Three More Questions with… Victor Shih
UC San Diego School of International Relations and Pacific Studies (soon to be the School of Global Policy and Strategy) and the 21st Century China Program are host to some of the world’s leading China scholars. In this column, we sit down with these experts and ask them three questions related to their field of expertise.
Professor Victor Shih is a leading expert on the financial system and elite politics in China. China Focus Blog staff writer Peter Larson sat down with Professor Shih to get his take on the Chinese economy, the numbered days of the Chinese stock market rally (this interview was done before this week’s 5% tumble in the Shanghai Composite Index), the Asian Investment Infrastructure Bank (AIIB) and much more.
Peter Larson: Last fall, in the first annual China Focus Debate against fellow IR/PS Professor Barry Naughton, you argued in the affirmative that the Chinese economy will collapse in the next five years. Do you still believe this is a real possibility? Could you unpack and explain your argument a little bit?
Victor Shih: I definitely think that this is still the case. I guess by now it would be sometime in the next four and half years. I will still stick with the same timeline. Chinese growth will either fall to zero percent or negative, or they would have to devalue the currency by 20 percent or more. You remember last Fall actually the renminbi (人民币) was extremely strong. Since last Fall the renminbi has devalued by around three percent. So I think it is beginning to happen. I think there’s a good chance that the devaluation route is going to be taken instead of the economic collapse route.
The basic reason for these predictions is that China’s debt level is extremely high right now by global standards. Non-financial debt as a share of GDP is now well over 250 percent. Only Japan and Europe have a higher non-financial debt level than China. Those are developed countries where the interest rates are extremely low. And even in those countries, they have managed to avoid financial crisis because the central banks in those countries have begun to purchase government issued debt in these two areas. But when Japan and Europe engaged in this behavior of central bank balance sheet expansion, their currency dropped 30 to 40 percent vis-à-vis the dollar. As China will need to engage in very similar behavior, which is to have the central bank print massive amounts of money to purchase some kind of assets, either government securities or other debt in society, I expect the renminbi to also devalue substantially.
The challenge is that, if the central bank didn’t do that, just to pay interest on so much debt – which is equivalent to 250 percent of GDP – requires interest payments that are around 20 percent of GDP. Basically, no economic actor in China is capable of financing so much interest payment, especially at a time when China’s own GDP is only growing at eight percent. I’m talking about nominal GDP here, the real GDP is growing even slower at seven percent. Therefore the only actor in the country that can pay for these interest payments and prevent a financial crisis is the central bank. The central bank can only do that when it prints money. It doesn’t matter how strong or powerful they are, when every country prints money to that scale – like the US did, like Europe is doing, like Japan is doing – their currency is going to fall substantially. I don’t think China can avoid that fate.
It doesn’t matter how strong or powerful they are, when every country prints money to that scale – like the US did, like Europe is doing, like Japan is doing – their currency is going to fall substantially. I don’t think China can avoid that fate.
Peter Larson: You kind of answered my next question then. I was going to ask if you thought the government could hit its growth target this year. Li Keqiang has said that they expect the economy to grow at around seven percent, but it sounds like you’re pretty pessimistic about even this year achieving that?
Victor Shih: No, I think they can reach the growth target this year. But to reach the growth target this year without the renminbi falling substantially, I think would be very, very difficult. Because even though Janet Yellen, the Federal Reserve Chairwoman, has decided to delay increasing US interest rates by another three months, most people now expect the Federal Reserve to increase interest rates sometime this year. As we get closer to that date, whether it’s September or October, the dollar’s going to get even stronger, the tendency to sell the renminbi will get even stronger. When people are selling renminbi, they sell it to the central bank and the money supply actually shrinks. When you have a shrinking money supply, it’s very hard to reach these growth targets of seven percent.
In China it’s already a massive debt bubble. The only way to keep it going is to make it even bigger. And the way to make it bigger is to increase the money supply. So that doesn’t mean that China can’t do it. China can do it. But then the PBOC would have to print massive amounts of money starting this year. They have begun to do it. They try to hide it as much as possible. I think they’ll have to do it in a much more obvious way in the coming weeks. Actually, I think they’re going to cut the reserve requirement ratio in the next couple weeks. When they do that and at the same time the Federal Reserve is increasing interest rates, China is decreasing interest rates, the currency is going to be under heavy selling pressure. China can hit seven percent growth, but the currency is going to devalue by another three or four percent.
