Why the China Threat Is Overblown | Logan Wright, Author of Broken China
Are China’s economic troubles structural or cyclical? Has the largest credit expansion in history exhausted its financial system’s capacity to generate growth? Do Beijing’s official GDP figures hide what is really happening to Chinese households, local governments, and the property sector? Does Beijing still have the capacity to engineer a recovery? And perhaps most importantly, what does it mean for the West if China is a declining power rather than an ascending one?
Logan Wright, director of China macro and financial sector research at the Rhodium Group and author of Broken China, joined me on the Hidden Forces Podcast recently to help answer these questions. We discuss:
- Why largest single-country credit expansion in over a century has exhausted China’s financial system’s capacity to generate growth, leaving it unable to ignite the domestic demand needed to rebalance both the Chinese and global economies.
- How Beijing’s official GDP figures obscure what is actually happening to Chinese households, local governments, and the property market.
- Why the prevailing narrative that Chinese policymakers retain the capacity to engineer a recovery is fundamentally mistaken.
- The consequences of China’s credit bubble and property market collapse for ordinary households and local governments.
- The similarities and critical differences between China’s predicament and Japan’s lost decades.
- The striking parallel between the CCP’s political choices and those of Soviet leaders during the USSR’s era of stagnation under Brezhnev.
- How demographic headwinds are compounding the collapse in Chinese demand.
- Why Logan believes the RMB is overvalued, why capital flight persists, and why the RMB poses no credible threat to the dollar’s international role.
- What America’s strategic competition with the PRC looks like when viewed through the lens of a declining rather than a rising power.
Go deeper. Access the full two-hour conversation, complete transcript, and Intelligence Report by becoming a premium subscriber HERE.
TRANSCRIPT TO THE FIRST HOUR
Demetri Kofinas: Logan Wright, welcome to Hidden Forces.
Logan Wright: Thanks, Demetri. Really nice to be here.
Demetri Kofinas: It’s my pleasure having you on, Logan. This book that you’ve written is phenomenal. You know this because, well, you know it because you probably know it anyway because lots of people have told. But it is, I think, the best book on China’s political economy that I have read, and I’ve read a lot of books. So I’m very excited to get into it. What is the origin of your interest in China, and where did that interest begin?
From Debate Club to Beijing
Logan Wright: I think back to high school, it was part of a high school debate topic back when I was doing debate as an extracurricular activity. And so I started being interested in China related issues there, but really it was out of college. China was basically the first country I ever left The United States to spend any significant time in. Did that during the summer when I was in college and basically tried to figure out a plan to go back and move there after graduation.
So I moved immediately in 2001 right after I finished university, ended up working in a bunch of different companies that were helping small businesses get started in China, but I was interested from an academic perspective in the financial system. Particularly this idea that the problems in the financial system were perennial and they never really changed, but the actual mechanics of how the financial system operated changed so rapidly. So I was trying to settle on something that reflected the intersection of China’s political culture and the international marketplace. And so I started talking about the exchange rate and trying to beg Chinese officials to talk to me about it. And believe it or not, back in the early two thousands, it was pretty easy.
It wasn’t completely straightforward, but one conversation would lead to another. You could be invited into academic groups. You could be invited to dinners. No one really thought that it was unusual for a grad student to speak pretty mediocre Chinese and try to understand the way the Chinese system worked because the idea was China was becoming more powerful and there were gonna be more and more people that were gonna be interested in how the Chinese system worked, and I was just one of the first. So it was this three or four years of pretty intense interviewing processes and just getting the feel of how the Chinese system operated from people who were working within it, and that foundation has really been pretty critical for my own work throughout, even when it became later far, far more difficult to have those kind of conversations.
China’s Reform Era: Optimism and Its Limits
Demetri Kofinas: How did the Chinese view themselves then? How did they view us, the West? How did they view the relationship between the two? And what are some of the notable differences between then and now?
Logan Wright: It’s not that this was this blissful period in which there was no tension between China and the West. It was just that China was reforming legitimately. So there was this perception that first foreign influence was beneficial to China, that Chinese officials would often use international models for different reforms or legislative changes. And they would say, well, how has this country approached this problem of banking regulation?
And can we incorporate some of those examples? Or can we take the Singaporean model of looking at how they manage their sovereign wealth fund, or should we look at the Japanese model of how they create these sorts of structures? So that was just far more common at that point, basically up until the global financial crisis. So foreign influence was generally welcomed. I argue China was legitimately reforming.
It was a two steps forward, one step backward kind of process, but there was a convergent destination, the idea that no one really expected China to become a democracy overnight or at any point in the near future, but they thought that in terms of economic practices, in terms of engagement with the rest of the world, that WTO membership meant that they were moving closer and closer to the rules based system in global trade and in finance as well, greater integration with the IMF and other international financial institutions. So there was this idea that there was this convergent destination on the horizon, and that meant that there was a lot of patience in Western capitals for trying to facilitate reforms in China and trying to empower reformers and trying to give them space for this adjustment. A lot of that changed basically in the early twenty tens. The great debate among China analysts is just when did this fundamental shift away from this more convergent path really start? And there’s a number of different views, but I date it from this 2011 to 2012 time frame where you had the series of Middle Eastern revolutions, which really panics the Chinese security state as they thought that this being encouraged by Western intelligence services.
