What do economists think of Malaysia's economy?

China's debt and its foreign trade relations

Problem definition and recommendations

China's increasing weight in international relations is an expression of its economic rise. However, the stability of the Chinese economic model has been viewed more skeptically by some observers, including the International Monetary Fund. The country's debt is the weak point of the Chinese economy. Total debt has been growing at annual rates of 20 percent since 2008, which is significantly faster than economic output. From 2008 to 2016, the debt of the state, companies (excluding the financial sector) and private households rose from 135 percent of gross domestic product (GDP) to - depending on the source - at least 235 percent. In particular, state-owned companies and development agencies of local and provincial administrations are heavily indebted. At the same time, the credit bubble is inextricably linked with the high prices on China's housing market: two-thirds of the total collateral in the banks' loan books is real estate.

The Beijing government is therefore faced with a host of problems. It wants to maintain economic growth at a high level, reduce debt, prevent a further rise in real estate prices and also limit the economic effects of the trade conflict with the USA. These four goals cannot be achieved at the same time.

A continuation of the previous growth strategy does not seem possible within the Chinese borders, but an export of capital and production capacity of the People's Republic does. Against this background, the Belt and Road Initiative (BRI) - also known as the "New Silk Road" - energetically promoted by President Xi Jinping, could represent a strategy for exporting the previous Chinese model of debt-financed growth. However, the new debts will not be imposed on China, but on the recipient countries.

The OECD countries are faced with a challenge by China's precarious economic situation. This affects governments as well as companies. The golden years are over for European companies that are active in China, and the People's Republic is increasingly becoming a competitor for power and influence, and not just for Washington.

In view of this changed geopolitical situation, Germany is faced with the need to reorient itself. On the one hand, it is important to intensify relations with those countries that are directly affected by China's politics - in particular Australia, Japan and India. Relations with these countries, which, as in the case of Australia, are already exposed to harsh sanctions from Beijing, should be expanded both politically and economically.

On the other hand, German foreign trade policy will have to say goodbye to the long-nurtured illusion that China is not interested in developing its own regulatory model. In recent years, President Xi has made it very clear that he is striving for a leading role in his country. The central vehicle for this is the BRI. With this major project, China is creating dependencies and setting up a hierarchical system with the People's Republic at the top. The initiative is not only a result of Beijing's geopolitical ambitions, but also reflects the limits of the previous Chinese development model. In Germany, it is no longer possible to continue, because a further expansion of the infrastructure and even more vacant apartments would push up the country's already threatening indebtedness. Seen in this way, the BRI is an expression of the weakness of China's economy.

Unlike Japan, Europe and the USA have not yet launched any initiatives of their own to finance the expansion of infrastructure in developing countries in Asia. The multilateral development banks offer loans for this purpose, but from the perspective of the recipient countries, the requirements of the World Bank, for example, are often too strict and the application procedures too complex. There are options for a new initiative between the BRI on the one hand and the development banks on the other. Germany could use its huge current account surpluses to offer a European alternative to the Chinese projects.

In order to achieve a significant effect, a European alternative project to the BRI would have to have a volume of 250 to 300 billion euros. Such an initiative to support infrastructure projects in Asia could be financed either through direct borrowing by the federal government, which can currently borrow almost free of charge, or through low-interest infrastructure bonds guaranteed by the federal government.

New initiatives are in order to prevent more and more Asian states from coming under the influence of Beijing. Europe and the USA have no interest in the BRI creating a network of dependencies that would significantly limit the foreign policy scope of many Asian countries in the future.

China's rise to become an economic heavyweight

For a long time, numerous observers followed the rise of China benevolently and in amazement at the same time. The state and party leadership in Beijing seemed to succeed in almost anything. The usual economic laws did not seem to apply to China. Trade with the People's Republic became more and more important for almost all states. In addition, China gained international importance as an anchor of stability for the global economy, especially in the years after the severe financial crisis in 2008. These successes make a financial crisis in China seem unlikely at first glance, if only because the country's government has so far mastered all economic turmoil.

Many observers, however, also looked with amazement at the high level of investment in China. The country has produced what is probably the largest investment boom in economic history. From 2002 to 2014, private and public investment rose from 37 to 47 percent of GDP. This value is well above the investment rates of other economies, including emerging markets.1 With such high sums, the accuracy decreases. It is therefore very likely that there were also a lot of bad investments. The ongoing boom in China has led to exaggerations because euphoric investors miss a sober calculation - a phenomenon that the Canadian economist Hyman Minsky described as early as the 1970s:

“The deals that are made between banks, investment bankers, and business people increase the accepted amount of debt that can be used to fund various types of activities and positions. [...] As this continues, the economy begins to boom [...] The tendency to convert a positive development into a speculative investment boom is the fundamental instability in a capitalist economy. "2

The exaggerations in China are thus a phenomenon that shows up again and again in capitalist economies. In this regard, the People's Republic has taken on the instabilities of Western economies. Since China has not borrowed abroad, the write-offs on bad investments - which the state has also recorded - will have to be borne by residents.

The expansion of the infrastructure in China repeatedly arouses incredulous amazement. The world's largest network for high-speed trains was established there in just ten years. A total of 25,000 kilometers of new rail lines were laid. Two thirds of all high-speed rail lines in the world are now in China. These construction investments were financed with new debts.3 Profitability considerations were just as unimportant as sustainability aspects.

