I saw this question on the public discussion forum Quora and thought that the other answers were really off-base.  The person asking this question was probably thinking about the bursting of the Shanghai stock market bubble, but in fact, I believe that the recent fall in Chinese stock prices is not the cause of a crisis, but one effect of deeper, structural problems. Here is my take, as posted on Quora.

China has structural problems that have led to the present stock market falls in Shanghai. I don’t know if the decline in Shanghai stock prices is what you mean by “Chinese financial crisis,” but I’ll talk about the real (and perhaps impending) Chinese financial crisis and how that ties in with the present stock price fall in Shanghai.

A few commentators here have tied Chinese weakness to issues with the export market and I can’t disagree with this more strongly. Chinese exports are the one bright spot in the Chinese economy.

In essence, the real issues in the Chinese economy stem from three factors:

  1. Building projects that waste resources and cause distortions in the Chinese economy.
  2. A weak system of social safety nets which put a damper on consumption spending.
  3. Poor demographic trends caused in part by the implementation of the one child policy.

The first large-scale building projects in China were based on real demand, so embarking on them created real economic growth. These building projects centered around supplying cheap labor to U.S., European, and Japanese companies for manufacturing and assembly projects.

I’m writing briefly so I’ll simplify the complex process that subsequently occurred, but essentially, builders and politicians saw the success of the coastal development projects and realized that land development was a way to wonderful riches (builders through development jobs, politicians through bribes and kickbacks). Increasingly, building projects that were uneconomic were started and completed. By “uneconomic,” I mean the projects were undertaken without immediate demand for them. This has led to the rise of Chinese ghost cities (here is a good, thoughtful look at ghost cities: “Enough empty floor space to cover Madrid”: so why are China’s ghost cities still unoccupied?).

Builders needed capital to build, and got that capital from local banks. The banks were virtually forced to lend to the builders because of the tight connection between the banks and the local governments. In a real, economic transaction, a builder would borrow from a bank, build out a property, and use the sale / rental of the buildings to pay the banker back. But if there is no demand for the buildings, the bank will not get paid back. The builder will still get paid and can still pay his workers, but they are all getting paid from the bank’s money, not from the sale / rental of buildings.

So as long as politicians have control over banks and are economically rewarded (bribes / kickbacks) to start new construction projects, the banks will pay out money to producers who don’t have customers for their goods.

This leads to other big problems in that in order to build, you need steel, concrete, glass, etc. For instance, China now produces more steel than the rest of the world combined. As building has slowed (there are reasons for this that are tied to rising Chinese manufacturing salaries, a reallocation of manufacturing sites to lower cost regions, and an increasing urgency to “tighten credit” — i.e., not allow banks to loan so much money out), this massive overcapacity has become a big problem for Chinese social stability. If you are a steel worker and have been pulled into the middle class by your job, and now you are not receiving a salary because your company is not getting steel orders, you’ll be upset. Your dreams for your future and your children’s future will be crumbling, and you’ll try to figure out who is responsible for this. More likely than not, your anger will eventually turn toward the government.

The biggest problem in China is not the crashing of the Shanghai market, but the social and political stresses that are beginning to be felt due to the fall-out of a misallocation of economic resources toward uneconomic projects. The Chinese government’s ham-fisted attempts to halt the fall in share prices has likely exacerbated these stresses rather than relieving them.

Lack of Safety Nets
With the effective dissolution of the communist economic system, the costs of educating and insuring the population was shifted from the government to the people. There is a great article which explains these dynamics on the Carnegie Institute website.

Because Chinese citizens have to pay for their own health care, their own elder care, etc., they have a huge disincentive to spend a lot of money on consumer goods. If your mother faces a protracted illness and you have to pay for her care yourself, you know you can be financially devastated. Your response is to save on other goods so that you can “self-insure” against a future, uncertain calamity.

The Chinese economy is designed to produce rather than to consume goods, in other words. As such, some of the excess manufacturing capacity which might be soaked up by domestic demand cannot be.