You had the Bo Xilai incident, which revealed the instability in China’s internal political process and how that might actually endanger Xi Jinping’s rise to power. And since then, you’ve had a far more hostile view toward Western influence over time, and that has extended all the way into basic people to people communications and basic research practices. It’s arguably reached even worse extremes at this point where many people after the detentions of Michael Kovrig and Michael Spavor are very reluctant to travel to China, very reluctant to subject themselves to this potential kind of uncertainty. So it’s been a longer process, but the point I make is that this was genuinely not a Pollyanna-ish everything was gonna get better kind of viewpoint. It was genuinely improving incrementally, and therefore there were good reasons for businesses, for policymakers to try to give China some space and to allow this reform process to continue and to take them at their word that this was the ultimate objective.
Demetri Kofinas: You went out of your way early in the book to establish that optimism about China was rational and evidence based and not part of this end of history exuberance. Why was that important?
Logan Wright: Yeah. I mean, I think that, well, first, I think there’s this common view out there that we never should have let China into the WTO, that this was always a mistake, that this was and I pushed back very strongly against that. I think that, no, there was a very legitimate case for China becoming a more constructive member of the rest of the world and of the global economy, and we might have been unhappy about the pace at which it was occurring. We might have been unhappy about several policy choices that were happening along the way, but again, there was the same destination that was sort of in mind. Second, this reinforces the point in the book that the future’s highly contingent.
We really cannot predict exactly how Chinese policy processes are going to evolve, but this has been a byproduct of very particular choices primarily made in Beijing, not made in Western capitals, to change course. Even as late as 2013, China was arguing for the third plenum reform agenda for a very pro market structural reform agenda. And then because the balance of payments crises, because of the stock market boom and bust, they moved away from that in 2015, 2016. But the point is this is not the result of the Chinese narrative is that China’s facing this containment from Western pressure. I strongly reject that.
This was the result of Chinese policy choices and how the rest of the world has reacted to China. The Western narrative is that China was never going to reform. The political system is fundamentally incompatible with Western democracies, and this path toward confrontation was inevitable. And I strongly reject that as well. So the first chapter is laying out the real on the ground experience from being in China in the two thousands.
The idea that if you told many of the Chinese interlocutors I spoke with back then that in twenty years, they would be subject to one man authoritarian rule, that they would face severe travel restrictions, that there would be rising trade tensions between China and the rest of the world, that would have been the remotest possibility. They would have attached tiny infinitesimal probabilities to those kinds of outcomes at that point. And it just reinforces to me that these realist interpretations of where The US China relationship is going really cannot possibly account for the degree of policy choice that’s mattered and the degree to which none of these trends were inevitable or structural in nature.
The Case for Structural Decline
Demetri Kofinas: So as you say, you make a very provocative argument in the book, which I should mention to listeners is titled Broken China, and your critique is substantive. The argument is essentially that China’s economy is in structural decline. Its currency is overvalued and counter to what seems to be conventional wisdom, its leaders are not the strategic, successful, long term planning geniuses that we and they have convinced us that they are. Lay that argument out for me. What is the prevailing narrative about China?
I mean, you kind of touched on this a little bit in your previous answer, but I want you to be as specific as you can because you’re extremely specific in the book. What is that prevailing narrative and how is it different from the story that you tell in the book?
Logan Wright: Yeah. I think the prevailing narrative is basically that China has problems, but the problems in their economy are ultimately the result of their policy choices and that they still have capacity to reverse them. So in other words, this was a problem because they intended to crack down on the property sector. This is a problem because they extended zero COVID policies for too long, but the underlying structure of the economy is still healthy, and the leadership is still capable of making some of these longer term pivots that are necessary to kick start the next waves of economic growth. That’s, I think, the prevailing narrative out there.
And it comes, I think, from a political lens that people tend to look at. Most of our analysts of the Chinese system basically start from this premise of this is a different political system. It’s a one party state with a technocratic elite. That technocratic elite can therefore make long term plans for the benefit of the political leadership. Therefore, what we need to understand is the nature of those plans and where China is in terms of achievements on those plans, like made in China 2025.
Therefore, we grade China’s state capacity along those lines in terms of are they actually achieving what they’re setting out to do. From a financial perspective, from a macro financial perspective, this is a country that had the single largest credit boom and bust in at least the last century. So you just don’t think about the capacity of policymakers to influence economic outcomes in the same fashion at the start of a credit boom and at the end of a credit bust. If you look at any emerging economy or developed economy that has had this kind of credit overextension, you do not assume that they have capacity to influence their economic future in the same way. And I like to say if everyone asks, how can you say that China’s facing these kinds of dilemmas when they haven’t had a financial crisis?
