Will China Implode? Not Just Now

So to recap, the world economy was swinging along nicely, despite the collapse in confidence, when it ran across  three potential catastrophes:

1. The possibility that the US recovery is stalling (a complex nexus of causes and effects which includes the impact of a profoundly divided political establishment on economic and financial confidence); 
2. The existential crisis of the Eurozone;
3. The possibility of a hard land for China. 

Today I'm going to look at the third - China.

(But first, note that the debt crises in the US and Europe are actually historic reflections of each other. The US Treasury market was a war-child - between 1861 and the end of the Civil War in 1865 government debt  mushroomed from US$65 million to US$2.756 billion. Out of desperate need to finance a war to finally settle the historic States/Federal political question, was born a single dominant Federal debt market. We watch now as that debt market becomes hostage to precisely the same question of State/Federal rights and powers (which is what, ultimately, the Tea Partiers are on about). Meanwhile, over in Europe, the attempt to try and retain a full fiscal panoply of State Powers whilst sharing a single currency has delivered bankruptcy to at least one State, and probably more. The result, more likely than not, will be the construction of a single dominant Federal debt market.)

I remain sanguine about China's immediate future.  This is not, I hope,  because I don't recognize China's problems, or the threat they pose. But for the most part they are not new. Take, for example, the worry about the debts of local government financing platforms. Now, there is no doubt that they are far bigger than they have been, and far bigger than they should be - whether you accept the National Auditor's lowball figure of around 9.5 trillian yuan, or the higher estimates, which range up to around 14.5 trillion yuan.  But in the end, these debts represent the accumulated fiscal deficit of provincial and lower levels of government. Since in China taxes flow upwards to Beijing, but responsibilities flow downwards to the regional authorities, how to finance these layers of government has been a perennial problem for China for as long as I can remember. Indeed, I'd say that how to finance lower-tiers of government has been the problem for China, possibly exceeded only by problems of water and agriculture (to which, of course, it is linked).  Monetising this problem away was the underlying reason why China used to be inflation-prone , and which ultimately brought Zhu Rongji to power in the 1990s.  About his first act was to re-set the split of China's tax-take between national and provincial governments. Anyway, here's the big bad secret which China's (not) been hiding all these years - if you're fiscally squeamish look away now. . .

As you can see, between 1995 and 2009, Guangdong and the Yangtze Delta can lay claim to fiscal respectability.   But most of the rest of China can't. The capital region (Beijing-Bohai) has finances which, were it not the capital, would be among the most disastrous in the nation - but we can perhaps give it a pass on account of its unique position in China. But the Industrial Northeast, which ran a fiscal deficit of over 12% of provincial GDP in 2009, has a distinctly rust-belt fiscal legacy. And in the Central Provinces - China's heartlands - the deficit was running at near 8% of GDP in 2009. In short, the fiscal position of China's provincial governments is a mess, and has pretty much always been a mess.

So although the situation is now news, it's not exactly new. Nor are the ways in which it has been solved. First, the central government rebates the vast majority of taxes back to lower levels of government. And secondly, local governments supplement their budgets by land sales and by using near-deniable near-provincial-sovereign financing platforms.  When times are tough, or when provincial countercyclical spending has been particularly ferocious,  there will be an extended tussle about who, ultimately, gets to pick up the tab.

With a bit of luck we will not be witness to the grisly infighting which will eventually produce a settlement.  But we can be pretty sure that it's a question of 'who's going to pay', rather than 'where on earth are we going to get the money from', because we can track the underlying cashflows of the whole China economy via the private sector savings surplus. And here is my estimate of it, up to June this year:

The key point of this chart is that although the private sector savings surplus is in decline, it's still massive at around 5.6% of GDP, or 2.4 trillion yuan a year. And that surplus is effectively the net cashflow into China's financial system after the banks have done all the lending they can do to the private sector (which for these purposes includes the local government financial vehicles). There's nothing for this money to go on except either central government debt, or foreign assets. This persistent deluge of cash into the banking system is the reason why China's banking system has a collective loan/deposit ratio of only 66%. It's the reason why bank lending can growth at mid-teen levels persistently even though the government has commandeered and disabled 20%+ of the deposit base as reserves.  And, of course, it's also the reason why China isn't going to run out of financial or fiscal options any time soon.