The Chinese Subprime Crisis: A Systemic Financial Tsunami Triggering Soviet-style Balkanization of the Middle Kingdom

Over the span of three decades, the Middle Kingdom of China has embarked on an extraordinary growth journey, largely orchestrated by the involvement of American corporations. These companies infused trillions of dollars into China’s economy, coupled with their advanced technical know-how, propelling the nation to the forefront as the “Factory of the World.” This symbiotic relationship between American corporations and the Communist Party of China proved mutually advantageous, with China meeting the demands of American consumers while receiving preferential treatment. However, just as China’s economic prowess reached its zenith, the world was rattled by the emergence of the Wuhan lab-engineered virus. Despite this setback, as the world’s second-largest economy, China remained poised to potentially surpass the United States in the upcoming decade, representing approximately 18.4% of the global economy in 2020. The global economy has experienced a robust rebound, with GDP surging from $103.86 trillion USD in 2022 to $112.6 trillion USD in 2023. However, China’s share of the global GDP has continued to decline, dropping further to 17% in 2023 from 18.4% in 2021. This marks a significant two-year decrease of 1.4 percentage points for China.

With the growth of the Chinese economy, the nation’s foreign exchange reserves surged to approximately $3.22 trillion USD. Historically, China has predominantly held its reserves in US Treasury bonds, currently amounting to around $850 billion USD, comprising approximately 11% of total foreign holdings of US debt. However, there has been a notable shift in strategy, with China gradually decreasing its reliance on the US dollar. This reduction is evident, with the share of American treasury bonds in China’s foreign exchange reserves dropping from 59% in 2016 to 25% in 2023. This strategic diversification, coupled with the ongoing tariff tensions between the United States and China, has strained bilateral trade relations. Notably, in December 2023, China experienced the first outflow of foreign direct investment (FDI) in decades, signaling a trend of multinational corporations seeking to establish additional supply chains in more amicable nations. The exacerbation of these economic tensions has been further compounded by the global spread of the Wuhan-engineered lab virus and China’s stringent “zero-covid” policy, resulting in sporadic lockdown measures. Consequently, manufacturing companies have been compelled to reassess their operations, leading to a notable exodus from China.

China’s extraordinary growth has long been underpinned by its heavy reliance on the real estate and construction sector, which constitute approximately 30% of the nation’s GDP, making it the largest contributor to the world’s second-largest economy. The sheer scale of China’s construction endeavors is remarkable; between 2011 and 2013 alone, the country consumed more cement than the United States did throughout the entirety of the 20th century. However, this rapid development has also resulted in the proliferation of ghost towns across China, where built infrastructure remains largely unoccupied, reflecting significant capital misallocation. To sustain this growth momentum, local governments have increasingly turned to borrowing to meet ambitious growth targets set by the Communist Party of China.

China’s debt accumulation reached alarming levels when the total debt, including corporate, household, and government debt, surged to 303% of GDP in the first quarter of 2019, as reported by the Institute of International Finance (IIF), a prominent global financial industry association headquartered in Washington. In efforts to sustain high GDP growth rates, Chinese local governments resorted to unconventional measures, such as creating local government financing vehicles (FGFVs) and leveraging debt from shadow banks. According to Goldman Sachs, China’s total local government debt is projected to approach Rmb100 trillion ($13.8 trillion) by the end of 2022, highlighting the magnitude of the debt burden.

China’s State-Owned Enterprises (SOEs) are strategically employed to serve the clandestine objectives of the Communist Party of China, which include safeguarding the employment and lifestyle of its 90 million CCP members. With a total of 6,363 SOEs, these entities collectively hold a substantial debt of US$15.6 trillion, representing 56% of China’s total corporate debt of US$29 trillion. As of June 2023, China’s household debt composition mainly comprised consumer loans, credit card debt, private borrowings, and business operation loans, amounting to 38.6 trillion yuan (US$5.38 trillion).

The Central Bank of China has implemented tighter restrictions, reducing exposure to smaller banks and consequently exposing around 4,000 of them to systemic risk. Policymakers faced significant challenges in containing a bank run last year when three banks in Henan province failed in 2022. The economic struggles of banks are further exacerbated as tens of thousands of individuals in China are refusing to pay their mortgages for unfinished apartments. The real estate sector’s woes are deepening, with property prices plummeting and a cascade of developers defaulting on their bonds. China’s financial system is burdened with 46 trillion yuan ($6.8 trillion) in outstanding mortgages and still holds 13 trillion yuan in loans to the country’s distressed developers.

Offshore defaults by China’s leading real estate developers prompted the Hong Kong court to initiate the liquidation of assets belonging to the nation’s heavily indebted real estate giant, Evergrande. With ownership of over 1,300 real estate projects in China and a workforce of approximately 200,000 individuals, Evergrande indirectly contributed to the creation of 3.8 million jobs annually. Its debt burden amounted to 1.6% of China’s GDP. In response to concerns within the real estate sector, the Chinese government implemented a series of measures, including reducing mortgage costs for homebuyers, urging banks to increase lending to distressed property developers, and lowering interest rates.

Foreign investors and portfolio managers are witnessing a gradual erosion in confidence, reflected in the CSI 300 index shedding a staggering $7 trillion USD in market capitalization since the meltdown of 2021. On February 5th, 2024, the Chinese CSI index plummeted by 8%, compelling the exchange to halt trading in 30% of stocks. In response, the government swiftly introduced a series of measures, including a $250 billion USD stimulus package and a ban on short selling at Chinese brokerages. Additionally, the economy faces challenges such as high youth unemployment rates and weakening overseas and domestic demand, leading to a drop in consumer prices and signalling emerging deflationary trends.

The current downturn in the Chinese economy, characterized by debt-to-GDP levels exceeding 300% and defaults by Chinese real estate developers on their overseas bonds, has the potential to send shockwaves across global financial markets. There are concerns that the situation could echo the subprime crisis, this time originating from China. The Chinese shadow banking system, valued at $10 trillion, fueled by local governments’ use of special purpose vehicles to fund infrastructure projects, has experienced multiple loan defaults. In contrast to the Federal Reserve’s ability to address the 2008 $3.2 trillion subprime crisis in the US, the Chinese yuan lacks the status of a world reserve currency, limiting its options for mitigating such crises. Additionally, despite China’s Belt and Road Initiative (BRI) involving around 2,600 projects totaling $3.7 trillion, the strategy of debt trap diplomacy has faced setbacks as many nations have refused to service BRI debts, forcing China to renegotiate the terms.

The IMF’s projection of the Chinese economy growing at below 5% in 2024 poses significant challenges for a nation that once aspired to surpass the United States as the world’s largest economy. Furthermore, consecutive years of dwindling population growth rates have compelled the Xi Jinping Administration to abandon the one-child policy and incentivize couples to have three children. Despite these measures, growing social discontent persists, exacerbated by stringent censorship and surveillance mechanisms, with the government allocating a budget of $196 billion USD for internal surveillance. These indicators suggest a rising internal dissent reminiscent of the Soviet-style disintegration and Balkanization of China. The territorial disputes China has with all its neighbour does not provide comfort and relief to the authorities in Beijing.

2 thoughts on “The Chinese Subprime Crisis: A Systemic Financial Tsunami Triggering Soviet-style Balkanization of the Middle Kingdom

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