And I would say, that’s not really the question. You can avoid a financial crisis every day if you just continue to provide short term liquidity and keep enterprises alive. The question is, what are the consequences of a financial crisis? The book starts with the financial crisis moment of the protests in Evergrande’s headquarters in September 2021, and if you told me that there was a financial crisis in a country at date x, and you asked me to look at what is that country’s policymaking system, what does that country’s economy look like x plus five years, it would look very similar to where China is today, which is you have persistent deflation. You have fiscal deficits that are already very large, fiscal policy that is overextended.
You have a financial system that cannot generate the same rates of growth. You’re struggling with how to write down bad loans and how to write down the capital stock, and you’re increasingly dependent upon domestic demand and expansion of the central bank balance sheet to generate domestic demand. You’re increasingly dependent upon external demand rather than domestic demand. So you really have these very impaired tools, and it’s you go down through those, it’s check, check, check, check, check, check, check. This is exactly what we would expect to see.
So the argument I make is that look at China from a macro financial lens, and it looks very different. The argument of the book is basically that you cannot separate the growth of China’s economy from the growth of its financial system. The financial system facilitated China’s growth, served as a shock absorber for the political system for the consequences of malinvestment for years, and now it constrains China’s growth. If it constrains China’s growth, then the actual capacity of leadership to control their economic outcomes is far more limited than it has been even four or five years ago.
Demetri Kofinas: Before we continue, I just want to mention Michael Pettis’ book, Trade Wars or Class Wars. Michael had been on the podcast a few years ago. Some of your work touches on what he talks about in that book, but I think one important distinction for people that are interested in possibly reading your book is that your book, if that hasn’t already come across in the course of this conversation, assigns much more blame on leadership decisions and policy making decisions and the agency of the Chinese Communist Party, which I think makes it exceptional in that sense. So I have so many questions to ask you. First of all, if China’s economy is truly broken, as you say in the book, then why don’t we see it in the data?
What the Official GDP Data Hides
Logan Wright: Well, first, you do see it in a lot of the data, just not necessarily the data that Beijing wants you to look at. I always say that we haven’t seen an economy that is growing at 5% in real terms the way that Beijing is declaring it, facing persistent deflation probably ever, maybe since the gold and silver standard adjustments in the late 1890s and US immigration at the time, but that’s basically the set of economies that are in this kind of predicament. So there is a lot of data that shows this slowdown, and we at Rhodium go into tremendous detail trying to unpack where money is actually flowing on the ground. The only data series that really point to stability are headline industrial value added and headline GDP. Again, if interest rates are as depressed as they are, if there’s no real inbound investment the Chinese system as they’re facing persistent capital outflows, if prices and consumer prices have maintained basically no growth above 1% since the collapse of the shadow banking sector in late twenty eighteen, and if you’re facing persistent pressures in producer prices, it’s a very reasonable question to ask what the GDP data are hiding.
We go in far greater detail than that though. The basic story of why growth is overstated, there used to be a realistic debate among Chinese economic specialists and statistical experts that there was a degree of smoothing of China’s data between 2014 and 2019, that it was far too stable to be credible, but there were mistakes that were probably being made on both sides. But since 2022, the mistakes were only on one side, and that’s because the property sector has collapsed. The data does not incorporate the collapse of the property sector or the headline GDP data does not incorporate the collapse of the property sector, and nothing has replaced it. So that’s the biggest disconnect here.
In 2022, new housing starts fell by 40% in China’s most important industry that represented 20% to 25% of GDP. That’s not surprising. There were COVID restrictions in place. You had the fallout of these property developers defaults that were ongoing, and you had construction activity weaken across the board, new construction equipment hours worked, which they beam directly from the equipment to headquarters, was down by 14% that year. Alibaba’s Taobao and Tmall sales were down, I believe, by six or seven percent that year.
Headline retail sales had declined 0.2%. So there was no debate that domestic demand was weak, but they still published and was actually declining, but they actually still published a growth rate of 3%. It was impossible to reconcile. Then the next year, the property sector continued collapsing. Investment continued collapsing.
Consumption rebounded after they relaxed COVID restrictions, but that was the only source of growth. So growth was actually probably closer to 1.52% relative to what the 5.2% that they posted. And that cyclical recovery sort of continued in 2024 and 2025, but has now rolled over. And so if you ask me to put a number on Chinese growth right now, it’s probably below zero in Q2 and Q3 because domestic demand is negative. Consumption growth is barely above 1% at this point in retail sales growth, and fixed asset investment is falling by 7% in nominal terms and by larger margins in real terms.
So we can get into the arguments about why China overstates the data, why that’s critical for their narrative, because a lot of it has to do with strategic competition. But fundamentally, there’s no real debate right now that Chinese data are overstating growth. There is a realistic debate about by how much, but it’s a huge disconnect between 2022 and 2026.
Demetri Kofinas: Well, so as long as I’ve been studying China and its economy, going back to the earliest episodes of the podcast with guests like Ann Stephenson Yang, it was my understanding that the GDP number doesn’t serve the same purpose in China as it does in The United States. That it’s also a signal and a target for the rest of the actors in the economy, in particular local governments. So to what degree is it functioning as a signal? And to what degree is this actually about the larger narrative that you mentioned? And who is the audience for that narrative?
