Arthur Kroeber: prediction

Transcript context

…It's a good question. I would start by emphasizing the ways in which China is very, very different from Japan. The central thing that is really different and lies at the root of a lot of this, is that China is an independent geopolitical actor. Japan was not. Japan, at the end of the day, could rely on the US for security. They were demilitarized. China basically is on its own. They're in a very dangerous neighborhood. They have 14 land neighbors they share borders with. They have names like North Korea, Russia, Pakistan, Afghanistan, a lot of dangerous actors. Several of them have nuclear weapons: North Korea, Russia, Pakistan, and India. So China, just in a very narrow sense, lives in a very dangerous neighborhood. They quite legitimately have some pretty significant national security needs. They also have aspirations to be a great power, and they want to do it on their own. The incentive to get things right is much more existential in China than it was in Japan. Japan essentially could take the choice to sort of say, “Oh, we're going to have a stagnant economy and that's bad and whatever, but actually we'll be fine.” For China, it's not fine. So underlying it, there's a spur that increases the chances that the Chinese leaders will do the things that they need to do to keep the system more dynamic. It's not a guarantee, but it's a pretty strong incentive. Then, if you look at some of the specifics, the big difference between the way that China and Japan are economically organized is essentially the relationship between the financial and the corporate sector. Japan had a system where banks owned equity in these giant industrial companies and trading companies, and vice versa. There were these cross shareholdings, which meant that essentially the entire economy of Japan, the entire corporate and financial sector, had one big balance sheet. All of that balance sheet rested, by the late 1980s, on land values that had just gotten completely detached from any form of reality. There was an investment thesis among investors who were playing the Japanese stock market in the late 80s, that you did not look at the earnings of Japanese companies. Those were irrelevant. What you looked at was the value of the land they controlled. You looked at essentially a capital ratio where you assumed that the value of their underlying land capital was a permanent contribution to their wealth and prosperity. The valuations of these stocks, which again got crazy, you couldn't justify them by earnings. They said, it doesn't matter because the land they're sitting on is so valuable. Then the land values collapsed by 80%. The stock values had to collapse by a similar amount, 80%. Everyone was holding shares of one another. So the banks’ capital got eroded because a lot of their capital was tied up in the land and in the stocks which were collateralized by land. So they were unable to lend. They just had to deleverage as fast as possible. tal got eroded because a lot of their capital was tied up in the land and in the stocks which were collateralized by land. So they were unable to lend. They just had to deleverage as fast as possible. The companies had to deleverage as fast as possible. The entire economy got engulfed by this phenomenon of debt deflation, which basically means in the act of paying down the debt—because you're doing fire sales of assets—you're reducing the prices of those assets and introducing deflation. So the real value of your debt continues to grow even as you are supposedly reducing it, because of the deflationary effect. It's very, very difficult to get out. China does not have this problem at all. They looked at the problems that Japan got into, they looked at similar problems that Korea had in the late 1990s, and they said, “We will never allow this kind of cross shareholding between financial companies and corporations. This is way too dangerous.” They have kept the two quarantined. It is illegal for industrial companies to own a bank. The bigger ones are allowed to have internal financing subsidiaries, but they can only sort of manage finance inflows within the group. It is also illegal for banks to load up on shares of industrial companies. So you have a distinct financial system and industrial system. That means that the particular type of macro problem that Japan got into is very, very unlikely to occur in China. You do have huge debt problems. The property developers are very over leveraged, it’s a huge problem. We've had a massive property crash in China over the last five years. That is a big, big problem. You have local governments that borrowed a lot of money, invested in infrastructure which is now delivering very little returns. They have a big debt problem. You have very substantial debt problems in China that have significant negative macro consequences. But they're all isolated and they can be dealt with sort of one by one. If you look at the industrial sector, it's not very highly leveraged. Debt levels in fact are not high. Most private companies in China have learned for many years that they couldn't get access to bank credit. The banks only wanted to lend to state-owned enterprises which were secure, had physical collateral, and had a state guarantee. Private companies for years have learned to make do by basically financing their investment out of retained earnings. Their leverage ratios are not that high. They're creeping up now over the last few years because of the big industrial policy push. But fundamentally they're in a very different position from the Japanese companies. Interesting. This is just stuff from your book that I'm citing back to you. You talk about these local government financing vehicles which are backed. The local government takes out a lot of loans in order to build this infrastructure. That is backed by the presumed appreciation of the land, which should go up as this infrastructure goes up. That sounds actually very similar to the problem you were describing with Japan. You say, “Look, this is debt that's on the local government's balance sheets. But fundamentally it's like one country.” You have this system where the government can just hand the debt to somebody. So how immune is the private economy really? Will it just take down the local government and then nobody will make a fuss? These other companies will just never have to hear about it again?…

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