In the last few months, various news channels and educators have been warning of the collapse of the Chinese economy due to a potential downfall of its real estate sector. With asset prices skyrocketing before beginning to decline drastically, the Chinese economy closely resembles the
collapse of the US banking system in the early 1930s and 2008. However, this article argues that though the Chinese economy has all the elements that caused the Great Depression and the Great Financial Crisis (GFC), an entire economic collapse of unbelievable proportions is very unlikely.
Leading up to the Crisis
Since 2009, Chinese banks and other financial institutions have embarked on a lending spree causing a huge spike in property prices. As a result, cities like Shenzhen and Shanghai were four times more expensive relative to income than New York in 2020. But since asset prices —-- compared to the size of the economy —-- could not rise indefinitely, they eventually cooled down. Consequently, banks that gave loans which were backed by these assets, started to fail. With a growing lack of trust in financial institutions, people began demanding their money back, which sparked a bank run. This is where the Chinese economy currently sits. But, unlike popular belief, it is very unlikely to trigger an effective economic collapse as China’s bubble is different from that in the US.
Depressing Past of the US Economy
In the US, The Great Depression started with unprecedented growth in the banks’ lending as well as a massive increase in asset prices—mainly on the stock market. Similarly, the GFC also began with a credit boom accompanied by a hike in asset prices, mainly in the property market and the stock market. Looking back, various scholars have argued that the US central bank delayed intervening and allowed the banking system to collapse during the peak of the Great Depression. Though it might seem normal for governments to allow the free entry and exit of any business firms, the same principle cannot be applied to banks as they play an important role in credit creation for the entire economy. As an example, it may be seen as the equivalent of letting all electricity companies in India go bankrupt due to their business losses without any government intervention whatsoever. Although it may be morally justified, it kills an entire economy. In such cases, some banks are so huge that they are ‘too big to fail’ and that their closure could create a domino effect within the entire economy.
The failure of the bank during the Great Depression in the US affected the economy so drastically that it took almost a decade for it to recover. Learning from its past mistakes during the Great Financial Crisis in 2008, the Federal Bank stepped in to support the economy after the collapse of Lehman Brothers. This helped in preventing the financial system from spiralling out of control. Although events that led to the Great Depression and GFC bear a close resemblance to the current state of the Chinese economy, things begin to diverge from here onwards.
Why is China Different?
The Chinese central bank, aware of the dangers of letting the credit system and the monetary system collapse, has already lowered interest rates and started rescuing both banks and property developers who are about to go bust. Moreover, the Chinese banking system is largely state-owned. So, a bank run would be short-lived since China’s central bank could easily provide for it by increasing the monetary supply. Also, unlike US politicians and policymakers, who waited for the bubble to collapse on its own, the Chinese bubble was popped by the government itself. Specifically, when the government implemented the three red lines policy which required ‘bad and poor’ property developers to start deleveraging. Since China's central bank has realised that reckless lending should be penalised, and not by crushing the entire economy. Therefore, it can now be said that the Chinese economy will not collapse in the US-Great-Depression Style. Furthermore, the Chinese government has valued stability more than anything else and hence, it will try to spend its way out of trouble more forcefully.
At the same time, the Chinese scenario is also different from other Asian economies, such as Sri Lanka, in an inflationary death spiral. This is because, unlike Sri Lanka, China has achieved monetary independence in two different but related ways. Firstly, being a manufacturing superpower, China has always run a trade surplus with many countries. And now, with its economy slowing down, leading to fewer imports, it has huge reserves of dollars to prevent a large-scale depreciation of its currency. Furthermore, the Chinese government has effectively imposed capital control which limits the flow of foreign capital out of the country. This was the same type of policy that Russia started implementing in response to western sanctions. And as one can discern, it helped Russia rescue its currency and avoid a Sri Lanka-style collapse. Therefore, this combination of capital controls and large trade surpluses enables China to create as much currency as it chooses to rescue its banking system, thereby preventing a complete collapse.
The Chinese economy is traversing turbulent waters. Its property bubbleis massive and a burst could send shockwaves throughout the economy. Though the government is careful not to blow it up any further, some of its actions did hurt the Chinese economy significantly. The harsh stance on the ‘Zero Covid Policy’ has shrunk industrial output and put millions of livelihoods at risk. Moreover, its crackdown on the tech and private industriesin recent months has prompted investors to resort to capital flight. However, owing to the independence of the Chinese monetary system and its government's commitment to stability, a collapse of the Chinese economy, against the popular notion, is unlikely to happen. A short recession, followed by major government intervention, and then a period of stagnation and slow decline, like that of the Japanese economy, looks like the most likely outcome.
(Written by Sashank Rajaram and Edited by Siya Kohli)