Is it The United States? Is it Europe? Is it the rest of the world? How much of it is the Chinese people themselves who are primarily the audience? Why is this, in other words, this narrative so important if we take your argument and accept it?
Why is it so important that the Chinese Communist Party and China have people believe the story?
Logan Wright: Absolutely. You stated it very well. This is an internal signaling mechanism and statistics are often communication devices between central and local governments and between officials in terms of how they’re projecting. So one Chinese official once told me, yeah, the GDP growth target is necessary, but it’s really more of a fiscal and financial stability target. And his point was that we do think that 8% at this time is too high, but if we adjusted it down to 5%, then it would send this signal that growth isn’t as important, and actually fiscal and financial stability isn’t as important because you wouldn’t generate as much tax revenue.
So you have to make these very incremental adjustments or else people would panic because this is what they’re used to within the system itself. So there’s a kind of path dependence to this process that had always emerged. But why does China need to project strong growth? Fundamentally, it is about the governance of the party, but fundamentally, the number one propaganda message from China is that China’s rise is inevitable. Therefore, if China’s rise is inevitable, we will be stronger tomorrow than we are today, and therefore, makes more sense to deal with us today rather than waiting for us to become stronger tomorrow, and this pervades virtually every aspect of China’s external diplomacy.
And one of the key arguments of the book is it’s just wrong. You have reached this point where they can’t actually maintain the same rates of growth in the future, and in several measures of China’s rise, it has come to an end, especially as a proportion of global GDP, if we think about it in those terms. So that’s really the overarching propaganda message. Who are the audiences for it just as you ask? Internally, it’s the party members themselves.
I tell this anecdote in the book where I had a conversation with someone who worked in the CCP central committee’s economic finance office, where they basically wrote a lot of the editorials in the People’s Daily about the economy. And I asked them, this was in 2009. And I said, okay. You’re putting out a growth target of 8%. Why does it have to be so aggressive?
Let’s say potential growth is 8%. You just came off of 14% growth. Right after the financial crisis, everyone just wants to see that growth is positive in China, that policy works. Doesn’t matter whether it’s eight, three, five. So why don’t you say, okay.
Potential’s eight. We were at 14 at the peak. We’re gonna go to five at the trough. We’re gonna bounce from there, and we don’t therefore need to expend all of this credit in order to kick start growth at a higher rate. And he said to me it was one of these conversations I always remember.
This was back in 2009. He says, I completely agree with you. But if we actually said it was five, everyone in the system would think that it’s zero, and they would start panicking. So his point was there’s this internal party coherence aspect of this that you need to be sending messages that show that the party leadership has this under control among party cadres themselves. It’s not really directed at the people, so to speak.
It’s not really directed at a nationalist message that we’re the first out of the financial crisis. And then externally, especially now, the importance of the narrative is basically in my view, why can’t Xi Jinping admit that growth might be lower? Well, one, he probably doesn’t believe it. He believes that growth might be lower than 5%, but there’s no way that Logan Wright is correct and growth is zero. So it’s somewhere in between.
We have some things going for us. We have robotics and AI and export dominance, and things are going pretty well for us. And I don’t really understand what the economists are saying, but it’s not nearly as bad as it was a couple of years ago when we had this local government fiscal crisis. So there’s that view that they just don’t believe it. The other is this narrative, this ideological narrative.
The East is rising. The West is declining. So how can China have a problem? How can there be slower growth in the West? I say this all the time, by every measure, The United States has outgrown China in the last five years.
Official data, unofficial data, nominal it’s in nominal terms. Yes, it’s because there’s higher inflation in The US, but this is really what matters. It’s nominal growth that repays debt and drives corporate profits and drives reinvestment. You do not want persistent deflationary pressure.
And then the other part of this is the strategic messaging. If you are trying to push back against derisking, you do not want to say domestic demand growth in China is gonna be weak because then the economy is not worth arguing over. If you are trying to push back against Western sanctions and export controls, you wanna say, our economy is still vibrant enough that you still wanna trade with us even if we’re being sanctioned and face these controls. So strategic competition comes into all of this and is actually, I think a pretty critical part of unlocking some of these changes as well because China is basically coming into a set of choices where relaxing strategic competition and seeking some kind of detente with the rest of the world, especially in trade tensions, is going to become a preferred option because they really won’t be able to continue this kind of model for much longer.
Demetri Kofinas: I’m fascinated at the differences between the Chinese political economy and what we have in Western countries, and the role that things like Xi Jinping thought seem to play. It’s almost like presidential doctrines. When the executive in the White House has a specific vision for the country and foreign policy, that diffuses throughout the cabinets within the executive branch and people use it as a point of direction to navigate because most people in government don’t have regular access to the president. It feels like to some degree China’s economy functions in a similar way that it’s more bureaucratic. So I think when people look at it from a Western perspective, it’s hard to really capture that.
I also want to mention Joseph Torigian’s book, The Party’s Interests Come First. Joseph had been on the podcast, and I think also was very helpful for me in thinking about some of the policy choices that Xi Jinping has taken and in so far as not reforming the economy along the lines that someone like you or Michael Pettis would think is necessary. Okay. So I think we’ve done a good job here of establishing a base. Let’s talk about where things went wrong.
