New Cycle or Old (Guaranteed) Bubble?

Ning Zhu
Oct 04, 2017



It seems necessary that one gains some deeper understanding of the sources of China’s phenomenal economic growth. Apart from all well-founded extant explanations, my recent book Guaranteed Bubble argues for another important yet previously overlooked source: the guarantees provided by the Chinese government.

The pickup of speed in China’s economic growth was probably one of the most watched developments in the global economy in the first half of 2017. The optimists argue that China’s economy has started showing signs of the onset of yet another impressive stretch of high-speed growth, based on the recent resurgence of both investment and consumption sectors.

Skeptics, on the other hand, point out that the short term rebound in China’s growth may reflect more of a lingering effect of the massive housing market boom and fiscal stimulus in 2016. As soon as the wealth effect and investment momentum wears off, some argue, the speed of economic growth will have to revert to a level significantly lower than 8 percent—the impressive rate which China has maintained over the past three decades.

It is worth pointing out that this is not the first debate of its kind in recent decades and it is very likely not the last either. As a matter of fact, China has faced several periods of skepticism about the sustainability of its economic growth over the last thirty years, most notably around the Tiananmen Square incident in 1989, the Southeast Asia financial crisis in 1998, and the global financial crisis in 2008. Each time, China’s economy ended up proving the naysayers wrong and demonstrated its extraordinary vitality and resilience. Such incidences, in turn, provide ever stronger support for the rest of world to bet even more on China’s ability to maintain high-speed growth going forward.

Granted, China has accomplished astonishing economic miracles over the past three decades, through successfully utilizing a large army of cheap labor, unleashing labor productivity and entrepreneurship, and increasing capital inputs. Such economic accomplishments have not only drastically improved the standard of living in China, but also elevated Chinese economic, political, and military influence around the globe.  

As China’s international influences grow, the rest of the world has been paying increasing attention to whether China can sustain its economic trajectory, especially with its increasing labor costs, diminishing investment returns, worsening environmental conditions, and depleted natural resources, in the wake of the 2008 global financial crisis.

To answer these questions, it seems necessary that one gains some deeper understanding of the sources of China’s phenomenal economic growth. Apart from all well-founded extant explanations, my recent book Guaranteed Bubble argues for another important yet previously overlooked source: the guarantees provided by the Chinese government. This article summarizes this view.

Government guarantee, namely the explicit and implicit guarantees that the state provides to the private sector, is a global phenomenon. Governments in many countries use guarantees to create markets that otherwise would not exist or to incentivize market participants to take more risks or provide public goods, which are otherwise too risky or too expensive to provide. Government Sponsored Enterprises (GSEs) in the U.S., most notably Fannie Mae and Freddie Mac, are clear examples of the impact that government guarantees can have in a market economy.

What sets China apart are not only its huge size and population, transitional nature, and historical soft budget problem, but also policymakers’ commitment to bring wealth and prosperity to the nation. In order to achieve as-fast-as-possible economic growth, Chinese governments at various levels have provided tremendous and highly valuable guarantees in three primary categories.

First, policy guarantees. Beginning in the 1970s, Mr. Deng Xiaoping successfully shifted the nation’s focus from class struggle to economic growth, by promoting the notion of pragmatic economic growth reflected in sayings such as ‘to grow is of paramount importance’ and ‘regardless of black or white, a cat that catches a mouse is a good cat’. Such policy guarantees provide necessary institutional assurance and social incentives for people to unleash their entrepreneurial spirits and direct their mind toward economic development.

Second, capital guarantees. The capital formation process that has plagued many developing countries did not likewise place a curse on China. Instead, through trade surpluses and counter-cyclical monetary easing, China’s monetary supply and total social financing increased enormously during the past three decades, alongside the country’s economic growth. Technically, China’s monetary supply (M2) increased by about 300 times during the past thirty years and more than 15 times during the past fifteen years. Such tremendous monetary supply facilitated economic growth, but it also laid the foundation for potential asset bubbles and inflation.

Third, investment guarantees. Even though rarely stipulated in any contract, there is a widespread belief among Chinese households and entrepreneurs that the government is behind most investment projects and hence, private investors should expect to make decent returns from such investments, or at the very least should not have to suffer investment losses. This idea partly stems from citizens’ firm belief that the government will do anything in its capacity to ensure high economic growth and social stability, and partly from the fact that the Chinese government is the ultimate ‘deep pocket’ and has the resources to deliver such implicit guarantees.

These lines of thinking were reflected by the massive protests staged after investors lost money from stock market declines, defaults in trust products, financial technology platform frauds, and price drops in the housing market. The protestors understand that they can ensure their investment gains by exerting pressure on the government and that government will eventually give in and guarantee protesters’ investment gains, or at very least their principal, in the name of the greater good of social stability and civilian satisfaction.    

With the increasing size of the Chinese financial sector and the ever stronger belief in the government’s guarantee, the drivers of Chinese economic growth have now grown out of control and, in fact, are posing many new challenges to China.

The two main problems challenging China’s economy right now, namely the housing bubble and escalating leverage problems, are indeed two faces of the same coin. The housing sector has become the no-fail investment in China, which has attracted tremendous capital and resources. Such self-fulfilling prophecy drives housing prices to ever-formidable price ranges, at the cost of requiring additional capital to come to the game to keep the bubble from bursting.

This safe and high-returning investment is directly responsible for the increasing levels of indebtedness across China, encompassing corporations, households, and governments. Maintaining a higher level of debt gradually has become acceptable in light of the housing bubble in the backdrop. With housing prices reaching new highs at an unbelievably fast pace, previous debt levels seem not only manageable but also perfectly rational.  