Relations with other states have always been described by Chinese politics as conflict-free. During Hu Jintao's presidency (2003–2013), Beijing used the catchphrase “common prosperity in peace and harmony”.4 President Xi also repeatedly used comparable formulations, for example in April 2018 when he raved about a world of great harmony and peaceful coexistence.5

But this picture has cracked; it is no longer accepted unconditionally in some neighboring countries, but also in Europe. The perception of China in international politics has changed significantly since around mid-2017. The remarkable increase in the importance of the People's Republic is now viewed with suspicion in many OECD countries. In earlier years, Western observers often assumed that China would develop into an open, democratic society. At the same time, numerous political decision-makers expected that the leadership in Beijing would ultimately give up its mercantilist approach to trade and investment policy. These assessments turned out to be incorrect. As the British magazine "The Economist" headlined in March 2018: "How the West Got China Wrong."6

In the 2000s, Western experts hailed China as a good neighbor and constructive partner.

The rise of China, beginning with Deng Xiaoping's reforms in 1978, was astonishingly smooth for almost four decades. Foreign skeptics regularly predicted crises in the People's Republic without ever having occurred. In international politics, Beijing managed to avoid conflict. In the mid-2000s, David Shambaugh, one of the country's most prominent American observers, extolled China's politics. As he wrote at the time, most of the countries in the region viewed the People's Republic as a good neighbor and constructive partner, an attentive listener and a non-threatening power.7 Shambaugh remarked euphorically: "Today China is an exporter of goodwill and durable consumer goods and no longer of revolution and arms."8

The Southeast Asian group of states ASEAN, founded in 1967 as a bulwark against the advance of communist China in the region, concluded a free trade agreement with the People's Republic as early as 2001. In the same year, after long negotiations, China joined the World Trade Organization (WTO). It managed this step despite extensive, tough requirements from the EU and the USA, thereby strengthening its reputation as an actor willing to cooperate in international relations. China had to significantly lower its average tariffs from 40.6 percent (1992) to 6.8 percent (2007).9 From 2001 the country was considered a constructive force in the WTO for a long time; for example, it supported the conclusion of the Doha Round.10

At the same time, China benefited from its integration into international economic relations. Real wages in the country rose 400 percent between 2000 and 2016. The fact that the People's Republic was incorporated into the global division of labor was therefore very beneficial for domestic workers, but had negative effects for workers in other countries. For the low-skilled, especially in the USA, increasing trade with China meant increasing competition, as the American economist Paul Samuelson pointed out in 2004. He found that productivity gains in less developed economies can lead to a situation in which developed economies lose their competitive advantage due to changed exchange relations in trade ("terms of trade"). According to Samuelson, the increase in productivity in China has weakened the competitive position of American companies; Employment and profits came under increasing pressure.11

Twelve years after the publication of Samuelson's essay, three American economists stated in a highly regarded paper that China's rise had been a shock to some of the workforce in the United States.12 The liberalization of US-Chinese trade compensated for factor prices, including wages. From the point of view of American workers, the increase in trade with China has resulted in continued pressure on wages.

Since China's accession to the WTO in 2001, the question of what consequences the country's rise will have for international politics and the institutions that regulate economic relations has been discussed. For a long time the opinion was widespread that China would move within the existing order and not try to develop a competing system. John Ikenberry, for example, did not see any threat to the Western model in this regard in 2008.13 The capitalist-democratic world, he argued, had powerful supporters to maintain - and even expand - the existing international order.

This point of view is now being held less often. Today, for many observers, China is an actor who disregards the rules of international politics. Former WTO director general Pascal Lamy sees China's state capitalism as the biggest problem of the global market economy. Even 17 years after Beijing joined the WTO, he still believes the question of whether the globalized market economy is compatible with the Chinese state economy remains unanswered.14

Against this background, surprising new constellations emerged in 2018. China is currently facing a coalition that has never existed before. The US, Japan and the EU are jointly putting pressure on Beijing to bring about reforms in the WTO. It is about hidden subsidies and forced technology transfer.15 During a visit to Beijing in summer 2018, EU Commission President Jean-Claude Juncker let Chinese Prime Minister Li Keqiang know that, while the EU does not share Donald Trump's rhetoric and methods, it does share an essential part of his economic policy goals.16

Parallels to Japan

Certainly the economic development of China differs from that of Japan. But there are also remarkable parallels. China could repeat what happened in Japan three decades ago. During the 1980s, many observers expected the island nation to become the leading economy of the 21st century.17 At that time there was awe in the West about the fate of the Japanese Ministry of International Trade and Industry (MITI). In Washington, on July 2, 1987, congressmen smashed a Toshiba radio with a sledgehammer on Capitol Hill, denouncing what they saw as inappropriate economic policies in Japan.

The Japan of the 1980s and today's China also show astonishing similarities with regard to the exaggerations in the stock and real estate markets. In 1990, Nippon Telephone and Telegraph (NTT) was valued at 250 times its annual profit. The Nikkei 225 stock market index reached an all-time high of 38,915 points on December 29, 1989, a six-fold increase within a decade. Real estate was extremely expensive: the value of the Imperial Palace in Tokyo - had it been for sale - would have been enough in 1990 to purchase all of California's real estate. The then US Ambassador to Japan, Mike Mansfield, never tired of stressing that the bilateral relationship between the two countries was the most important in the world. But worries about Japan have now given way to worries about Japan.