Get Demetri Kofinas’s stories in your inbox
Join Medium for free to get updates from this writer.
When did things go off the rails for China’s economy in your view?
Logan Wright: It’s a good question. So I think that there’s a first run of disorder, so to speak, and instability that starts in 2012 to 2016. And so this is right after the global financial crisis. You have this huge credit expansion. Money supply basically doubles.
I think it was up 85, 88% in
Demetri Kofinas: Because I really want to make sure that we spend quite a bit of time on their response to the financial crisis. Also, tell us a little bit about because the financial crisis happened at the same time as the Beijing Olympics. What was the overall lesson that China’s leaders took from those two events? And was it important that they happen concurrently? Then go ahead and complete your answer.
The Olympics, the Crisis, and the Credit Boom
Logan Wright: Yeah. I talk about this in the book as well. So the Olympics happens, and it’s this enormous coming out party for China, and it’s this enormous signal that China’s joining the rest of the world and is committed to joining the rest of the world and has been successful in doing so as this important marker. And then at the same time, all of the borrowing from foreign influence that I discussed, all of the importance of using foreign economic models and different structures, that comes into this the financial crisis causes Chinese officials to start questioning a lot of that logic because it looks like the system just failed and created this huge disruption. At the same time, China reveals that they’re vulnerable to dollar financing constraints.
So trade credit contracts globally. It impacts China’s exports. The crisis in Beijing’s view, notwithstanding the savings glut and savings glut versus The US consumer housing debt overlap, their view is basically, this is a Western financial crisis. How come our trade is being impacted to this extent through purely financial lenses? And so then you start thinking about, okay.
Can we internationalize our currency? Can we drive renminbi denominated trade credit? And puts that marker down for a change in the international monetary system as early as March 2009. So this was a period of very significant shifts in China. There’s also and I don’t think I even mentioned this in the book, but there’s also outright conspiracy theories going on about the financial crisis in China.
So one of the most popular books at that point was this it’s like protocols of the elders of Zion kind of overlap with international monetary theory called currency wars and written by this armchair historian. But I recall being at a conference with this guy on the stage and a bunch of macroeconomists in two thousand eight, two thousand nine, and they were talking about the book, and the macroeconomists are saying things like, mister Song, we read your book, but this isn’t really how the global economy works, and these are the forces that you’re not looking at, etcetera. But he gets all the applause, absolutely all the applause for this the West is conspiring to use currency politics to contain China in certain ways. I don’t remember the exact argument. It was kind of silly.
Demetri Kofinas: Is there an important lesson we need to draw from what you just said there, or is this just a general appeal to populist messaging that would also operate in Western countries?
Logan Wright: The point I would make from this is that Western models are suddenly being questioned. And so suddenly, you have this idea of convergence with Western practices doesn’t look nearly as attractive to critical elements of the party structure and Chinese people, and the global financial crisis creates this delegitimization process. That was really the point I was trying to make.
Demetri Kofinas: One more quick question before you continue with your previous answer. Why was it so difficult for Chinese policymakers and people within the intellectual community to recognize that part of the explanation for the crisis was the structural trade surplus and the capital deficit that The United States was running and importing capital from China?
Logan Wright: I recall having this conversation with people in the PBOC. I said, well, yeah, but your savings glut is part of what’s financing US corporate debt? The responses were just, that’s impossible. No. It’s US household borrowing that is driving this.
We can’t create liquidity. Only you can create liquidity. This was straight from the PBOC. I recall having these conversations in 2007, 2008.
Demetri Kofinas: that informed by a puritan perspective? The same ideas that Joseph Torigian puts forward in the party’s interest come first in terms of Xi Jinping’s upbringing and the need to eat bitterness?
Logan Wright: No. I think it’s more fundamental. It’s just we can’t possibly be that important in terms of what was driving this. We can’t possibly be the causative agent. You still see this right now.
China has an investment led economy, very weak domestic demand. They can only grow relative to the rest of the world by displacing others’ investment because they are the largest investor in the world unless they are actually rebalancing their domestic economy, but they don’t view that as a fundamental economic imbalance from their perspective. They view that as a diplomatic problem, to make the world safer for Chinese exports. That’s a huge risk. So it’s this China became far more important in international finance relative to its importance in international politics.
That happened faster, and that empowered certain individuals within the Chinese system who had these outsized roles. The other example I’ll give you. So I worked as a stringer covering the strategic economic dialogue between The US and China in May 2007, and I was in DC. And it’s just this interesting microcosm into the Chinese system. So all of these ministers walk out of the room, and I’m speaking bad Chinese, and I’m trying to interview the head of the NDRC who at that time was Ma Kai.
And so I try to ask Ma Kai a question, and Ma Kai looks at me like, first, who is this foreigner speaking Chinese? Second, who the hell are you to ask me a question in this regard? Four people later, Zhou Xiaochuan comes out, governor of the central bank. Everyone swarms around Zhou Xiaochuan. He’s the lowest ranking official within this delegation, but all the foreigners just want to see what is Zhou saying about monetary policy, which makes perfect sense for a financial market audience.
