Ep. 9: China: Shadows and Ghosts

 Jim Grenn: Envision New York City.  Now double it.  You’re starting to get a picture of China’s richest city.    Shenzhen boasts more millionaires per capita than any other city in China and the city has something of an obsession with skyscrapers.  More skyscrapers were built in the city of Shenzhen alone than in the entire United States in 2016.

Nestled among the skyscrapers is a large city park called Litchi Park.  It’s comparable to Central Park in New York.

At the southern end of the park is a large billboard about the size of a video scoreboard at a professional sporting event. People visit the billboard to snap selfies and bring flowers.  The billboard features an image of an older Chinese man with grey hair and a half-smile named Deng Xiaoping.  He is celebrated for creating the parabolic economic growth China has enjoyed for the last three decades.

But it’s not so simple.  To understand the legacy of Deng Xiaoping is to understand the paradox that is China. 

This is Domino.  A podcast that explores an historical event that had a ripple effect on the global economy.  I’m Jim Grenn, the host of Domino.

Kent Oliver: For centuries, China had a closed economy, rarely engaging in global trade or opening its borders to the outside world. That all changed in the late 1970s with a small change in Chinese government policy.

Jim Grenn: That’s Kent Oliver – our big picture guy.

Kent Oliver: Deng Xiaoping is credited with the policy change that opened their borders.  But as you mentioned, that isn’t the whole story.  Deng is also responsible for the misery and death of millions.

Brady Raanes: A quick backstory on Deng’s life: Deng comes on the scene politically in 1949 when he was tasked with confiscating land from peasants for the Chinese government to redistribute at its discretion.

Jim Grenn: That’s Brady Raanes.  He is our detail guy.

Brady Raanes: Remember, China is a communist country, and they do this kind of thing pretty consistently throughout history.  They confiscate land, force peasants to move and use the land for some other purpose.  In this instance, Deng was tasked with overseeing the confiscation of a whole lot of land… and an estimated two to three million Chinese died who were killed resisting the land confiscation.

Jim Grenn:  Two to three million people.  Wow!

Kent Oliver: That’s not even the really shocking part.

Jim Grenn: Oh?

Brady Raanes: Yeah, in the 1950s Chinese leaders had a vision to remake their economy. They called it the “Great Leap Forward.”  The plan was to confiscate land and force people into different groups with assigned tasks for a specific economic purpose.  And everyone was assured that the government would provide food, clothing, entertainment, and the like.

Kent Oliver: The government even took away the elderly people to avoid distraction, so the groups could focus solely on increasing economic production.

Brady Raanes: So, the government confiscates the land and personal property of an estimated seven hundred million people for government use.

Jim Grenn:  700 million people… that’s more than double the present-day population of the United States!  That’s wild. This sounds like something out of a dystopian fiction book.      

Kent Oliver:  Within a year, food production was inadequate.  The government couldn’t provide what they promised… the number of those that starved to death are staggering

Jim Grenn:  That’s unreal. More people potentially died from the famine during the Great Leap Forward than in all of World War 2?!  That’s unreal.  Why have I never heard of this?

Kent Oliver: I guess because Chinese history isn’t a big part of the American education curriculum.

Jim Grenn: Yeah, but that’s staggering.

Brady Raanes: So, one of the officials tasked with carrying out the plan for this failed social experiment was Deng Xiaoping.  There is a book called Mao’s Great Famine, that blames Deng specifically for ordering the extraction of grain from starving peasants to be exported abroad for the sake of the economy.

Jim Grenn:  Wow, this is the guy they celebrate on the billboard.

Kent Oliver:  Deng rose and fell in political power numerous times over the next fifteen years until 1976, at which time Deng moved into the spotlight as one of the top Chinese officials. At the time, economic growth in China had been stagnant for years.

Jim Grenn: This was just about the same time as things were really taking off for their neighbors in Japan, right?

Kent Oliver: Yes, South Korea, Taiwan, Hong Kong, Singapore, and of course Japan were becoming engines of economic growth in Asia. Deng had come to the startling and controversial realization that China’s international isolation was stunting the country’s development - the regulations and restrictions put in place to protect the country might be the main force limiting growth.