The most important parallel to today's China is the high level of debt. In Japan in the 1980s, too, politics encouraged extremely high investment rates and the build-up of substantial debt positions. The country has not fully recovered from the mistakes of that time - almost 30 years after the double price bubble in stocks and real estate burst in the country. The criticism of the Japanese economic model at that time is similar to the current criticism of China, even if today more far-reaching questions are asked about the compatibility of state-controlled and liberal economies. But in the 1980s, observers also warned against a fundamentally different type of economic organization from the one practiced in Japan, and questioned the competitiveness of companies in the western industrialized countries.

British journalist Martin Wolf has also pointed out the parallels between China and Japan. He noted that in the 1980s, Japan became vulnerable to extremely high levels of investment and rapidly growing debt. The same picture is seen today in China. Wolf regards its investment ratio of 44 percent of GDP in 2017 as inappropriately high. He is therefore by no means certain that China will develop into an economy with high per capita incomes within a few years.18

There is, however, one major difference between Japan 30 years ago and China today: At the time, no one assumed Tokyo wanted to develop an alternative model for organizing the economy and society. The People's Republic, on the other hand, is increasingly seen as a competitor not only in the business sense, but also at the level of the economic systems.The Federation of German Industries (BDI), for example, published a position paper at the beginning of 2019 in which it turned away from the previous policy supporting cooperation with China. For the BDI, the country has gone from being a partner to being an adversary.19 The association no longer assumes that the People's Republic will approach the model of the western industrialized countries. Rather, he sees a systemic competition between the western economies and communist China:

“For a long time it looked as if China, through integration into the global economy, would gradually move towards the liberal, open market economies of the Western model in shaping its economic system. This convergence thesis is no longer tenable. Structurally, China is hardly developing in the direction of a market economy and liberalism, but is in the process of realizing its own political, economic and social model. "20

Another example of the harsh criticism that is being leveled against China and its political leadership today is the elderly stock market investor George Soros. In a high-profile speech at the World Economic Forum in Davos in January 2019, he described Chinese President Xi as the "most dangerous opponent of open societies".21 These new assessments of the People's Republic by foreign observers are relevant in assessing the risks in the Chinese financial sector. The country has to cope with the dangers lurking there at a time when it is being shown far less goodwill from at least most of the OECD countries than it was two or three years ago.

It is difficult to answer the question of what led to this change in sentiment. Why is China more or less perceived so much more critically around the world today than in the past? Why is Beijing's rhetoric working worse today than it was in previous years? A striking example of how bilateral relations with the People's Republic have deteriorated is Australia. Tensions between Canberra and Beijing have increased significantly since 2017. Australian Senator Sam Dastyari had to resign in early 2018 for accepting payments from China. The Dastyari Affair resulted in a new law prohibiting foreign actors from influencing Australian officials.22 The government in Canberra is under massive pressure from Beijing today. China is now often perceived as a threat in the country's public debate.23

Similar reactions can also be found in other countries. Certainly, no single factor or measure has led to the reassessment of China's foreign and foreign trade policy. Rather, a whole range of events contributed to this, including China's aggressive disregard for international legal norms in the South China Sea, its attempts to influence weaker European countries as part of the 16 + 1 process (now 17 + 1 after the admission of Greece) and the increasingly offensive one Chinese diplomats' tone.24 In this situation, questions about the health of the Chinese economy are also being asked with greater urgency. Have western observers indulged wishful thinking and overlooked dangers not only in the political outlook of China, but also in the assessment of its economy?

The risks in the Chinese financial sector

In the years when China was rapidly building its economy, the country's financial sector was a crucial pillar. The high savings of private individuals were used to finance investments in strategically important areas. This function of the financial sector has lost its importance with the transition from the export-oriented economy of the past to the service and consumer society. It would be all the more important that the financial sector no longer relies solely on uncontrolled credit growth, but rather takes the profitability of lending into account more than before. Apparently, many players in the Chinese financial sector fail to make this change.

Growing doubts about economic stability

Some observers, including the Bank for International Settlements (BIS) and the International Monetary Fund (IMF), are increasingly concerned about China's economic stability. The core of the problem is simple: since 2008, the country's total debt has grown faster than its economic output. This is a new development. In the 1980s, for example, it was the other way around - at that time, China reduced its debt (of the state, private companies without a financial sector, private households). Subsequently, debt and economic growth developed in parallel. But since 2008 there has been a growing gap. From 2007 to 2014, China's debt rose from 158 percent of GDP to 282 percent.25 It is the downside of economic growth. Chinese growth since the global financial crisis of 2008 is far less solidly financed than many observers suspect. Beijing will probably not be able to afford another credit-based package of measures like the one that was put together at the time.26

In this context, hardly anyone still believes the data published by the Chinese government on the country's economic growth. In 2018, for example, an inflation-adjusted rate of 6.5 percent was reportedly achieved. A report at the beginning of January 2019 caused a sensation, which put the actual growth at 1.7 percent.27 Neither the high nor the low value can be checked, but some indicators point to weak growth. In 2018, for example, sales of passenger cars in the People's Republic fell for the first time in 20 years. Sales fell by 6 percent to 22.7 million vehicles.28 The Chinese economy is unlikely to see significant growth if consumers showed such reluctance to buy.

