Is China’s “Black Box” Economy About to Come Apart?

After 30 years of torrid expansion, perhaps the single most consequential factor in China’s economy is how much of it is a “black box”: a system with visible inputs and outputs whose internal workings are opaque.

There are number of reasons for this lack of transparency:

  1. Official statistics reflect what officials want to project, not the unfiltered data.
  2. Policy decisions are made behind closed doors by a handful of leaders.
  3. There is little institutional history of transparency.
  4. Many important statistics are self-reported and prone to distortion.
  5. Large sectors of the economy are informal and difficult if not impossible to measure accurately.
  6. Endemic corruption distorts critical economic yardsticks.
  7. There is little historical precedent to guide policy makers and individual investors.

None of these is unique to China, of course, with the possible exception of #7: few nations in history (if any) have experienced an equivalent boom in infrastructure, credit, housing and wealth in such a short span of time.

Saving Face By Editing Data

As anyone who has lived and worked in Asia can attest, public perception (i.e. "face") is of paramount concern.  There is tremendous pressure to put a positive spin on everything in the public sphere.  Negative publicity causes not just the individual to lose face, but his boss, agency, company and family may also be tarnished.

For this reason, reporting potentially negative numbers accurately may put careers and hopes for advancement at risk.

This accretion of fear of reprisal/disapproval builds as it moves up the pyramid of command.  This process can lead to tragic absurdities being taken as truth.  In one famous example in Mao-era China, officials ordered rice planted in thick abundance along a particular stretch of road, so that when Chairman Mao was driven along this roadway, he would see evidence of a spectacular rice harvest.

In reality, China was in the grip of a horrific famine resulting from disastrous state policies (The Great Leap Forward). But since everyone feared the consequences of telling Mao his policies were starving millions of Chinese people, the fields along the highway was planted to mask the unwelcome reality.

Even the most honest reports reflect the biases of those summarizing feedback for their superiors. As a result, when the feedback finally reaches the top leadership, it may be inaccurate or misleading in ways that are difficult to detect.

The Dangers Of Opaque Leadership Decisions

All leaders have their own biases and experiential limits, and left unchecked by accurate feedback and honest dissent, these have the potential to generate disastrous decisions.

Perhaps the top leadership in China is soliciting honest dissent, but without a vigorously free media and multiple unedited feedback loops, this is unlikely for systemic reasons.

Most people—leaders and followers alike—seek to confirm their own views (i.e. confirmation bias). A system in which key decisions are not aired publicly and the trustworthiness of the data being considered behind closed doors is also unknown is a system designed to reinforce confirmation bias and yes-men.

In this environment, destructive policies may be supported by the chain of command despite the consequences.

Lack Of Institutional History of Transparency

Institutions with a long history of independence and a policy of priding transparency have the potential to counter the tendency of hierarchies to encourage confirmation bias and fudged feedback.

But China’s tumultuous history in the 20th century—invasion, foreign occupation, civil war, revolution, mass famines, the Cultural Revolution’s mass disruptions and purges, the end of Mao’s Gang of Four and Deng Xiaoping’s “to get rich is glorious” reforms—has not been conducive to the establishment of independent institutions.

Developing the independence of institutions in the midst of such unprecedented political, social and economic turmoil is a long-term work in progress. Though no comparison is entirely analogous, we can look at the first equally tumultuous 30 years of the American Republic (1790 – 1820) and the French Republic (1789-1819) for historical examples of the difficulties in establishing enduringly independent institutions.

Self-Reported Statistics

Self-reported data plays a significant role in any economic snapshot that measures sentiment and expectations. But when it comes to income, outstanding loans and other data, there’s no substitute for accurate numbers.

As a general rule, the larger the informal cash economy and the greater the leeway and the incentives to under-report, the lower the quality of self-reported statistics.

Take income as an example. In the U.S., the vast majority of non-cash income is reported directly to the tax authorities: wages, 1099s, sales of securities, etc.  The leeway to fudge income is low, which pushes the incentives to fudge onto the expense/deduction side of the ledger.  For this reason, IRS income data is more trustworthy than self-reported measures of income and employment.

Consider this chart of household income in China.  A survey of households found incomes were much higher than the officially collated numbers. In the case of the top earners, the difference was significant enough to skew a variety of key numbers such as household income as a percentage of GDP.



The differences between official data and data collected by surveys is troubling for a number of reasons. Given the incentives to under-report (to avoid paying higher taxes), why should we trust the accuracy of self-reported income? Who’s to say that wealthy households don’t habitually under-report their true income even to surveys?

