With foreign investment withdrawing from China and a series of lockdowns in past years, many businesses closed down, resulting in massive unemployment. Housing sales were hit hard, leading to the endgame of developers’ Ponzi scheme.
That says developers’ chain of repeated augmentation in investment by recycling cash from house sales is broken. As the loop fails, developers also fail to pay back their debts, causing a series of defaults. This, in turn, transmits to other areas; the first affected is trusts, but additional financial sectors will sooner or later be affected.
As discussed in this column, the immediate impact of this is Japanisation, which means prolonged debt deleveraging with stagnation and deflation.
But this is not the end of the story. Japanisation is only one of the outcomes under careful management where all unwinding and deleveraging processes are done orderly. If deleverage is done too much or too fast, such order is not guaranteed. However orderly it is done, the insolvency might happen to a substantial portion of the private sector, ultimately becoming sovereign insolvency.
When China was ruled by the Chinese Nationalist Party (Kuomintang) during wartime, the global depression in the early 1930s and the institutional government corruption led to persistent capital outflow and recession for years.
Naturally, the government tended to finance the deficits by printing money—creating something out of nothing. The story ending is familiar: the intention to monetarise debts results in exchange rate depreciation and hyperinflation.
At the onset of depression, China experienced deflation from 1932 to 1934. However, monetary expansion did not stop throughout the period, as is shown in the accompanying chart. After the depression period, when the economy recovered, budget deficits did not improve but got even worse. Monetary expansion was in line with such exponential speed, suggesting that government spending and money printing were uncontrolled. As a result, the currency depreciated in a similar manner, and hyperinflation began after a few years. Finally, the regime collapsed in 1948.
Which route would China follow, the Japanese one or the Nationalist Party one? It depends, especially depends on whether there is a civil war. The wartime experience was a civil war where economic and political regimes collapsed. If the current dictatorship is powerful enough to suppress all revolutions to avoid civil war, then the “ordered deleveraging” would still differ from Japan’s outcome due to China’s poor status (per capita GDP) and massive unemployment. Instead, a great famine like that in the Mao era or North Korea is likely.
This is not an exaggeration. The outstanding debt black hole is of massive scale. As trusts, funds, or even banks incur significant losses, the deleveraging process will evaporate vast amounts of assets, causing extensive bankruptcies, including billionaires and the middle class. Finally, there could be no way out but to write off most debts, which means an equal amount of asset evaporation affecting many others. This will effectively destroy most markets and return to the nation’s goal—communism like the 1950–60s.