The current trade conflict between China and the USA distracts from the causes of the Chinese economic misery. President Trump believes that his trade policy measures have contributed to the economic weakness of the People's Republic.29 For its part, the Chinese government likes to point to the US for a scapegoat for the country's plunge. Both assessments are incorrect. The trade conflict is worsening the situation, but China has been struggling with problems for several years. Evidence of this is the decreasing interest of foreign investors. At 168 billion US dollars, their inflow of funds in 2017 was lower than in the crisis year of 2008 (172 billion US dollars). The share of FDI in China's GDP has been falling for nearly three decades. In 1993 it was 6.2 percent; In 2017 it was only 1.4 percent.30 Foreign investors are therefore increasingly critical of the prospects for the Chinese economy. What is deterring, in addition to the now quite high wages in the country, is above all the threatening over-indebtedness. Added to this are problems that have been lamented for a long time, but external investors have not been hindered to the same extent in the past: the compulsion to enter into a joint venture with Chinese partners, the threat of theft of intellectual property, a forced technology transfer and the one that has grown in recent times Influence of the Communist Party in companies.

According to the IMF, there has never been a historical case in which credit growth as fast as in China has not led to a financial crisis.

Depending on the source, the information on the Chinese debt level varies. The Asian Development Bank puts it (government, private and state-owned companies excluding the financial sector, private households) at 290 percent of GDP in 2016, of which private and state-owned companies account for 166 percent of GDP.31 Including the financial sector, China's total debt was already 470 percent of GDP in 2016.32 According to calculations by the IMF, even the so far low national debt will reach 88 percent of GDP by 2021. Taking into account the risk-weighted debt of the state-owned enterprises, the Chinese national debt will rise to over 115 percent of GDP in 2021.33

In a 2018 working paper, the IMF examined whether the country's credit boom is dangerous. Are there factors to consider that make China's situation less dire? The straight answer is that there has been no case in history where credit growth as rapid as in China did not result in a financial crisis. The IMF warns against delaying the necessary adjustment further - each postponement will make it all the more serious.34

Kenneth Rogoff, Harvard economist and former IMF chief economist, described China as the epicenter of the next financial crisis in January 2019.35 The country's economic difficulties are widely underestimated. Rogoff identified the overindebtedness of the Chinese economy as the most important problem.36 Arvind Subramanian and Josh Felman argue similarly. In August 2018, they warned of a world-shaking crisis that would emanate from China. They tightened their prognosis again in February 2019 when they spoke of the impending "China Shock".37

However, it would be incorrect to expect contagion for other financial markets from a Chinese financial crisis. The country's financial system remains very little intertwined with other financial systems. Chinese investors have a strong presence abroad, but - as far as it can be said today without doubt - loans were not granted to the People's Republic on a large scale. However, there is one transmission channel that has received little attention so far: If China's central bank provides liquidity, this can lead to cash outflows despite extensive capital controls. The long investments made by Chinese investors in real estate - from Sydney to Stuttgart - are evidence of this.38

The financial sector is the Achilles' heel for China's further economic development. There is a long list of false incentives. Widespread implicit guarantees have added to today's risk and debt inflation. The most important factors behind this excessive risk appetite in the Chinese financial sector are the reluctance of banks to impose losses on retail investors, the expectation that the government will guarantee the debts of state-owned companies and local financing vehicles, and the efforts of the Chinese state to stabilize the equity and bond markets in volatile periods as well as the protection mechanisms for various financial institutions.

Chinese investors believe that most of the domestic financial system, from the debts of local authorities and state-owned companies to the investment vehicles issued by banks, is ultimately secured by the central government. Reliance on such implicit guarantees - combined with a high savings rate, dominance of small investors, restrictions on capital outflows and a small number of long-term investment products - has led to recurring volatility in the Chinese financial markets.

State and private company indebtedness

The indebtedness of Chinese companies outside the financial sector has grown dramatically over the past decade; At the end of the first quarter of 2017, it was 165 percent of GDP.39 State-owned companies have lost their overall importance for Chinese economic development compared to the 1990s. Today they are only responsible for around 15 to 20 percent of total employment and economic output. Twenty years ago these proportions were over 40 percent.40

But at 57 percent, the share of state-owned companies in corporate debt is disproportionately high. Their debt - basically public debt - was equivalent to almost three quarters of China's annual economic output in 2016.41 The credit-driven investment surge in recent years exacerbated overcapacities in industry, especially in traditional, state-owned sectors such as steel, cement and energy.42

A number of factors are responsible for this problematic development. The Beijing government emphasized the importance of high growth rates, encouraging state-owned companies to invest excessively without concern for profitability considerations. There is no tough budget constraint, similar to what the Council for Mutual Economic Aid used to do in the socialist economies. State-owned companies borrow to generate economic growth and employment. The achievement of profits and the sustainability of borrowing, on the other hand, only play a subordinate role.