Peter Larson: What you’re saying sounds like China is facing a very serious currency crisis in the short-term. But a lot of the news we’re seeing out of China is about the Shanghai stock market rally and the new Asian Investment Infrastructure Bank (AIIB). It seems like China is this unstoppable juggernaut. Would you like to comment on the stock market rally? Is this a bubble that we should be expecting to burst?
Victor Shih: It is a bubble. It’s very much a bubble. The real reason for the rally – there are a couple of things. One is that there’s this valuation effect, which is that if you look at price-earning ratios of Chinese stocks, it has been lower than the price-earnings ratios of other emerging market countries. So people who don’t know anything about the dynamics and the debt problems in China, they’ll say, “Oh, here’s a bargain. I can buy some Chinese stocks because it’s really cheap compared to the rest of the developing world.” I think that’s just ignorance.
Domestically, the reason why the A-Share has rallied so much is because they’ve relaxed margining rules. Margining, of course, is when people borrow money from some intermediary to purchase even more stocks and they use the stocks as the collateral for their loans. They relaxed rules for margining in the beginning of 2014 and that has really allowed people to speculate in the stock market. That generated a lot of excitement initially for high net worth individuals and some funds to pile into the equities market. There’s a very recent study by Gan Li, who’s a professor at Texas A&M and the Southwest University of Finance in China. What he found is the people who have just joined the stock market, who have just started buying stocks, three quarters of them are not even high school graduates. So now you really have this – grandma, grandpa, desperate migrant workers trying to make it big so they can get married – they’re joining the fray and usually this is the sign that the bubble is about to burst. It’s when you have the final wave of, for lack of a better word, suckers buying into the stock market. Now valuation is not very attractive anymore.
So now you really have this – grandma, grandpa, desperate migrant workers trying to make it big so they can get married – they’re joining the fray and usually this is the sign that the bubble is about to burst.
A lot of buying is done by margining. The problem with margining is, let’s say you borrow money to buy a stock at 10 dollars a share. If it goes up, obviously that’s fine, but if it starts going down from 10 dollars to eight dollars, the broker will automatically sell that stock. Because the broker doesn’t want to lose all the money it has lent to the buyer of the stock. As the stock begins to go down, it feeds into even more selling. When you have so much margining in the stock market it can lead to a very sharp downfall of equities. I think this for sure will happen before the end of the year.
Peter Larson: Is the AIIB a real challenge to the World Bank system?
Victor Shih: Diplomatically, it looks good. China’s got money to throw around. That’s great for China and all these countries are signing on. But I think economically it doesn’t make a lot of sense. There are two parts to what the AIIB wants to finance. One is more port facilities in the Asia-Pacific region. That potentially makes some sense and the reason is because 95 percent of China’s trade is through the ocean. So you can imagine if you build better port facilities in the region, these ports are going to be used not just for Chinese goods, but shipment of US goods and goods from other countries.
But the big drive in the AIIB is to finance a series of highway and railroad infrastructure in Central Asia. That makes absolutely no economic sense.
But the big drive in the AIIB is to finance a series of highway and railroad infrastructure in Central Asia. That makes absolutely no economic sense. Only five percent of China’s trade is through land, and I would say 80 to 90 percent of that is through Russia. So there’s a lot of goods being shipped from Inner Mongolia all the way through Russia, into the Ukraine, into Poland and it gets to Europe. That route works extremely well. It’s not very expensive and that’s why goods are being shipped that way.
It makes no sense to try to open up another route through Xinjiang, starting in Xi’an. It makes domestic political sense because of course Xi Jinping is from the Xi’an region in Shaanxi province. He wants that region to do well and his cronies to do well also. Xi’an to Xinjiang, very volatile region, into Tajikistan, through several other Central Asian republics to Iran. You have to go through Iran interestingly – this railroad – ultimately to Turkey. Once you get to Turkey you still have to find a way to get to Western Europe. And all that just to service just one percent of China’s trade? Of course once you build the railroad that ratio will increase, but is it ever going to increase to five percent or 10 percent? I don’t believe that. I think it will never ever replace the ocean lanes and it will be hard for it to compete with Russian route on a cost basis.
Peter Larson: Thank you very much for taking some time to talk with me today.