But within the Chinese system, they’re just, what are they missing? Why on earth do they wanna talk to Zhou? We’re a lot more important, and we’re not gonna talk to you, but this has to be this huge moment of cognitive dissonance, but it reflects this idea that China became far more important in international financial policy relative to where they were in international politics or in terms of trade flows as well.
Demetri Kofinas: Is the understanding of the Chinese leadership to the trade restrictions placed by other nations on China similar to their understanding and perception of the 2008 financial crisis and the role that their trade surplus played in generating capital outflows and increasing credit availability in Western countries? In other words, do they see the responses as anti China being driven by fears about China’s rise and attempts to contain China and less so about the manifest hollowing out of domestic industry and the political interest groups within these countries, like Germany, for example, that are invested in preventing it.
Logan Wright: Right. So I think there are parallels there. I think that the current disconnect is far larger than it was back then. Back then, there was a lot of concern about, if you recall, Chinese exchange I wrote my dissertation on China’s exchange rate reform. So during 2004, 2005, you had this threat of tariffs from Lindsey Graham and Chuck Schumer in the senate, and treasury got to say, good cop, bad cop, look.
If you don’t do something about the currency, there’s going to be this congressional pressure to do something about trade, so therefore you need to adjust the currency. So China reforms the currency in 2005, but there’s this belief that, okay, this is unfair in terms of they shouldn’t be pressuring China’s growth model and that the China shock isn’t at that time, it was a supply shock of labor. It was about wages, and it was about currency undervaluation because productivity gains in the Chinese system weren’t the same as they were later, but you had real consequences in the industrial Midwest for outsourcing of a lot of those jobs. So the first China shock was a real development, but because foreign companies were so involved in that movement, the agency wasn’t really placed on China itself, like that this was a policy problem from China. That is very different now.
Because the real issue is that if China cannot generate domestic demand, then trade tensions are inevitable. But how is Beijing interpreting those trade tensions? They’re interpreting, I think, exactly the lens that you’re talking about where this is a containment oriented approach. They’re just trying to stop China’s rise. I like to frame it this way.
We think about global economic imbalances as temporary problems to be alleviated with policy so that you don’t have these dramatic adjustments in a crisis. Right? China thinks of global economic imbalances as the deliberate objective of their policy. They want to expand global export share and global value added, and they are not in position to expand domestic demand at the same time. So that is a far different state of affairs, I think, relative to the past.
But I do think that the global financial crisis, as we go back, was this pretty important inflection point for thinking about foreign influence in China’s economy. And you start seeing first, it’s harder around this time. It’s not 09, 10, but it’s 11, 12. It’s harder to get meetings. It’s harder to have forthright conversations.
There’s more investigations into foreign influence. And in part, this is because of the Bo Xilai incident and all sorts of things that were happening in the US China relationship at the time, which are beyond the scope of the book. But the start of this is really during the financial crisis itself.
The Largest Credit Expansion in a Century
Demetri Kofinas: All right. So put the scale of China’s post GFC credit expansion in perspective. How large was it relative to anything that the world had seen before?
Logan Wright: Larger than anything that’s happened in at least a century in a single country. So $24 trillion between 2008 and 2016, $27 trillion by 2017, depending on how you cut it off, relative to only about $6 trillion in GDP during that time. Credit to GDP multiples expand about 80 percentage points during that timeframe, depending on how you measure, but it’s in that range, and that is equivalent at the time to about a third of global GDP. So I urge people to just grapple with this. You’re saying that Chinese state banks and local government banks basically extended credit the size of Germany or Japan’s economy every year for eight years and increasingly had less and less control about where it was going.
And the idea that all of this lending was productive is just impossible to sustain if you think about that in that context.
Demetri Kofinas: How much of that was driven by domestic savings and how much of that was driven by foreign capital?
Logan Wright: Right. So at first, China’s savings rates are high, still 40% overall, but it’s not that it’s all funded by this expansion of household deposits. So for years up until about 2011, until the European debt crisis, actually, you had this very steady inflow of new deposits into the system because China was running trade surpluses that were very large starting in 2003, 2004. And so the challenge for banks was how do we lend out all these new deposits that are generated? Because you’re intervening in the currency markets.
Therefore, PBOC is buying the dollars, generating new renminbi liquidity. The concern is inflation, and the concern is too much credit growth, which they try to control with quotas. When they put controls on those with quotas, that leads to the growth of the shadow banking system, which then starts to have this own self fulfilling logic from 2012 to 2016, which we can talk about in terms of where that goes. But there’s this strong external component to funding China’s credit expansion at that point. Then in 2012, you shift from a system that was broadly characterized as financial repression in which you have no opportunities as domestic savers to really invest outside the banking system, you’re forced to put deposits on at low rates in the state banking system, they lend them out to state owned enterprises.