Brady Raanes: As a side, another large factor limiting growth was China’s strange view on education. For years, Chinese officials held to the belief that intellectuals were dangerous. Education and intellect, they believed, could sow the seeds of an uprising and disrupt the Chinese order. At one point, Deng Xiaoping had even been tasked with leading an attack on Chinese intellectuals, which led to half a million citizens being sent to labor camps.

Jim Grenn: My goodness…

Brady Raanes: Right, but Deng’s views were beginning to change.

Kent Oliver: By loosening the reins he hoped he could stimulate economic development. Deng sent Chinese delegates to begin to study other economies. From January to November 1978, the government sent more than five hundred different groups of people overseas to study the economies of other countries. In total, more than three thousand Chinese officials traveled abroad in search of ideas.

Jim Grenn:  Interesting.

Kent Oliver:  The trips revealed some interesting findings.  They were amazed at the level of automation and the use of computers in Europe. The gap in technology compared to China was enormous, as was the overall level of economic development.  European countries also seemed willing to supply credit, export technology, and invest directly in China.

Brady Raanes:  Closer to home, Taiwan had embraced global trade more than a decade earlier, in 1966, and it had done wonders for their economy.

Jim Grenn:  When you say “embraced global trade” I assume you mean that they chose to begin focusing on exporting things.

Brady Raanes:  Yes, thanks for clarifying.  The decision to become an export driven economy had become a major success. South Korea had done the same and the decision had ripple effects on South Korea’s employment, service industry, and economic development.

Kent Oliver: Singapore, though, more than any other country, offered concrete proof of the potential success an export-driven economy could bring. The Singapore model allowed for a semi-capitalist system to exist alongside an authoritative regime. Singapore experimented with something called “special economic zones”.   

Jim Grenn:  Ok, and how did that work?

Kent Oliver: Essentially, they re-wrote capitalist laws that only applied to a certain city and allowed that one city to become an export hub.

Jim Grenn:  Gotcha.  So, China sees this success, and figures they can try the same thing.  But China had never allowed this kind of thing in the past and I assume this was a massive mind set shift. 

Kent Oliver: Yeah, many Chinese officials struggled with the idea. Some feared that these zones may just be another form of concession to the Western world. Opening up, they feared, would compromise their principles.

Brady Raanes: Eventually, Chinese officials made the commitment to test the idea by opening four areas that would be referred to as special economic zones. But rather than use established cities, China strategically selected four peripheral locations for its experiment that could easily be forgotten if the experiment failed.

Jim Grenn: That seems smart…

Brady Raanes: Yeah, and each zone was strategically located relatively close to a larger city like Hong Kong or Macau in an effort to attract migrant workers to the new cities.

Jim Grenn: Ok

Kent Oliver: Again, Deng Xiaoping was at the heart of the decision.  He realized that to fulfill their full potential, these economic zones would need to become model cities, complete with diversified industries such as shopping and real estate development, and the zones would be given different laws than the rest of the country, including pro-business rules and preferential tax treatment to attract foreign investment.

Brady Raanes: The first zone in Deng’s experiment would be a small fishing village near Hong Kong known as Shenzhen, home to just thirty thousand inhabitants. At the time, the village’s notable industries included primarily rice paddies and duck farms.

Jim Grenn:  So, what were these special economic zones like?

Kent Oliver:  So, for starters, these zones were like entering a new country.  In the case of Shenzhen, A sixty-seven-mile-long barbed-wire fence was constructed around the city and Chinese citizens wishing to work would pass through something resembling customs.

Brady Raanes: Businesses got more favorable tax rates but workers were hit with an additional 30 percent tax on all wages.

Jim Grenn: Ok, and obviously, this worked or we wouldn’t be talking about it – how quickly did everyone embrace the change?

Kent Oliver: Eh.  The idea was that Western business would begin building plants and factories in the new export zones.  Initially, though, the most notable Western investments in the early years came as a $5.5 million Pepsi [HD1] bottling plant.

Despite making headlines with the move, the Pepsi plant only provided employment to thirty-five people. Wages at the plant began at roughly $100 per month—low by US standards, but nearly triple the monthly wage earned by the average Chinese industrial worker.

Brady Raanes:  Roughly 70 percent of the investment flowing into Shenzhen came in the form of assembly line operations. You see, China was at the opposite end of the innovation spectrum from Japan. The country’s exports were initially low-tech goods requiring minimal education and training.

