For years, there has been constant speculation that a debt bubble could burst in China. Forbes predicted in 2016 that “big bubbles would burst” in China the following year, BusinessInsider saw “a wild debt boom which fueled rapid growth for China and emerging markets ‘may already have burst’” (2019), the South China Morning Post asked, “Will China’s debt-fuelled economic bubble eventually pop?” (2020). These texts were gladly garnished with statistics showing rising private and government debt. The theoretical content behind them is mostly thin. This is by no means surprising. After all, anyone who could accurately predict financial crises would quickly become a billionaire. Will there be a financial crisis in China? Very likely, yes. When? That is almost impossible to predict.
Much more important than the question of if and when a financial crisis will come is probably the question of whether the Chinese government could deal with it. The last major financial crisis of 2008/09 was overcome relatively quickly in China. The fiscal stimulus of the equivalent of more than $500 billion was sufficient to get the economy going again. The political will to expand government spending was there, unlike in the eurozone, which imposed austerity programs on national governments. Thus, even in 2019, Greece and Italy had not reached their respective 2007 output levels. The question now is whether a financial crisis in China could overwhelm the Chinese government. Will it run out of money in the event of a major financial crisis – as was the case in Greece in the aftermath of the 2007-08 financial crisis? Is the government’s debt threatening to cut off its air?
Hardly. Because the Chinese government is not limited in its spending in Chinese currency. The People’s Bank of China (PBoC) and the Chinese government are institutionally highly intertwined. It is, therefore, inconceivable that the PBoC would refuse to pay for Chinese government spending in a crisis.
How states create money
To understand this more clearly, we need to look at how governments spend money. While textbooks assume that governments finance themselves through taxes, government bonds or the printing press, the reality is different. A state’s central bank – in this case, the People’s Bank of China – is the creator of the currency because it manages the payments system. This is a massive spreadsheet in which a country’s central bank enters who has how much yuan, US dollars or euros. The money in central bank accounts is called reserves. These reserves can be exchanged for cash. So private and state banks, as well as government agencies, keep accounts at the central bank. They use reserves to obtain cash for their customers and to carry out their transfers. The central bank can increase these accounts according to its rules if, for example, banks borrow reserves from the central bank against collateral.
It is important to know: The central bank – on behalf of the respective ministry of finance – pays the bills of the respective national government by increasing the credit balance on a bank account. The bank, in turn, increases the credit balance in the account of the recipient (company or individual) and settles the bill. For this process, a government does not have to issue bonds or collect taxes. In this process, it is also inconceivable that the PBoC would refuse to make payments from the Chinese central government. The chairman of China’s State Council nominates the governor and deputy governor of the central bank. The political will to fight a financial crisis will probably be there. But what happens if it were to become the biggest financial crisis in human history?
Deficits and public debt unproblematic
Mosler’s Law, named after the mastermind of Modern Monetary Theory (MMT), Warren Mosler, states: “No financial crisis is so severe that a sufficiently large increase in public spending cannot overcome it”. So for China, this also means that a financial crisis would not automatically lead to a collapse of the Chinese economy. The collapse in household and business spending on goods and services would reduce demand for them. The government, however, can compensate for this by spending additional amounts as necessary. The resulting deficits and government debt are unproblematic because the government can always obtain currency through its central bank. A default is unthinkable. This is also in line with Chinese economic policy. In an article in the journal The Chinese Economy, Lili Li, Hanyu Tan, and Hongmei Zhang write about the 1980s, “Because the PBoC was affiliated or subordinate to the Ministry of Finance, the two formed a de jure ‘consolidated government.’” So China is familiar with the situation where the central bank pays for government spending and the Ministry of Finance “wears the pants.”
The authors go on to write that fiscal policy is still relevant in China and that state money creation is still possible. The authors describe that the PBoC has not been independent of the Ministry of Finance in recent decades. Likewise, they elaborate that fiscal policy is responsible for straightening out income distribution. This means that, especially after a financial crisis, it would be very important for the government to stabilize private incomes with its spending. The authors also emphasize the relevant countercyclical component of fiscal policy: in bad times, additional government spending – in the face of falling private spending, hence countercyclical – can ensure that output and employment are stabilized. In good times, the government can increase spending weakly to not fuel inflation. The Chinese government thus has sufficient economic policy instruments at its disposal to cushion the consequences of a financial crisis, regardless of its size.
The “Chinese century” proclaimed by Wolfram Elsner could be expected to happen with or without a financial crisis. A financial crisis only reduces numbers on balance sheets. Wealth, on the other hand, would remain: Machines and factories, real estate and infrastructure. In China, this prosperity is based less and less on the export model and more and more on domestic consumption. In many sectors, Chinese companies are already technological leaders (solar industry), and in others, they are catching up fast (EVs). So China is well advanced on the development path. The biggest threat to Chinese prosperity in the medium to long term is probably climate change. Economic development has contributed to an increase in CO2 emissions. Air pollution is also a problem in China. If fossil fuels have to be abandoned in the future, China will be forced to greatly expand alternative energy sources. Since the country is a leader in the solar industry, the conditions for this are not so bad. In this respect, a possible financial crisis could even be used as an opportunity for an ecological restructuring of the Chinese economy.
Dr. Dirk Ehnts is an economist and political scientist living in Berlin. He is the spokesman for the board of the non-profit association Pufendorf-Gesellschaft e.V. which aims to educate people about how the banking and financial system works. His book “Geld und Kredit: eine €-päische Perspektive” explains the money creation of the eurozone from the perspective of Modern Monetary Theory (MMT).