Undervaluing risks leads to excessive domestic borrowing and indebtedness. A high savings rate at the same time dampens the return as well as the risk premium and increases the willingness to take risks, while the strict restrictions on capital movements prevent investments from being diversified.

In 2017, the IMF proposed developing a coordinated strategy for China's over-indebted state-owned companies. The focus should be on the write-off of loans, the reduction of implicit guarantees from the Chinese state and the liquidation of companies that have been artificially kept alive (»zombies«).43 Benno Ferrarini and Marthe Hinojales recommend the same. They do not consider the situation of the indebted companies to be insurmountable, but state that there is a need for action. In their view, the situation will only remain manageable if the lax lending policies of the past are ended.44

The IMF has indicated that dismantling implicit guarantees in China is a dangerous balancing act. A courageous, radical departure from the previous policy could therefore trigger panic in the financial markets and endanger the solvency of banks and companies.45 Such a balancing act is also so difficult because in many cases it is not about explicit promises, but about mere assumptions of the financial market participants. How is the Chinese state supposed to make it clear that private investors who trusted the state could have made a mistake without causing panic?

Reforms are therefore necessary, but the question remains whether Beijing is currently in a position to implement these recommendations. Are President Xi and his government ready to face the consequences if state-owned companies shut down and it leads to unemployment? Can the People's Republic even leave the previous path of implicit guarantees without endangering the stability of the entire system?

The Chinese state has clearly recognized the risks that the escalating debt and the thin capital base of the banks entail. The country's commercial banks had written off nearly $ 800 billion in bad loans by mid-2018 and increased their equity base by around $ 150 billion.46 The IMF, on the other hand, has described the risk as high that the perception of financial market participants will change with regard to guarantees from the Chinese state. In this case, there is a risk of a sharp rise in risk premiums, i.e. interest rates.47

In this context, it is noteworthy how the Chinese Executive Director at the IMF, Zhongxia Jin, commented on the fund's financial market analysis. He pointed out in 2017 that there was no legal basis for the Chinese government's imputed guarantees for state-owned companies. A precedent is the bankruptcy of Guangdong International Trust & Investment Corp. (GITIC) in 1999. At that time, Beijing did nothing about the company's bankruptcy; since then, foreign investors have been well aware of the risk of default.48 It is telling that the Chinese executive director trusts that a single bankruptcy case two decades ago would be enough to make investors aware of the risks involved in their activities. In addition - and this seems even more worrying - he only has the effect on foreign investors in mind, but not on the much more important domestic investors.

In April 2017, President Xi emphasized that stable financial markets (»financial security«) are an important part of national security and »the basis for stable and healthy economic development«. But he left it open how this goal should be achieved.49 The requirement to write off loans makes sense in principle, but is problematic in practice. For banks in China with weak equity it is difficult or even impossible to make massive write-downs without running into the risk of bankruptcy.

China's shadow banks

The Chinese financial system has a number of peculiarities that make it difficult to assess risk. The shadow banking system in particular helps to cover up possible dangers. A considerable proportion of the loans in China are taken out of the official bank balance sheets.The rating agency Standard & Poor’s estimated at the end of 2018 that such loans from unregulated financial intermediaries totaled around 6,000 billion US dollars, which would correspond to around half of China's annual economic output.50

In China, regulated commercial banks and shadow banks are particularly closely intertwined, as a study by the Bank for International Settlements shows.51 In this study, Torsten Ehlers, Steven Kong and Feng Zhu identify five characteristics of the Chinese shadow banks:

  • 1) The link between shadow banks and commercial banks is very close. The securitization of loans and market-based instruments for supplying shadow banks with liquidity play only a minor role here.

  • 2) Shadow banks play an important role in providing alternative investment opportunities as well as providing credit to the private sector.

  • 3) The Chinese shadow banking system is less complex than the American one. There an average of seven steps have to be taken to get a loan, while in China it is an average of one or two steps.

  • 4) Assumed and actually given state guarantees play an important role. The comprehensive guarantees for the operations of shadow banks are a specialty of China.

  • 5) The provision of loan collateral does not play a role in China, unlike in the USA.52

The International Monetary Fund also sees strong links between commercial and shadow banks in China. This poses considerable problems for banking supervisors:

"The banks continue to be at the center of this highly networked system of indirect lending, with insecure links between numerous institutions posing a challenge for banking supervision."53

But why has the shadow banking system grown so much in the first place? A turning point was the financial crisis of 2008. The Chinese government responded with a package of measures designed to stimulate the economy. Small and medium-sized banks were encouraged to become active in the shadow business and to offer new wealth management products (WMP) there.54 The promised returns attracted many investors to this segment. Until October 2015, the banking supervisory authorities imposed restrictions on deposit rates, which was what created the business model for the shadow banks in the first place. The latter consists, among other things, in the fact that banks and shadow banks package loans to companies with poor credit ratings into complex financial products. These products, in turn, are often sold to investors looking to generate returns above bank deposit rates.