Kent Oliver:  Workers flocked to Shenzhen. The population tripled in the first four years to ninety thousand. Within a few years, however the Western world began embracing China.  DuPont, Pepsi, IBM, and Compaq each opened factories. KFC and Pizza Hut entered Shenzhen as well. Chinese officials even chose Shenzhen as one of four locations for the country’s major stock exchanges. Early estimates by city officials calculated expected population growth to hit four hundred thousand by 1990.

Jim Grenn:  More than a 10-fold increase in a decade.

Brady Raanes: McDonald’s entered China in 1990 and chose Shenzhen for it’s first location. The meals cost a small fortune relative to the income of the average worker in China. Still, for many, the experience was worth the price. Locals flocked to get a taste of America.

Jim Grenn:  Ok, so with a solid understanding of the backstory behind the making China’s economic engine, let’s shift gears for moment and modern-day China.

Brady Raanes: To understand modern day China, we have to do so in light of the great recession of 2008 / 2009.

Jim Grenn: Of course.  Let’s take a quick break. Domino will be right back.

Kent Oliver: The mortgage crisis in the United States sent shockwaves of a different kind through the Chinese economy. China was one of the few economies in the world that continued to post strong economic numbers.

Brady Raanes: The banking system in China was one of the few to largely avoid the toxic-loan game. As government-owned enterprises, Chinese banks focused primarily on domestic financing and rarely ventured into holdings outside of the country.

Kent Oliver: However, the global recession caused consumers around the world to buy less ‘stuff’, which began to hurt China as the world’s leading exporter of ‘stuff’. China faced an employment crisis as exports slowed and companies laid off workers. To avoid a spike in unemployment, China would need to replace the jobs lost from the decline in global demand with jobs in another industry.

Brady Raanes: And unlike democratic countries, China had a unique advantage in dealing with the crisis. Government officials could stimulate the economy without manipulating interest rates or incentivizing the private sector to spend.

Jim Grenn:  That’s an interesting point- because China is communist, they don’t need to incentivize borrowing and spending by fiddling with interest rates, they can just decree it and it will happen.

Brady Raanes: That’s right. The powers that be in China [HD2] can simply give an order for a bank to begin making more loans and it happens.

Jim Grenn: Because banks in China are under government control.   

Brady Raanes: Right.  So, Chinese officials determined that the best course of action to offset the drop in exports is to increase investment in construction and real estate development.

Kent Oliver: To carry out the plan, city governments were instructed to confiscate land and auction it off so that development could begin.

Jim Grenn:  Interesting, so how does land get confiscated logistically?

Kent Oliver:  In many cases, the government would simply announce that they were taking over an older neighborhood and relocating their inhabitants to other areas involuntarily. After they confiscated the land and moved the peasants to some other slum the government auctions off the land to developers. 

Jim Grenn: So, they can build apartments or malls or whatever.

Kent Oliver: Yes, and it began a pretty big business. Land auctions soon became a primary source of revenue for local governments throughout China, generating more than $230 billion in 2009.

Brady Raanes: Right, so.  Let me clarify one thing.  There are two things at play here.  The Central Government of China and the Local Government.  The Central Government sets the rules and decrees that certain things happen, and it’s up the local government to carry out the details. 

Jim Grenn: Ok gotcha.  Kind of like our Federal Government and State government.

Brady Raanes:  Yes, so in most cases, the local government would confiscate the land sell it off to the highest bidder.  But… keep in mind.  China is communist, so virtually everything is government-owned.  So… the local government would sell the property to a government owned business… who usually paid a premium price.

Jim Grenn: Ok?

Brady Raanes: Then…Government-owned banks would loan money to government owned developers to develop the land. 

Jim Grenn: Wow.  

Brady Raanes: in 2009, government owned banks loaned $1.4 trillion toward land purchases, double the previous year. Land prices soared as the strategy played out. Individual Chinese investors who had money followed suit and scooped up investment properties. Home prices in Shanghai, Beijing, and Shenzhen increased more than 50 percent in 2009…

Jim Grenn: Which as a reminder, was the same year that real estate prices around the world were falling off a cliff.

Kent Oliver: Right.  And get this…in 2010, more than eight hundred million square feet of real estate were bought and sold in China, more than in every other country in the world… combined. In Shanghai, home prices exceeded $200,000 despite average income throughout the city of only about $4,000 a year.