Given the ubiquity of the informal economy and shadow banking system in China, official data cannot accurately reflect peer-to-peer lending, private loans outstanding and many other data points that are critical to understanding income, risk and credit flows.

The Informal Economy & Shadow Banking

These discrepancies between actual debt and what’s reported could have monumental consequences should expansion turn to contraction and debts become uncollectible.

It’s been estimated that a third of all Chinese households engage in informal lending to friends and family, as well as to enterprises that pay high rates of interest due to the risky nature of their investments.

Interest can run as high as 34% -- loan-shark rates.

Even the slices of the credit/investment sector that are reported—for example, Wealth Management Products (WMPs)—are more Wild West than staid banking. WMPs are managed off-balance sheet and don’t require any reserves:

“Legally WMPs are not deposits. They are investment products that are managed ‘off-balance-sheet’ by banks, and there is little transparency about where the funds are going,” said Stephen Green, head of Greater China research at Standard Chartered in Hong Kong, in a note.

According to Green, the funds from different WMP products are often mixed and deployed to finance a broad pool of assets that more often than not fall into the sectors of the economy that regulators have attempted to fence off from normal bank lending (real estate, local government infrastructure, etc.), partly because these sectors are deemed to be particularly risky. In addition, the banks hold neither reserves of WMP deposits nor capital against the assets.


In other words, transparency is low while risk is unknown but possibly high.  This volatile mix of opacity and risk is the perfect recipe for cascading defaults and catastrophic losses.

Endemic Corruption Distorts Data

In China, as in many developing economies, problems such as permit applications, tax bills or development rights are solved by greasing the skids of officialdom.  Just received a big tax bill? Maybe a friendly tax official can help reduce the tax in return for promises of favors and an envelope of cash.

While the central government is cracking down on highly visible corruption, the system of buying privileges with influence, favors and cash is too deeply entrenched to be eliminated in a few months or years by high-level policies.

As with all the factors listed here, the impact of corruption is difficult to assess -- and that’s what makes China’s economy such a black box: if what’s known is untrustworthy, and what’s not known is potentially destabilizing, then how reliable is any projection?

Few Historical Precedents to Guide Policy Makers and Individuals

In the U.S., analysts and policy makers can draw upon a long history of economic policies and debate their applicability to the present.  Rising income disparity, for example, is often compared to the Gilded Age of the late 19th century. The financial crisis of 2008 is often viewed as an analog of the 1929 crash that triggered the Great Depression.

China’s recorded history stretches back thousands of years, but in terms of applicable financial and economic parallels to the current economy, there is no precedent.  China’s leadership is truly in uncharted waters.  This in itself heightens the risk of miscalculation and basing policies on faulty premises.

In Part 2: Why China Is Extremely Vulnerable Now, we zero in on China’s real estate bubble, and the outsized risks it poses to China’s economy -- and the world.

As the housing bubble bursts, alongside the trillions of losses already experienced in the Chinese stock market, the flood of capital from China into world assets is going to be substantially compromised. Asset prices are set at the margin: what the highest buyer is willing to pay. For many years now, the world has become accustomed to China's dependable willingness to pay well in excess of everyone else. When China is no longer the highest buyer, how far will prices need to fall in order to match the next highest buyer's ability to pay?

Click here to read Part 2 of this report (free executive summary, enrollment required for full access)

This is a companion discussion topic for the original entry at

As I read this article, I kept running across statements that could as easily be applied to the United States (home of the free).

Official statistics reflect what officials want to project, not the unfiltered data, policy decisions are made behind closed doors by a handful of leaders (executive orders?), there is little institutional history of transparency (CIA, NSA, Military, executive branch, Fed),  without a vigorously free media and  tragic absurdities being taken as truth… all could have been written about the US just as easily.

So then this would mean that we're not "exceptional"? 

Meh, think I'll keep my delusions then cool.

And "shadow banking" sounds, quite frankly, creepy.  Who would want to be stuck in a dimly lit room with one of the Banksters, performing "transactions", anyway?


Thank you for the comments. Yes, these traits are visible in practically every major economy i some degree.  So it boils down to the impact of each failing.
I think one similarity between the US and China I didn't mention is that both have been supported by vibrant, globally competitive enterprises. Nations without this asset stagnate because all the usual corruption, fraud, waste etc. is not offset by any wealth creation.

On the other hand, my point here is China's households and thus its economy are far more vulnerable than advertised. the housing boom and bust in the US ruined the marginal 5% of recent home buyers who weren't qualified by previous standards, and hurt around 20% of other recent buyers (underwater homeowners). A crash in China will impact the 90% of the populace who own homes, as an illiquid market can easily lose 50% of its value very quickly.  Declines on the order of 80% are possible in insanely overvalued markets in China, and there is no other equivalent engine of household wealth.