You shift to a system of subsidized moral hazard because suddenly there is no net inflow. In fact, you have an outflow of capital, and so some banks are actually scrambling for funding. They have to bid against other banks to attract this funding and maintain their loan books because there’s still credit demand from local governments to keep these projects going. So this introduces new funding stress, and it introduces this new problem of wealth management products, these shorter term deposit like instruments that have to be rolled over. You fast forward by between 2012 and 2016, you’ve completely changed the structure of China’s financial system. 2012, you had a system that was deposit funded, made loans inefficiently, but made loans to state owned enterprises, and had a pretty stable funding base because there was this steady inflow of new deposits in the system so it could grow.
By 2016, marginal growth in funding is from a nondeposit instrument, a wealth management product. Marginal growth in lending is via a shadow bank, a trust company, something else that’s largely lending to property developers, margin financing for equities, local government financing vehicles, you name it. And then there’s huge volatility in balance of payments conditions as there’s these enormous capital outflows from China that happened in 2015. So it’s a totally different system, and this happens very quickly. So suddenly you have a far more unstable system, but the actual pace of credit growth is still large.
And why? Because there’s this implied moral hazard. No one thinks that anything can default, and it can’t default as long as more and more credit goes out to roll over existing loans. And so the financial system serves as the shock absorber for the political system. It insulates individual investors from losses, and it insulates companies from bankruptcies and provincial leaders from unemployment until it can’t.
And it stops really in late 2016, but by 2018, it’s pretty apparent. I don’t want to get too far ahead of your questions here, but I can tell you the whole narrative of deleveraging campaign if that’s interesting.
Demetri Kofinas: I should mention before we continue for anyone that heard those sirens, we’re actually recording this on September 23rd and you’re in Washington DC. So we’re anticipating the arrival of Xi Jinping this evening for the Trump Xi Summit. So I think this is quite apropos. There’s just so many questions I want to ask you, and you’ve addressed a lot of them in pieces in your previous answer. I guess before you continue on with the narrative, what is important for us to First of all, why is it important that this lending happen through the banking system and then eventually increasingly through the shadow banking system as opposed to the central government?
How should we think about the role that local governments played? Just put this all within the context of how China’s political economy operates, which is so foreign to the Western mind.
Logan Wright: Sure. And we’ll step back a little bit to the immediate post crisis environment. So the G20 looks at the global financial crisis and the mandate that goes down is basically everyone, let’s find 10% of GDP in stimulus. And so China comes up with a 4 trillion yuan quote unquote stimulus plan. And everyone’s just like, well, how are you actually funding that 4 trillion?
Is that direct fiscal spending? It’s not. It’s funded indirectly through the banking system. Why is that? Because fiscal spending takes time.
You have a periodicity to government bond issuance, and then you have to transfer those resources to local governments, and then you have to find projects for them. But you’ve actually been just controlling local governments’ borrowing for a long period of time. So the easiest thing to do to stimulate lending is just to let the local governments borrow as much as they can and to get this kick started where loans create deposits and then that facilitates new credit growth at the same time. So that’s really how this gets started in 2009. So the expansion in credit happens very rapidly.
Then that starts to filter into inflation by 2011, but a lot of infrastructure investment, a lot of property investment. I recall in 2009, state owned companies were just like, well, what do we buy? Let’s just speculate in some commodities. So they just started buying, stockpiling commodities and things like that because they had so much money at hand. This is where none of this was strategic.
People were arguing at the time that this was the opportunity to rebalance the economy. This was the opportunity in which you could have come up with a different form of economic management. You could have changed the fiscal system to prioritize transfers to households, but the priority was let’s get out of the crisis first and let’s clean up the consequences later. And the banking system was the tool to do that. What that means is that none of these loans that were extended were ever really intended to be repaid by the ultimate borrowers.
There was an assumption that these were the state owned companies and that there was a government guarantee behind them. And basically, as I pithily noted, moral hazard wasn’t a problem. It was a strategy. The idea was that everything could continue to expand because everyone assumed that the government was on the hook for one part of this lending one way or the other. So therefore, everyone’s just happy to continue to generate more money creation.
And so the constraints become rolling over the loans, the actual funding of the system in terms of wealth management products themselves, and then inflation. And so you have an inflation pickup in 2011 and you haven’t really had any significant inflation in China since that time, since basically the summer of 2011. And that just shows you how inefficient the lending has become even after the shadow banking activity continued expanding. You instead got bubbles in the equity market. You got bubbles in the property market.
You got bubbles in commodity trading because that’s where the money started to flow under these shadow banking, shadow lenders.
Demetri Kofinas: God, this was such a good book. In this portion of the book, I kept thinking to myself, wow, this is like Hayek’s worst nightmare. I mean, the convoluted intervening to fix a previous intervention becomes so messy that you just feel like they’re caught in this situation where anything they do to try to fix the problem just ends up making the problem worse. But if they step away, it’s obviously going to be way worse in the short term, which is the dilemma that policymakers find themselves in today. We’re going to have a chance to talk about that too when we discuss the consequences and the aftermath of the bubble.
Just one more question before we move to the second hour. So you mentioned the implicit guarantee. How widely held was this assumption? How important was it in helping to fuel the expansion? How similar is it to the widely shared belief that the US government won’t allow, for example, money market funds to fail?