WMPs issued by banks are considered safe by investors, but in most cases there is no explicit guarantee for the deposits. The reason for this is simple: only by foregoing guarantees can commercial banks refrain from including the deposits on their balance sheets. The bottom line is that the banks act as asset managers and charge investors with fees without being subject to regulatory restrictions. By the end of 2016, the share of non-guaranteed WMPs in the total outstanding WMPs in China had reached almost 80 percent.55

Most WMPs are closed, which means they have a set life cycle and investors must subscribe during certain time periods. Such closed funds accounted for around 57 percent of the outstanding portfolio in mid-2016. Banks listed on the stock exchange had issued over 42 percent of the outstanding WMPs at the end of 2016. Another 32 percent came from large state banks.56

For many borrowers, the shadow banks offer a way of even gaining access to the credit market. China's still state-centered financial system favors state, not private, borrowers. Small businesses and private households are inadequately supplied with money by the classic banking system. This created scope for new, insufficiently supervised financial intermediaries. The granting of loans with a high probability of default shifted from commercial banks to the less strictly supervised segments of the financial system.57

In China, the risks of the shadow banking system have a direct impact on commercial banks.

The shadow loan brokerage in China hardly includes the securitization of claims or financing by large investors, both important sources and drivers of the US shadow banking business. In fact, the shadow banking system in China is much more similar to traditional banking. It collects "deposits" or cash from private and corporate investors and then turns their savings into loans of various forms to fund businesses. The shadow banking business in China is also a purely national matter; it is operated by local financial institutions, investors and investors.58 There is no strict separation between the regulated banking system and the shadow banks. In other words: the risks of the shadow banking system have a direct impact on the commercial banks.59

Shadow loans to private companies flow mainly in the form of loans from trust companies (trust loans) and in the form of direct bank-brokered company-to-company loans ("entrusted loans"). Lending to firms that are considered trustworthy is favored by the fact that many firms have untapped capital. Large state-owned companies are also making use of easier access to bank credit and better credit terms to extend credit to their subsidiaries and affiliates.60

The shadow banking business has also developed so rapidly because Chinese investors are confronted with multiple investment crises. Equities, like real estate, are considered overvalued, and the Chinese government made investments abroad much more difficult in 2015. In this environment, so-called peer-to-peer loans (P2P) flourished. Private savers lent money to private borrowers using one of the approximately 2,200 relevant Internet platforms. Supposedly high returns attracted around 50 million people into such businesses. As is so often the case in financial market history, lenders ignored the fact that high returns come with high risk. The Chinese authorities allowed the loan brokerage portals to work for a long time, although the seriousness of many providers has been doubted for some time. When the controls were tightened in the summer of 2018, more than a quarter of the P2P platforms collapsed.61

Close and growing interdependencies in the financial sector mean that the potential for the spread of financial shocks among savers, banks and the bond market continues to increase. In addition, new forms of internet-based loan brokerage such as P2P have developed at an extraordinary pace. Chinese policymakers face a dilemma with shadow banks and P2P platforms, which are part of the irregular system. With regulators tightening the reins and making the exaggerations go away, there is a risk of self-reinforcing, panic-fringed downward spirals.

In 2019, in view of the dangers of a credit crunch, the Chinese government will be discussing abandoning the tighter control of the shadow banks. The financial supervisory authority is aware that it would basically make sense to supervise the opaque shadow banks more strictly. But such a policy would mean that the drivers of economic growth were not getting sufficient new credit. The commercial banks cannot step in here - on the one hand they are undercapitalized, on the other hand they are under pressure from financial regulators to reduce risks instead of increasing them.62

The IMF has made it clear what the consequences of reducing the uncertainties in the Chinese financial sector would be. It would mean accepting significantly lower economic growth in the country. The prerequisite for this would be that Beijing set less ambitious growth targets for the local authorities. According to the IMF, China's banking supervision and regulation are overwhelmed if they are to cope with the stabilization task on their own. If there is a lack of support from macroeconomic measures, particularly monetary and fiscal policy, the mountain of debt (“credit overhang”) cannot be eliminated.63

A shortage of credit could, for example, cause real estate prices to collapse and thus become dangerous for the Communist Party. That is why it can be observed again and again that Beijing adjustments that are actually overdue are being postponed. In August 2018, the Financial Times reported that China had interrupted the fight against over-indebtedness in order to achieve short-term economic growth.64 The tendency to postpone corrections is clearly not unique to China, but the sheer magnitude of the exaggerations is unique in the case of the People's Republic.

Local government debts

It is the local authorities that implement the requirements of the Chinese central government. A conflict of objectives has developed in the process. The obvious main objectives, namely to prevent severe job losses and to achieve certain regional growth rates, contradict other economic policy objectives, in particular financial market stability.

The contradictions of Chinese economic policy can be seen in another national peculiarity: the financing structures at the local level. The local authorities are prohibited by law from entering into debt. With the approval of the central government, they have been circumventing this ban since 2008 with so-called "local government financing vehicles" (LGFV). These are companies owned by the local authorities that offer land use rights as collateral for granting loans. Basically, it is about disguising prohibited borrowing. However, the municipalities are dependent on this route to finance ambitious urban infrastructure measures.65 This approach is also known as “fiscal income from land”. But are these sums relevant at all?

By the end of 2016, the LGFV had issued bonds worth 18,500 billion yuan, about 2,300 billion euros. This level of debt, which roughly corresponds to the total Italian national debt, is remarkable. Even more worrying, however, is the rapid increase in the corresponding value, which in 2013 was 577 billion euros.66 The IMF puts the annual loan growth of the local authorities at 25 percent since 2007 - two and a half times as high as the central government debt.67

The inconsistency of Chinese financial policy is particularly evident in the LGFV. As mentioned, local authorities are legally prohibited from entering into debt, but the central government has asked them to circumvent the 2008 requirements. In order for the growth targets to be achieved, the loan volumes must be expanded; but this endangers the goal of financial market stability.