That will absolutely destroy the 'wealth effect' in China.

This is the downside of highly concentrated household assets and an economy that is extraordinarily dependent on fixed capital investment, real estate development and exports.

This is another topic entirely, but I think China's currency is very likely to revalue sharply as the authorities grasp at straws to keep an unsustainable status quo afloat a bit longer.

Every major economy has a unique set of resources and problems.  We can see which the Chinese elites see as most at-risk–it's China, hands-down, as they move their children and wealth to N. America, London, France, etc.

I got that, but the Chinese housing boom portion of your excellent article was largely in the second (premium) section.  The content of the second section, spoke largely of issues that are uniquely China… and it's frightening for the world as a whole.

The Chinese economy is both a critical portion of the world economy and home for 22% of the worlds manufacturing.  When China is on life support, the world will feel the pain.

Right next to the Highline in fashionable Chelsea (where not so long ago one could live "on the wild-side, honey").
$2-$22 million.


People’s Bank of China decides to devalue its currency
In a potentially major move for trade and relations with the U.S., China’s central bank has decided to devalue its currency in a bid to shore up its sluggish economy.

The U.S. has long accused Beijing of manipulating its currency, keeping its value artificially low so as to boost China’s exports and discourage imports. Beijing had been allowing the yuan to rise in recent years but this had slowed China’s explosive growth rate, which has been based largely on exports.

Yes, this was easily foreseeable, but the timing was a surprise because the decision making is all 'black box" in China.  Devaluation is a two-edged sword–it makes China's exports cheaper in other currencies but it also increases the costs of imported materials and food.  I personally think the yuan will go to 12 (currently 6.8) to the USD–a massive devaluation that will simply reflect the negative fundamentals of the Chinese economy.
Those who anticipated China's currency replacing the USD are discovering just how wrong they were. 

What about the price of pork?
I thought the best line in this article (re: China) was the following:

However, in China there is one big problem with this... stoking inflation... and most crucially the social unrest concerns when suddenly a nation of newly minted equity losers can no longer afford their pork (which is facing record shortages)...
More dominos coming, I suspect.

"but I think China's currency is very likely to revalue sharply"
Charles you were spot-on on this; today china central bank has de-valued the yuan.

Regarding the raising price of imported material I think the sector that will be hit the most is energy as I think they import most of the oil they use. Not sure about how much coal they import, which I think they use the most. If the price of energy raises then price on food will also raise and the low-salaried people will feel the hit the most.

As exports tank more and commodities continue to tumble what can FED do?  QE4!
Did anyone else notice PBoC lost control of the devaluation as gamblers front-ran more than expected?

On a recent trip to Calgary, Alberta, I spent my Sunday morning taking a stroll in their wonderful series of parks and walkways. These are shadowed by a plethora of new condominiums going up faster than one can imagine. As I walked, I ran across mainly elderly oriental folks doing their tai chi along the pathways. the predominant language - you guessed it - Chinese. Is it any wonder real estate in Canada's major cities is ridiculously high and has no signs of abating. While Syrians, Ethiopians, Libyans, etc. are leaving the turmoil in the middle east for a better life in leaky boats, the Chinese have opted for non-stop flights to the wonderful delights of the Rocky Mountain foothills. Surprising? The yuan may be devalued, but not so much when you decide to bring millions of them with you. Exporting heavy oil from Alberta won't bring in as much as this new import of cash. My ancestors left Germany 300 + years ago in leaky boats, too. I guess we were just ahead of our time. Note the background pictures in Calgary's promotional link, Hmmmm! No need to import pork, if you can eat it in your new home. English as a second language? ? ?

Many keep accusing China purposely massaged GDP data to look good. I see this view has following questions:

  1. If fake 1% increase this quarter, next quarter you need to fake more (~2%), it is not sustainable

  2. As I read, China put very little in imputation incomes to calculate GDP thus her GDP is more realastic

  3. Add all Chinese provinces and autonomous regions' reported GDP, it is ~15% higher than central government reported (people joke as missing 32th province)

  4. Check average wage against GDP, based on data from ( China average is above GDP while US is below. If you time labor participation rate, you can find Chinese average wage is well above 70% of GDP


  1. Chinese data statistic may need to further improve (31 region reported has huge difference with central government)

  2. Likely, Chinese GDP is under reported based on US standard of calculation

this is a valuable perceptive and that is what which is helping in growth of GDP of china…sometimes i thought it is fake…but whatever it is, sounds well for the nation…some kind of hidden things…