However, with housing prices reaching untenable levels for those who do not own a piece of property in the cities in which they live, the Chinese government is under tremendous and increasing pressure to provide the very basic sustenance to its citizens. Once a housing market stalls, it initiates a series of new problems such as slowing economic growth, diminishing corporate earnings, and struggling small- and medium-sized enterprises, which do not seem capable of generating returns commeasurable to those in the real estate sector.  

In some sense, the current situation in China is remotely reminiscent of the housing-stock dual bubble in Japan some thirty years ago. As in Japan, banks dominate the Chinese financial sector and properties serve as both the best collateral and the ‘safest’ loan destiny.

Even though the Chinese bond market remains relatively underdeveloped compared to that of Japan or even to its own stock market, there has been a lot of development of “bond-like” shadow banking investment products in China lately.

The rapid development of trust products, wealth management products (WMPs), and many products sold by the so-called internet finance platforms, all bear close resemblance to fixed income products in more developed financial markets, with one unique feature: implicit guarantees from their underwriters, the regulators, and, in the end, the Chinese government.

Many investors believe that, as long as the financial institutions are concerned with their reputations, as long as the regulators are concerned with career advancement, and as long as the Chinese government is concerned with social stability, the aforementioned will take care of the risks that investors themselves should bear when investing in such products. Although the Chinese government has issued stronger warnings about their intention to no longer provide such implicit guarantees, historical experiences of the government bailing out investors in the housing market, china’s A-share market, and shadow banking products have left such long-lasting impressions among Chinese investors that it will take a long time before China’s households and investors are truly convinced by the government’s new message.  

The investors, on the other hand, need only concern themselves with the high returns offered by such products and with chasing products offering even higher returns. This “heads I win, tails you lose” mentality is largely responsible for the aggressive speculation throughout the Chinese investment arena, such as the housing market, the stock market, shadow banking markets, and the newly developed “FinTech” field. These guarantees will continue to cause asset prices to rise far above their fundamental values and balloon into a series of bubbles.
What is more worrisome is that, during the recent past, the financing of local governments and local government financing vehicles (LGFV) have heavily relied upon land sales and real estate development in the form of trust products and wealth management products (WMP) with implicit guarantees. Many products that originally carry high risk and lackluster returns have been restructured into “safe” investments carrying attractive returns, in the guise of shadow banking products.
As Chinese investors see through to the implicit guarantee behind these products, they come to believe that the government will take responsibility for the risks that they themselves should be incurring when they make these investments and, accordingly, they decide to aggressively invest in such products regardless of the risk.

If these products should lose their implicit guarantee from the government, or if one day the government cannot afford to provide support any longer, the Chinese shadow banking sector, the high returns that investors have been enjoying, the cheap cost of capital many SOEs and LGFVs have been relying on, will all be seriously impacted, casting dark clouds over the long-term trajectory of China’s economic growth and its sustainability.
Furthermore, the challenges currently facing China’s economy, such as the slowing down of economic growth, serious overcapacity in many sectors, escalating debt at SOEs and local governments, and excessive volatility in many investment fields, may all be explained by the Chinese investor’s audacity and willingness to take excessive risks and speculate over the past few years. In some sense, the difficulties faced by the Chinese economy right now are indeed direct consequences of bursting bubbles created by implicit government guarantees over the past few years.

The government’s good will in seeking to grow the economy—highly effective in reaching the goal of high-speed economic growth in the short term—nevertheless shifted the risk preferences of investors and enterprises, in addition to the social allocation of risk and capital, the tradeoff between return and risk, and the balance between short-term and long-term objectives.

Many current dilemmas in the Chinese financial sector, such as the difficulty SMEs face in obtaining capital, capital shying away from industry and flowing into investment and speculation, and many mini-bubbles that have either burst or will eventually burst, are all tips of the iceberg of the “guaranteed bubble” phenomenon prevalent in the whole country, and in some senses the entire world.

On one hand, it is understandable that the speed of economic growth still matters dearly to further reform in China, to the improvement of Chinese wellbeing, and to the enhancement of China’s international status. On the other hand, the dictum “let the market play a decisive role in resource allocation,” as mandated by the 3rd Plenum, means that investors have to (learn to) take responsibility for the risks inherent in their own investment decisions and that the government must gradually taper off its implicit guarantees to various enterprises and investments.

Only when investors are required to take responsibility for the risks of their own investments, without the influence of various forms of implicit and explicit guarantees from the government, can investors set proper expectations for the rate of economic growth and for their investment returns.

Otherwise, once the expectation of “the guaranteed bubble” is established, investment speculation and misallocation of resources and capital will only be self-reinforcing. In order to truly let the market play a “decisive” role in allocating resources, it becomes imperative for the Chinese government, and governments around the world, to gradually wind down their guarantees.

As the borderline between the state and the market, the tradeoff between risk and return, and the balance between present and future become transparent and clearly defined, the overcapacity, worsening debt, deteriorating SOE performance, SME financing difficulties, and the resulting mounting systematic financial risks—all of which currently challenge China’s economy—will gradually be resolved.

(Ning Zhu is an Oceanwide Professor of Finance and deputy dean at National Institute of Financial Research, Tsinghua University and a Professor of finance at the Shanghai Advanced Institute of Finance.)


Ning Zhu (2016), China’s Guaranteed Bubble, Mcgraw-Hill, New York, NY, ISBN 978-1-259-64458-0



Most Popular