the banks may have more patience. The important aspect for our discussion is that the banks and the firm both have some level of control over when these 'assets' are declared as losses.

China is not a market economy. The major banks may try to do their job effectively, but they are constrained by political direction and control. If they are told to lend, they will. If they are told to roll over a nonperforming loan, they will. If a bank manager is told not to allow any losses to be declared in their portfolio, then there won't be any losses in that period.

This is one important aspect of Bubble China. Any number of investments have been created, leading only to paper growth, but they haven't been declared as losses, even though they are not productive economic endeavors. This is very similar to what happened in Japan during the Lost Decade, which has arguably led now to 30 years of extremely low economic growth. Zombie banks had non-performing loans on their books, and acknowledging those losses would have sent the banks into bankruptcy. So, the banks simply did not declare the losses.

The actions of these zombie banks may seem unobjectionable to some, because they are making their decisions based on their economic position. Why not try to survive? The problem is that these banks create a drag on the economy in multiple ways. An example would be a factory built with bank funds. In this scenario, the factory is not being used in an economically-viable way: It's not making money. Indeed it may be sitting empty, losing value as it ages. In this situation the factory could quickly begin to break down, as a firm with such limited resources may not be able to pay for proper maintenance. In any event it's wasted capacity.

In a market economy the loss would be recognized, and the factory would be sold to a firm that can use it in a productive way. This would lead to the hiring of workers, and generate more taxes and profits. The government would earn more, employment would be bolstered. In some special economic situations this outcome may not occur, such as a significant economic downturn, where firms are not willing to invest. Still, in most situations recognizing the loss will lead to better economic outcomes.

In light of the very obvious land-use inefficiencies in China, the difference between these two outcomes should really be highlighted. One outcome is a factory slowly breaking down, with a few workers doing what they can, and little in the way of income or profits. The other outcome is more economic production, more tax revenues, and more employment. Currently Evergrande and Country Garden have thousands of half-built projects, and they are just sitting there, losing value, and falling into disrepair.

The government must send in experts to assess which projects can be made viable, and which must be declared as total losses. Even in the event of a total loss, the properties could be sold for something, and possibly firms could buy them cheaply and then finish construction. That would be an economic win.

Another example is a firm that is producing a product or service, but doing so very inefficiently. It is selling in the marketplace, perhaps even holding a significant portion of market share, but the inefficiency means that it is not making profit and can't pay off the bank loan. In this case the inefficient firm is blocking more efficient companies from growing, only by virtue of the bank loans. If the bank refuses to recognize the loss of this company's debt, then it effectively gives this firm an advantage in the marketplace. Declaring this loss would likely lead the firm to exit the market, allowing more efficient companies to earn more profits and, once again, pay more taxes. In this case employment might not improve, but profitability will. Once again the government will benefit, and a stronger company will be able to grow.

I do feel comparisons with Japan in the 1990’s are of limited value, but for this aspect of Bubble China the situation is very similar. Japan refused to acknowledge those now ancient losses, eventually saddled the entire banking system with the bad debts, and has paid a heavy price for these decisions.