China’s Minsky moment has arrived, a decade after the country chose to pursue policies that Minsky warned would make its financial system fragile and its economy unstable. What comes next for China nobody can say for sure. However, Minsky’s financial instability framework provides an insightful way to assess the risks.
Past is prologue when it comes to risk. A decade ago, the weaknesses in China’s economy and financial system were only possibilities, not foregone conclusions. However, as I wrote in 2015 and 2017, they were strong possibilities.
Going forward, there are significant risks that China will double down as it takes on excessive debt, invests in nonproductive enterprises, becomes less competitive than some of its Asian neighbors, experiences weak economic growth, faces internal unrest, and becomes more aggressive militarily.
Minsky Moment
Minsky provided a systematic way to think about business cycles. A Minsky moment involves the bursting of a major asset pricing bubble that had grown during a period of euphoric expectations, increased leverage, a rapidly growing shadow banking sector, the creation of innovative instruments to finance speculative activities, and weak regulation. I should say that Minsky did not use the term “Minsky moment.” The term was coined by Paul McCulley, former chief economist at PIMCO.
The risks attached to China’s doubling down relate to Minsky’s characterization of events which typically transpire in the wake of a Minsky moment. Minsky organized these events by associating them with four distinct policies: fiscal policy, monetary policy, labor policy, and industrial policy.
Comparisons To Japan In The 1990s
Many authors are now writing articles about China’s economic and financial situation. One of the most informative is by Robert Aliber, Professor Emeritus of International Economics and Finance at the University of Chicago.
Aliber is a co-author of the classic text Manias, Panics, and Crashes: A History of Financial Crises, written with Charles Kindleberger and Robert McCauley. In 2015, in the epilogue to the seventh edition, Aliber pointed out that China’s real estate market was in the midst of a major asset pricing bubble. At the end of 2022, Aliber described the consequences associated with the bursting of this bubble, drawing important comparisons with Japan.
Aliber is blunt, stating that for China, the 2020 decade will be like the 1990s were for Japan. Notably, during the 1990s, Japan’s growth rate fell below 1% after its 1980s real estate bubble burst.
Especially important is Aliber’s analysis of the link between Japan’s financial markets and its real economy, once its Minsky moment began. Aliber identified the main obstacle to robust Japanese growth in the 1990s. It was the need to deleverage and unwind the contractual implications of the meltdowns in its real estate market and its stock market. It is noteworthy that most of the key factors which underpinned Japan’s high growth rate during the 1980s persisted into the 1990s: a high savings rate, government support of industry, the competitiveness of its industries.
Ponzi Finance
Minsky introduced the term “Ponzi finance” to describe debt financing in which the source of the cash to pay both interest and principal is price appreciation in the value of the collateral, as opposed to cash flows generated by that collateral. He warned that bubbles are fueled by Ponzi finance, and that increased Ponzi financing makes financial markets more fragile and less stable.
Aliber discusses the case of the Chinese property developer Evergrande, which is currently crumbling, with its chair under investigation for crimes. Evergrande, like several other large developers engaged in Ponzi finance. Aliber explains that they did so by relying on cash received as down payments from what he calls “Wednesday’s buyers” in order to pay construction firms completing construction of apartments promised to “Tuesday’s buyers.”
Much of China’s construction boom occurred as part of the migration of its population from the countryside to cities. Eventually, this migration slowed when most of those who might migrate did so. Then the demand for urban apartments declined, generating a Minsky moment.
The decline in apartment purchases generated an associated decline in prices. Despite the decline, property developers such as Evergrande still need large amounts of cash to complete construction projects in their pipelines. Naturally, they try to borrow the funds; but, lenders are now reluctant to finance apartment projects whose prices are falling. This is why Evergrande is crumbling.
Minsky’s Perspective On Post-Bubble Events
Minsky’s analysis of what happens after the bursting of the bubble focuses on governments using public sector spending to try to stabilize the economy, keeping interest rates low to encourage spending and provide jobs, saving financial firms that are too big to fail, and going after large corporations.
All of this is happening in China. A recent article in The Wall Street Journal documents provides many examples of these activities. The public sector is engaged in massive projects, many of which are bridges to nowhere. Chinese officials are lowering interest rates. Many financial firms will fail and have to be recapitalized, a task that will be accomplished by the Chinese government issuing large amounts of debt. As for large corporations, Aliber states that the Chinese authorities have squeezed Jack Ma and other extraordinary Chinese entrepreneurs, actions which are consistent with China’s political traditions.
In the lead up to the financial crisis, the U.S. experienced the bursting of its real estate bubble. During this time, U.S. household wealth fell by half the country’s GDP. According to Aliber, the corresponding number for China is ten times GDP. Such a decline would generate enormous frustration for Chinese households, many of whom had high expectations and aspirations for a better future.
Currently, household income in China is still too low for China to qualify as a “high income” country. As a result, Chinese households will resist accepting declines in their incomes, and this means that China will be less competitive relative to Vietnam, Bangladesh, and other Asian neighbors.
Unstable economic conditions often generate social unrest. The structural weaknesses in China’s economic and financial system are significant and long-term. Chinese leaders have high aspirations and are sensitive about losing face. This combination tends to induce risk-seeking behavior. There is a significant possibility that Chinese authorities will seek to avoid falling short of their aspirations by engaging in risk seeking behavior that is military in nature.
Conclusion
Minsky very clearly recognized the importance of risking financial instability in order to achieve economic gains. The way he expressed it was by saying: “[L]essening the possibility of disaster might very well take part of the spark of creativity out of the capitalist system.” This is the case with all capitalist economies, including China.
During the last decade, what set China apart from other countries was the magnitude of the risks its leaders were willing to accept. This is something to keep in mind when assessing the risks currently facing China.
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