Jim Grenn:  Hang on.  The average income was that low and home prices were 40 or 50 times higher.  How could anyone afford it?

Brady Raanes:  They couldn’t, but it didn’t really matter.  The Chinese were creating jobs and economic growth with all their investment.  Basically, China purposefully created its own real estate bubble as a strategy to avoid the pullback in the global economy.

Kent Oliver:  Mania grew as companies with no connection to real estate development began expanding their corporate footprints to cash in on the surging values. The China Railway Group announced plans to develop residential apartments in Beijing. As the name implies, the China Railway Group engineered railroads, not residential construction. Shipbuilders, salt miners and tons of other companies bought land to develop residential property and build luxury high-rise condominiums and office buildings. 

Jim Grenn: Surely this couldn’t have been the intent with Chinese officials?

Brady Raanes: I don’t know.  Initially it may have been.  But it was quickly getting out of hand, so Chinese officials decided to clamp down by placing restrictions on bank lending to real estate developers, and on mortgages to individuals buying a third home in Beijing, Shanghai, or Shenzhen.

Jim Grenn: Wow, a third home. 

Kent Oliver:  Yes, it sounds silly, but Chinese investors had come to view real estate as a can’t-lose investment and happily bought as many properties as they could. 

Brady Raanes: The restrictions were put in place to slow the insanity.  And you’d think it would work.  I mean, Government-owned banks had to follow government demands and comply. However, local government officials were still under great pressure to create growth at any cost. If they were unable to show economic growth, then Chinese officials in the national government would replace the local government officials with people who could. Here is where things get weird—real weird.

Jim Grenn:  Uh oh.

Brady Raanes: Now stay with me.  Once the borrowing from government-owned banks was limited, a new subsector of lenders began to emerge known as “shadow banks.”

Jim Grenn:  That’s a cool name

Brady Raanes: These “shadow banks” were outside of the usual framework of government-owned banks. They weren’t even really structured as banks; they generally didn’t take deposits or offer banking services. In most cases they merely served as pass-through entities. They would borrow money from government-owned banks and immediately extend the same loan to the real estate developers at a slightly higher interest rate.

Jim Grenn: Ok – break that down a little more.  Why would they do this?

Brady Raanes: In simple terms, let’s assume company you own a company that can’t get a loan, but your buddy owns a company in a different industry who can freely borrow money from a bank. You could simply ask your buddy to take out a loan, then ask him to loan you the money and pay him a higher interest rate.

Jim Grenn: So, in that instance, my company still borrows money.  But it really only shows up that my buddy’s company has the loan not mine.

Brady Raanes:  Right, your buddy’s company acted as a “shadow bank.” The difference in China was that certain companies popped up with the sole purpose of borrowing money from a bank to lend to another company at a higher rate.

Jim Grenn: Fascinating. But what real purpose did this serve?

Brady Raanes: These new black-market loans allowed borrowers to circumvent the restrictions placed on government-owned banks. Which meant the real estate bubble could continue despite government restrictions.  The trick was to make sure the new loans were made by unregulated financial institutions outside of state control.

Kent Oliver: Yeah, these Shadow banks operated side-by-side with the large banks, which they had no intention of competing with. In fact, they were embraced by the traditional banks to fill the lending void caused by the banking restrictions. You see, government-controlled banks were also still under pressure to show profits, and in many cases still wished to make the restricted loans.

Brady Raanes:  And get this… remember in our episode a couple weeks ago when we discussed Lehman Brothers packaging and selling the subprime mortgages to investors? Well, the same thing began happening with these weird “shadow-bank” loans.  The “shadow banks” packaged the loans the same way Lehman had and sold them off… and just like in the US, the main end buyers were mostly retail investors.

Jim Grenn:  This sounds just like the mortgage mess in the US.

Brady Raanes:  The New York Times profiled one such investment as an example: Golden Elephant No. 38 It offeried investors a 7.2 percent return.  Which was more than double the comparable return on a savings account in China. But …the New York Times described the collateral backing Golden Elephant No. 38 as “a near-empty housing project in a rural town at the end of a dirt path amid rice fields in one of the poorest provinces in China.”

Kent Oliver: By 2013, the Chinese real estate sector made up 10 percent of the entire Chinese economy, nearly double the portion just five years earlier. Land prices in China had risen 500 percent from 2000 to 2013, and shadow banking accounted for half of all borrowing in China.

