In a recent letter to JPMorgan Chase (JPM) shareholders, CEO Jamie Dimon issued a warning about the Chinese economy and the potential $4 billion loss that a recession there could bring to the bank, although the CEO said the firm could handle it in the unlikely chance that actually happens. Despite China’s potential and upward trajectory, Dimon states that in short run, the U.S. and the rest of the world may see a major recession with massive defaults and consequently heavy trading losses, and history shows he’s probably right.
China optimists argue that an economy that is expected to grow 7% on average for the next 10 years can’t be considered disappointing, even if that represents a slowdown compared to previous years. The World Bank, one of the more prominent China optimists, says the country has plenty of room for fiscal maneuver and a huge capacity to absorb debt. At the microeconomic level, the expansion of corporate China (33% of all cross-border acquisitions were amassed by Chinese firms in 2015) is providing firms with geographical diversification and management skills they don’t have at home. And because China hasn’t yet resorted to monetary policy as a tool to fight a potential recession as the rest of the world has done, there is a lot of space for policy to take over in case the private sector fails.
What these optimists are ignoring, though, is what the Great Recession of 2008 taught the world about how big crises start and are later amplified: First, there is misbehavior in the private sector, spurred by dysfunctional regulation and permissive regulators. Second, global interconnectivity spreads the crisis outside of a country. Third, paralysis in the financial sector kills household credit and ends up deteriorating people’s quality of life by diminishing investment, contributing to unemployment and, ultimately, leading to poverty.
These ingredients are again at play in the Chinese economy, eight years after the Great Recession. A McKinsey report published in February 2015 showed that in the economies hit worst by the crisis (the U.S., the UK, Spain, and Ireland), homeowners have since borrowed a good deal less, while credit for households almost doubled (from 20% to 38%) in China between 2007 and 2014. Even worse, China’s corporate debt to GDP ratio has now reached an astonishing 125% of GDP, mostly through bank debt. Chinese banks now hold up to 65% of the country’s GDP in debt. Private debt to GDP in China was at about 200% by the end of 2014.
What is most worrisome, though, is that the links between the public and the private sector look a lot like the crony capitalism that was the root of the 1997 Asian financial crisis: government-controlled banks lending money to government-controlled corporations through government-appointed officials, whose businesses depend on government-provided licenses, which rely on government-promoted anti-competition policies.
China is now connected to the rest of the world thanks to the strange rules of the game that the West easily accepted. While foreign competition is very limited inside China, Chinese CEOs and private firms are heavily investing all around the globe. So if something bad happens in China, the rest of the world will suffer. Interestingly, between January 2009 and December 2014, the average correlation between the daily returns of the U.S. and Chinese stock markets was 0.13. The same correlation has doubled since the beginning of 2015. Even if small, a recession in China would have devastating effects on the rest of the world, regardless of the category: product markets, currencies, oil prices, foreign direct investment, stock markets, credit markets, central bank policies, or sovereign debt.
More fundamentally, the Chinese economy is not a normal market economy. Hundreds of years of experience have shown that product and financial markets can’t function without proper institutions, in particular, the rule of law and respect for property rights. China is basically a dictatorship, as are the United Arab Emirates, Singapore, and Venezuela. Like Venezuela, the lack of accountability in the public sector encourages corruption, self-serving policies for political elites, and inefficient decision-making. Unlike the UAE and Singapore, however, property rights are not respected in China, and improvements to the rule of law preclude entrepreneurship.
China is good proof that markets require an institutional environment to guarantee that they work. Economists either believe in markets or they don’t, but there is no halfway. What happened in the Shanghai Stock Exchange last summer is a result of years of market manipulation by Chinese authorities with an attempt to prop up stock prices. The 2008 crises showed the Western world what happens when regulators try to prevent the free flow of information by prohibiting short sales or by imposing severe circuit breakers: The best way to prevent markets from going down is to shut them down—but the active management of markets by regulators leads to disaster.
In the long run, market economies fail without competition, and Chinese companies are not competitive in the strict sense of the word. The largest Chinese banks (which are also the world’s largest banks) operate in a protected market where competition by foreign institutions is prohibited, but they are allowed to compete with international banks overseas. In the agrochemical business, for example, Chemchina—the owner of Pirelli and soon-to-be owner of the Swiss giant Syngenta—operates in a huge market without the threat of foreign competition. Antitrust regulation is applied by a government that is also the owner of most of the country’s monopolies.
Dimon is right to warn about China, as the next financial crisis will surely be named after some Chinese tycoon, firm, or bank.
Arturo Bris is professor of finance at IMD business school and director of the IMD World Competitiveness Center. IMD is a top-ranked business school in Lausanne, Switzerland.
