Here Are The Three Reasons The Chinese Government Will Not Allow A Hard Landing

China always surprises people with odd things.  On the Christmas day, the People’s Bank of China raised interest rates by 25 basis points for both one-year lending and deposit.  Today’s market reactions in China were as surprising as the rate hike itself.  In early morning, I tweeted that the Shanghai market opened higher in the morning.  But as the afternoon session opened, the index turned negative.  The market, at last, got crushed and closed 1.9% lower.

Mish pointed out today that China may face hard landing.  In my own analyses, I did not pointed out that China faces a hard landing.  Rather, they need a hard landing (or a recession) to contain their inflation problem, very much like Paul Volcker engineered two recessions in the early 1980s to end the era of stagflation.  But just to imagine, no government will deliberately engineer a recession as it will be very unpopular.  As a matter of fact, while Paul Volcker succeeded in fighting inflation, that cost Jimmy Carter his job.

Instead of trying to make my case for a hard landing, I would like to point out a few reasons why the government will not allow that to happen.  These reasons are by no means an exhaustive one, but I think they are among the most important reasons.  Note that it is very dangerous to believe that the Chinese government is omnipotent in manipulating the growth rate as they wish (I am talking about the real economic activity, not the fake GDP number), and I think there are a certain degree of complacency among some people who think that the government will not let the economy and real estate market to collapse.  So here are some of the reasons why the government will not allow recession to happen, but it cannot guarantee that recession won’t happen.

1. History showed how bad things could get if the Real Estate Bubble Burst

The massive property bubble is creating a huge dilemma to China.  On one hand, the government knows that real estate prices are still too high for many people.  On the other hand, a collapse of real estate market will be a massive drag to the economy.  A little review of history of Hong Kong real estate market and recent slowdown in the United States, together with the never-ending bear market of Japan make it apparent that a burst of real estate market will almost invariably produce a deep recession and deflation.

2. Local government relies on land sales for funding

Although we know that the Chinese government is financially more sound than their counterparts in many of the developed countries, there are hidden risks in the local governments that they are running short of funds.  Local governments have huge budget deficits, and they rely heavily on the so-called “Local Government Financing Vehicles” for funding of infrastructure projects.  The funding largely came from State-owned big banks, and the repayment is really contingent on the real estate market as many of the projects they invested in will not be profit making, such that they need to sell land to repay loans.  It is immediately obvious then, that a collapse of property market will be very dangerous for the Chinese economy because the loans cannot be paid back, and Chinese banks might have massive exposure to these bad loans.

Just like any piece of statistics concerning the China economy, the true size of these bad loans are not certain as these financing vehicles are off-balance sheet.  If the property market collapse, the Chinese local governments will probably need to be bailed out, and banks provisions will probably surge.

3. Social Unrest is the Number 1 fear of the Communist Regime

In the view of the Communist Regime, if there are anything common between inflation and recession, it would be the risk to social stabilities.  As a matter of fact, the 1989 Tiananmen protests were at least partly due to inflation.  Also as a matter of fact, Chinese leaders should know enough of ancient Chinese history that most if not all of the regimes in the era of Imperial China were ended because of poor economy which led to riots, protests, revolutions, and finally the overthrown of the regimes.  As a reminder, there are thousands of protests in China every day, small and big, despite the government’s effort to stop any of these from happening.

Again, I have to say that government is not omnipotent.  They can make up statistics for GDP, but not the real economy.  They do not want recession to happen, but it does not mean that recession will not happen.

This post originally appeared at Also Sprach Analyst and is republished here with permission.

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