But how are the LGFV's liabilities to be assessed? Are these loans within the financial sector and thus financial market risks? Or would it not be appropriate - because government agencies are ultimately behind the LGFV - to book the loans as risks for the Chinese state? The IMF tends towards the latter assessment.68 The rating agency Standard & Poor’s warned in October 2018 that the LGFV had piled up "a debt iceberg with titanic credit risks" in China. The total of LGFV loans exceeded 60 percent of China's GDP at the end of 2017. Standard & Poor’s expects increasing loan defaults from companies associated with local authorities.69

The exaggerations in China's real estate market

Real estate is the main engine of the Chinese economy. According to some estimates, it accounts for - directly and indirectly - up to 30 percent of the gross domestic product.70 The country's housing market is characterized by exaggerations for which there are hardly any role models. Apartments with the simplest equipment, which are hardly to be found in Germany even in socially deprived areas, are traded for seven-digit US dollars in China. In other words, the Chinese pay prices like those in Paris or Zurich and get accommodation that is comparable in terms of construction quality to apartments in Novosibirsk in the 1980s.

Within the third ring in Beijing, a fairly central location, citizens have to spend 44 times the average annual salary for an ordinary condominium. Even Munich appears to be inexpensive in comparison - people there pay 13 times as much.71 In 2018, China's top hundred cities were priced at $ 202 per square foot and $ 2,173 per square meter, respectively. That is 38 percent more than the median price in the USA, where the per capita income is, however, more than seven times as high as in China.72 For many Chinese, it is not possible to buy an apartment and pay it off within a working life.

A closer look at the prices of Chinese real estate illustrates the explosive development. As a Chinese real estate association has calculated, apartments, which were still trading for US $ 580 per square meter in 2003, cost no less than US $ 8,600 per square meter in 2018.73 In just 15 years, prices rose 15 times. It is important to remember that real estate represents 70 to 80 percent of the wealth owned by families living in cities. So it would not only jeopardize the economic but also the political stability of China if real estate prices collapse.74

The current value of all real estate in China is estimated at 65,000 billion US dollars, which is twice the annual economic output of the G7 countries.75 An economist who teaches at Renmin University in Beijing, Xiang Songzuo, warned in January 2019 that the real estate bubble would burst in harsh words:

"The Chinese people have played around with leverage, debt and financial dealings and finally created a mirage in the desert that will soon disappear completely."76

The first signs of growing unrest among the Chinese population were observed in 2018. In October, home buyers demonstrated in Shanghai and other cities after property developers cut prices. A request was made to reimburse the difference between the previous and current values.77

The market for rental apartments hardly provides relief for Chinese citizens, and neither does it for project developers. It is customary in the country to prepay rent for five years or more, for which people go into debt at banks. The tenant is therefore tied to the apartment and has to make high loan payments. Project developers, in turn, often pay bond interest of 7 to 8 percent, and their debt to equity ratio averages 380 percent. You are also not relieved by renting apartments that are not for sale because the rents hardly cover the capital costs.78 This unusual business practice is supported by the hope that the demand for real estate could one day increase significantly.

Real estate construction in China far exceeded demand - today one in five apartments is empty.

Local governments control the provision of land on which residential property is developed and depend largely on the income from these businesses. Local authorities therefore limit the supply of newly developed land in order to generate consistently high income. For this reason, property owners do not expect any significant price drops. Why should the municipalities jeopardize their future income by allocating too large amounts of building land?

It is above all China's tumbledown housing market that is fueling concerns about how solid the country's financial system is. The rating agency Moody’s, for example, examined 61 real estate developers in China and gave their bonds junk status in 51 cases. With over 80 percent of developers, the agency expects a high probability that payment defaults will occur.79 This is dangerous for the financial system because real estate - commercial as well as residential - is the most common form of loan collateral in China. Two-thirds of the total collateral in banks' loan books is real estate. A collapse in real estate prices, even a 30 or 40 percent drop in the price level, would bring the financial system to the brink of collapse.

It is also worrying that in the past decade construction was carried out on a scale that far exceeded demand. The result is a vacancy rate of around 65 million apartments.This value corresponds to 21.4 percent of the Chinese real estate portfolio.80 In other words: every fifth apartment in China is empty. The government is making things worse by encouraging banks and developers to rent out properties that are not for sale on the housing market. In connection with the sustained high level of lending to real estate companies, a correction in real estate prices will be postponed until Saint Never's Day.

The growing importance of mortgage financing increases the risk of major bank failures should house prices fall. Although the banks have only financed a comparatively small part of the purchase price of real estate, a sharp drop in real estate prices could lead to losses. It would also reduce the value of the land that underlies many corporate loans and dampen real estate investment. In earlier phases of instability in the housing market, mutual funds have switched to other forms of investment. However, since these are also viewed as overvalued, the only valve that remains is the outflow of capital abroad.81

China's turning point in foreign trade policy in 2015

There was a remarkable turnaround in 2015: since then, China has exported more capital than it imports. The gigantic currency reserves of around 4,000 billion US dollars, which had grown by then, melted by a fifth within a year. This development is due, among other things, to the drastic wage increases in the country. From 2005 to 2015, wages grew by an average of 14.6 percent per year. Together with the slight appreciation of the yuan against the US dollar, Chinese wages in US dollars have quadrupled.82 This resulted in considerable prosperity for workers, but also in a decreasing competitiveness of Chinese companies.