Jim Grenn: oh wow

Brady Raanes:  By 2014, developers were building complete towns without actual occupants. Stories of these ghost towns began making headlines in Western news outlets.

Kent Oliver:  In time it even went so far that they began to re-create famous cities. It’s not that these ghost cities are designed to stay empty for long. The Chinese government has a plan to relocate 250 million people into cities over the coming fifteen to twenty years. This relocation is intended to develop a more skilled working class and centralized, consumption-based economy.

Jim Grenn:  Still this is just nuts.

Kent Oliver:  It is.  The central government wasn’t blind to the craziness.  They tried to slow things a bit – or at least give the appearance that things were slowing with more restrictions. Rather than cracking down on bank lending, the central government decided to limit local governments’ ability to borrow from any source.

Jim Grenn: Local governments?

Brady Raanes: So, keep in mind, the local government largely controlled the land confiscation and development of the land.  If, in theory, the main government restricted borrowing by the local government they could slow the development.

Jim Grenn: In theory.

Kent Oliver:  Right.  But this won’t surprise you… China still wanted to show a strong economy and a high GDP growth.  So… there was still pressure to develop.  

Brady Raanes: In response, a new trend emerged in which local governments began setting up entities known as “local-government funding vehicles” …basically shell companies to borrow money. These shell entities were a black box.  They did not have to report what they actually owned or borrowed [HD3] which was a beautiful way around the new regulations against borrowing.

Jim Grenn: Ok.  Hold on a second.  Let me try and summarize this.  So.  Real Estate prices start getting ridiculous as everyone in China gets into real estate development.  To slow things down the Central Government begins restricting bank loans.  But shadow banks pop up and keep the loans going.  So, the Central Government restricts the ability of local government to borrow.  But… they get smart and basically create shell entities to borrow on their behalf.  And the game continues.

Kent Oliver: That’s a good summary.  These new shell entities allowed local governments to continue borrowings even when they shouldn’t have been able too, which allowed them to show increased economic activity. They quickly became the biggest borrowers from the shadow-banking system.

Jim Grenn: Oh my…. So… How much of what we are talking about is known by the average investor.

Brady Raanes: China’s confusing system of backdoor loans, hidden leverage, and wild speculation is known but not widely understood.  There are a lot of articles in the mainstream media and various economic papers written but much of the details are shrouded in mystery.  In fact we have a lot of links and sources in our show notes at dominopodcast.com for anyone interested in learning more.

Kent Oliver: In 2016, the size of the shadow-banking industry topped an estimated $8 trillion. The wealth-management products created by the shadow-banking system are roughly double the size of the mortgage-backed investment that nearly leveled the US financial system.

Jim Grenn: It’s scary that China seems to be continuing its debt binge to achieve its unrealistic output growth targets

Kent Oliver: The world has never seen credit growth of this magnitude over such a short time. it has directly or indirectly impacted nearly every asset price in the world, which is why the market is so jittery about the idea that credit problems in China could unravel.

Brady Raanes: Even the IMF has issued a warning about China’s ballooning debt. In 2016 they wrote “Since 2008, private sector debt relative to GDP has risen…to about 175 percent—such large increases have internationally been associated with sharp growth slowdowns and often financial crises.… All credit booms that began when the ratios were above 100 percent—as in China’s case—ended badly.”

Jim Grenn:  ended badly.  Interesting phrasing.  I guess.  I feel like we are discussing a massive domino that hasn’t completely fallen yet.  What might happen when it does?

Brady Raanes:  who really knows.  We could look back at past debt crisis for some clues, but China’s communist economy is different that other debt crisis that we’ve explored during our season.  So, it’s really anyone’s guess.  But one thing is likely.  This Domino will eventually fall.  And it probably won’t be pretty.

Jim Grenn: Recent tariffs placed on Chinese goods have raised more concerns about China’s slowing economy and huge debt overhang.  China recently reported their lowest growth rate since the financial crisis.  Only time will tell how this domino falls and the possible impact for economies around the world. 

Brady Raanes: This concludes season 1 of Domino.  We’d like to thank you for listening and subscribing.  We greatly appreciate all the feedback through the season.  As we brainstorm about doing a second season, we’d love to hear your thoughts.  What stories would you like to hear?  What did we overlook?  Please email us at Dominopodcast@gmail.com with any thoughts.  Until next time.