Or maybe a better analogy that the US government won’t allow the stock market to go down. Is it comparable in any way to that or is it just on a much bigger scale?
Moral Hazard as Strategy
Logan Wright: It used to be far more specific. This is important to understand, that financial risk was wrapped up in political risk in general. Why did people think that their assets were going to retain their value? You always believe that even if there were problems, as long as everyone was taking the same risk, the government was basically on the hook for stabilizing these asset markets. You might not have got 100% of your investment back, but there would have been some sort of compensation that extends to the stock market, the bailout in 2015.
But for wealth management products in particular, I remember these conversations very distinctly. So in 2013, in June, the government tries to break the shadow banking system. The PBOC tries to break the shadow banking system, and they conduct this experiment where they basically say, you have this asset liability mismatch. You have short term funding. You have long term assets.
You need to solve this problem, and we’re not going to help you, and you need to do this. So basically in about five days, the entire financial system started screeching to a halt, and the reason was that banks were buying wealth management products from one another. So in other words, if you’re a smaller bank, you’re funding yourself with this 5% wealth management product that you’re basically issuing on the interbank market. And if you’re a larger bank, you can’t really find a borrower for that, so you’re actually buying that wealth management product. But then the interbank rate goes to seven.
So therefore, it makes more sense to lend that money on the interbank market. So I therefore force maturities of the wealth management product from the other bank that I’m already holding. Holy cow. Then the smaller bank has to come up with additional money in the interbank market. And so the interbank rate goes from seven to nine, and then the interbank rate goes to twenty and thirty. So the overnight rate basically on June 20, 2013, the overnight rate hits 30%, which basically means there’s no lenders left in the system as a whole.
So suddenly, interbank rates are skyrocketing. Now and this is the critical part of the story. Everyone assumed that this is a financial crisis. The short end has collapsed. There is no liquidity, but everyone assumes the government’s going to step in.
So if you are a regular depositor and a bank is offering you a wealth management product at 10%, ordinarily, we’d think that’s risky, but there’s a flight to risk, a huge flight to risk. I know very intelligent Chinese financial analysts who literally took their life savings and put them in these wealth management products at 11% for this month. This is also how Bao for Alibaba started because suddenly they had these deposits, and they could then start offering people higher returns than they could get by the banks. So there’s a flight to risk because everyone assumes the government’s going to bail out the system. Well, what happens, why is there a flight to risk?
Because people assume the government is weak. And if you think the government is weak, they’re going to basically respond to this financial instability and protests by just paying compensation. I like to joke, if you’ve ever been in a delayed flight in China during this time, you had to all gather around and chant at the ticket counter if you were going to get repaid for your flight because otherwise they wouldn’t pay attention to you. So everyone has to act collectively. Same thing happens six years later, five years later in Beijing in 2018.
There’s defaults on peer to peer lending networks. About 10,000 people organize a protest. First, they protest in front of the banking regulator, which is hilarious because the banking regulator, who protests in front of the banking regulator? Everyone protests in front of the stock regulator because they’re concerned about the stock market going down. But the idea that you’d protest banking regulation is kind of silly, so they’re not even prepared for it. So they organized this on WeChat, but because they’ve organized it on WeChat, security forces are prepared.
Because security forces are prepared, they just bust everyone and get them out of there. And so they’re not repaid. So you went from this notion of the communist party is weak, and therefore they’re going to, there’s a collective leadership, and therefore they’re going to repay me if I face these financial defaults, and this is my expectation to Xi Jinping has centralized power, and if he’s not interested in the potential consequences of these protests, then I’m not going to be repaid. So suddenly when you get defaults of peer to peer lending networks in 2018, smaller banks in 2019, trust companies in 2020, property developers in 2021, individual mortgage loans in 2022, local government financing vehicles need a bailout in 2023, credit demand just collapses because suddenly there’s a flight to quality, not a flight to risk. That transformation that happens during the rise and fall of the shadow financial system is critical to understand why China’s constrained because you can’t go back and say, oh, we’re just going to guarantee all these shadow lenders again.
First, don’t want to. Second of all, no one will believe you.
Demetri Kofinas: There’s been a collapse in confidence.
Logan Wright: Yeah. Exactly. Sorry, long story, but that’s the way this has evolved.
Consequences, Implications, and What Comes Next
Demetri Kofinas: Brilliant setup. Brilliant setup. So let’s move into the second hour. I want to give people an idea of what we’re going to discuss. We’re just going to go into much more detail as it relates to the consequences of the credit bubble and the things that I think are most important based on having read the book, as well as the implications.
So obviously we’ve talked about the property market. I also want to talk about the concentration of power under Xi Jinping, zero COVID, the tech and education crackdown, which I think also has its own confidence crisis type downstream implications. Then what does this mean going forward, both in terms of policy implications for Beijing and for Washington? And how does this fit into The US China strategic competition? And what are the primary risk categories that you identify in the book?
Go deeper. Access the second hour of this conversation, the complete transcript, and Intelligence Report by becoming a premium subscriber HERE.