Restriction on the export of capital

For many years, capital flight has not been a problem for the Chinese government. From 1994 to 2014, the People's Republic had current account surpluses and private foreign capital flowed into the country. The central bank bought foreign currencies for yuan and built up foreign currency reserves. The inventories grew steadily and reached an all-time high in 2014 with the aforementioned 4,000 billion US dollars.

These developments supported the efforts of the Chinese government to strengthen the role of its own national currency in the international financial markets. A world power China, so the main idea, needs a currency that can stand up to the dollar in the medium term. At the same time, the Chinese government has no interest in strongly fluctuating exchange rates. Should the yuan fall, it could be seen as a sign of economic instability and weakness in China, and this could undermine the credibility of President Xi's economic policy.

It is striking how much the Chinese current account surpluses have declined. In 2015, the plus was 304 billion US dollars, which corresponds to 2.8 percent of economic output. This is well below the record highs seen in 2007 and 2008, when China's current account surplus was $ 353 billion and $ 420 billion, respectively. Because of the significantly lower GDP at the time, the surpluses accounted for 9.9 percent (2007) and 9.1 percent (2008) of the national product. In 2018, according to preliminary figures, the surplus was 0.3 percent of GDP.83 In contrast to Germany, the Chinese economy is now only achieving a very moderate increase in trade in goods and services. On the one hand, this reduces criticism of China's surpluses, but on the other hand it makes it clear that large capital exports would only be possible at the expense of their own currency reserves. Private or even state capital exports on a considerable scale would lead to current account deficits. The Chinese government can therefore only finance the Belt and Road Initiative if it only allows private capital exports to a very limited extent.

For a surprisingly long time, Beijing managed to keep the exchange rate stable and to gradually liberalize the country's capital movements. But the Communist Party's own citizens have been thwarting the Communist Party's plans for some time. You don't want to buy another apartment in China, but invest worldwide. Profitable investment opportunities in the country itself are in short supply. Real estate is overpriced and the stock markets overvalued. The only thing left for the owners of capital is the illegal export of capital. As early as 2015 it was noticed that there was a gap of around 500 billion dollars between the transfers made by Chinese banks for imports and the import statistics of Chinese customs. $ 2,200 billion flowed abroad, while customs only registered imports valued at 1,700 billion dollars.84

In 2015 there was a radical change of course. Since then, the Chinese government has viewed private capital exports as a danger. Within twenty months - from June 2014 to February 2016 - the currency reserves sank dramatically, from 4,000 billion to 3,200 billion dollars. Capital exports have been limited to $ 50,000 per person per year since 2015.85 The central bank has since tightened capital restrictions and stabilized the situation. However, the challenges facing the bank have changed dramatically; it is very different today than it was in the previous two decades. China's central bank must ensure that the domestic money supply grows appropriately despite capital outflows and falling current account surpluses.

The signal from 2015 is clear: Both Chinese and foreign investors are reducing their investments in China in favor of investments abroad.86 This turnaround can be the harbinger of a financial crisis. If residents want to keep their capital safe abroad, it can be assumed that they no longer have much confidence in their own national economy. The potential instability of the Chinese financial system is of course not just a concern for investors and financial scientists. A crisis in China could also have security implications.

The Belt and Road Initiative

China does not want to stop the export of capital entirely. Rather, private actors should be replaced by the state. The Belt and Road Initiative (BRI) presented by Xi Jinping in 2013 means nothing other than the export of capital to the recipient countries concerned. And should the BRI - the "New Silk Road" - be successful, the Chinese state would benefit in the long term from the interest and principal payments made by the borrowers. The initiative envisages Chinese investments totaling US $ 1,000 billion in 68 countries.87 The fact that the project initially received widespread approval was due not least to the unwillingness of other powerful investors - including the EU - to finance infrastructure projects in Asia.88

However, critical voices about the BRI have been increasing since mid-2017. It is more and more often characterized as an imperial project.89 Malaysia's Prime Minister, the now 94-year-old Mahathir Mohamad, did not shy away from branding the infrastructure projects financed by China as a "new version of colonialism" during a state visit to Beijing in August 2018.90 He initially canceled several projects planned by China in his country, including a high-speed rail link (East Coast Rail Link) for $ 23 billion.91

Just as remarkable was Mahathir's announcement that Chinese property buyers would no longer be granted residence visas in the future. In doing so, he withdrew its customers from the "Forest City" project, a new housing estate designed for 700,000 residents on the Malaysian west coast. Malaysia's citizens can usually not afford such apartments.92 The project was conceived by "Country Garden", one of the largest Chinese real estate developers. According to Mahathir, it is a settlement project, not an investment.93 Such an undertaking seems presumptuous, especially in Malaysia, where the relationship between the Malays and the Chinese minority is complex.