As a Chinese individual, you will become very happy for any opportunity to participate in an investment that gives you an opportunity to increase your savings cushion quickly. So if the price of real estate is going up rapidly, it is better for you to jump on the boat of real estate investing and try to boost savings that way. If the price of stocks is going up rapidly, it makes sense to buy stocks so you can build your cushion that way. This psychological profile is almost custom-designed to cause asset price bubbles (i.e., real estate prices too high, stock prices too high). Asset price bubbles can persist for a long time, but when prices start to decline, the best thing an investor can do is to sell in order to preserve their savings cushion. If everyone starts selling to preserve their individual savings cushion, you get a “bursting” of that asset price bubble.

Bad Demographics
Chinese leaders have been attempting to limit the population growth of their nation since after the Communist revolution. There are various reasons why this makes sense to do, but the most kind and gentle implementation of this policy is to restrict births rather than killing adults of a child-bearing age. Restricting births, which eventually became Chinese law in the form of the one-child policy succeeded in slowing population growth but did nothing about the people who were already alive. Taking a look at Wikipedia’s entry for Chinese demography, you can see the chart showing the 2010 demographic trends.

This plainly shows that there is a big lump of people who will soon be reaching an age at which it is hard for them to do a lot of productive work. This big lump will be supported by a much smaller base of people who are in their prime working years.

One way to read this is that, in a sense, the working age population will have to channel some of their economic output towards taking care of the less- or non-productive elderly population rather than to more productive pursuits.

Other countries also face this same issue (Japan for one) but the effects of this issue are more pronounced for countries that are not rich. China, the second largest economy in the world, can be considered rich at a country level, but not on a per-person (per capita) level, and this is the level that counts.

Put simply, China is becoming old quicker than it is becoming rich.

If China were rich on a per capita basis, some of the wealth held by the older generation could be allocated to its own care. As it is, some part of the population is rich, but another very large part of the population is not, so future economic activities will have to be channeled toward taking care of the elderly.

This is not a problem right now, but speaks to the possibility of a problem just at the horizon.

The Chinese Financial Crisis
If you take this term to mean the fall in average Chinese stock prices, the financial crisis stems from structural issues related to people having to build a large financial cushion exacerbated by what is called “behavioral” factors (i.e., “That hairdresser is getting rich in the stock market. Maybe I should put some money in the stock market too!”). This “crisis” is serious to Chinese savers, but I believe has been hugely overblown for European and U.S. savers (though not necessarily for Japanese and Australian ones…).

If you take “Chinese Financial Crisis” to mean a widespread breakdown of financial systems, including the bankruptcy of banks, a severe contraction in output, etc., I would say that we see some elements of financial crisis right now, but not enough to say that it is actually occurring or will necessarily occur.

Financial analysts like to deride the concept of “Fake it till you make it”, but in fact, that policy can work if you have a long enough time horizon. QE in the U.S. is one example of this policy working (or starting to work after six long years); the Greek fiasco is another example that will probably work as long as Greece does not descend into civil war.

The Chinese government is attempting a “Fake it till we make it” approach to economic development. Eventually there may be demand for Chinese ghost cities. Eventually the wealth along the coast may seep its way into the interior. Whether this “soft landing” actually happens or if China is subjected to years of civil strife and the gradual destruction of its role as a global goods production center is hard to tell right now. It depends a lot on government policy (especially the development of the interior and a rethinking of how the costs associated with the burden of the aging population will be borne), but depends also on factors that are uncontrollable. For example, climactic changes could create disruptions to water flows and rice production, and this would add stress to an already stressed economy. Perhaps the extra stress would make the hard landing scenario more likely.

The question whether China will eventually face a hard or soft landing represents the real potential Chinese Financial Crisis. If China faces a hard landing, it is likely to have some pretty serious consequences around the world. It is a nuclear power and its client state (N. Korea) is also a nuclear power that is still at a technical state of war with its neighbor. It is geographically near and economically important to an important developed economy (Japan). It is developing a large navy whose submarine capabilities are threatening to even the greatest naval power in the history of Man–the U.S.

I’m not at all worried about the fall in Shanghai stock prices and I think it is too early to worry about a real Chinese Financial Crisis.