The Chinese city of Ordos, built to house 1.5m people. In 2011, capital spending accounted for 50 per cent of China’s GDP. (© 2011 AFP)
In March this year, China’s new Premier, Li Keqiang, pledged to open the economy in a “self-imposed revolution” which would “feel like cutting one’s own wrist.” Even allowing for the possible infelicities of translation, this warns of an unpleasant and risky procedure. The new Chinese government is only a few months old but already the future for China looks quite different from what many commentators were expecting as recently as last year. For one thing expectations of economic growth are being steadily revised down. Li’s predecessor famously described 7.5 per cent growth as the limit for social stability. In the last few weeks both government spokesmen and several leading private sector forecasters including one of the most politically savvy of the investment banks, Goldman Sachs, have breached this important, if symbolic, level.
China, it seems, is slowing, and its growth may become even more sluggish in the coming months. The period during which China has provided greatest stimulus to the global economy is drawing to a close. Vast amounts have been spent on infrastructure projects intended to provide the platform for future growth, but experience of investment booms on this scale suggests that much of it will have been wasted, leaving behind apartment blocks in which nobody lives, roads upon which nobody drives and a small cohort of well-connected officials and businesspeople that have mopped up vast personal fortunes. China’s economy is stagnating. If it slows any more, the consequences will be felt across the global economy.
For years the engine for Chinese growth has been exports and a massive capital investment boom. Debt-fuelled capital investment on the scale seen in China in recent years, far exceeding the previous peaks of Korea in the 1950s and Japan in the 1980s, has seldom ended well. For all the wishful talk of the rise of a middle class and the emergence of a consumer society, China has been becoming more, not less, dependent on capital spending, particularly that sponsored by the state and local government. Even if China successfully makes the hoped-for economic transition towards a more consumer-based economy, experience points to even lower economic growth than is currently anticipated and also to a radical reassessment of past successes. When this process is complete the recent history of China will look quite different from how it currently appears.
There is no doubt about China’s extraordinary success in lifting hundreds of millions out of poverty and raising living standards on a scale never before seen. At the same time, a cursory glance at western economies in the last few years reveals how fundamentally an economic miracle can be mistaken, even with the advantage of the sophisticated data collection and analysis which China lacks. Ireland’s “Celtic Tiger” economy, for example, notoriously proved not to be a tiger after all.
During the “dotcom” boom in the United States at the end of the 1990s it was widely believed that the economy could, and would, expand at a 5 or 6 per cent rate more or less indefinitely. Growth was expected to be so strong that the government would be repaying debt at an accelerating rate. In the event, growth in the ensuing decade averaged something under 2 per cent and government indebtedness has ballooned.
Moreover, the boom itself has been substantially revised away. An economy which, at the time, was believed to be growing by 5 or 6 per cent has subsequently been revealed to have been achieving a more pedestrian 4.5 per cent. The year of 1999 had begun with the remarkable news that the US economy had grown at a staggering rate of 5.9 per cent in the fourth quarter of 1998. But 1999’s 4.9 per cent growth marked the most rapid year of the expansion and in 2001 it eked out a miserable 1.1 per cent, accompanied by the biggest collapse in capital spending since the Great Depression.
Although excessive capital investment, particularly in telecommunications, played its part in this boom and bust, it happened in the context of an economy in which consumer spending accounted for by far the biggest share. It was the housing boom, itself destined for a bloody denouement, which rescued the US economy from what would otherwise have been a deep slump.
Ironically perhaps, given the animosity between the two nations, it is Japan’s experience in the 1980s that can shed most light on some of the more likely outcomes for China. The more ambitious extrapolations of China’s recent successes draw heavily on the experience of the “Asian Tigers” which since World War Two have emerged from poverty to achieve first world standards of living. What can be forgotten is that the economic success of Hong Kong, Korea, Singapore and Taiwan is very much the exception rather than the rule. In two generations this small group of countries has seen incomes rise to put them among the highest in the world. Admirable as this is, it is unusual. The more common experience is to fall into the so called “middle income trap,” where living standards rise but the economy fails to make it to first world levels of sophistication. What is more, all of the Asian Tigers became rich before they got old. Due to the legacy of the one-child policy, China will struggle to do this. The population is already ageing—within just a few years the proportion of the working age population will begin to fall. It can be easy to overlook the fact that, notwithstanding its apparently inexhaustible population resources, China has already cashed a lot of its demographic dividends.
Even western-style democracies with their traditions of open debate and freely available information can fall foul of a combination of naive extrapolation and semi-willful self-deception, which serves to stifle criticism and thereby maintain a dangerous course. This happens that much more readily in a single party state; even in a relatively open and successful one like Japan, let alone in one like China. Japan’s state-directed investment model was widely admired in the late 1980s. Films like Rising Sun, and bestsellers like Japan as Number One: Lessons for America, constantly reinforced the idea of Japan’s emergence as the new economic superpower. Japan’s then Ministry of International Trade and Industry and its ability to direct investment into “strategic industries” was widely admired and emulated. Adverse criticism was heavily discouraged. An audience with ministry officials was eagerly sought; the drab anterooms were full of westerners sitting on the hard chairs lined up against the walls patiently awaiting their turn. A few years later the banking system was in crisis, the economy had slumped and the anterooms were deserted.
China reacts badly to criticism, however well-intentioned, and this creates a big disincentive to broadening the economic debate, let alone calling into question the Chinese economic model. The business of many “China experts” relies on privileged access to government officials and, naturally, they will avoid doing anything to prejudice it. Likewise, economists or analysts working in, for example, foreign banks in China will try to avoid harming business by antagonising a sometimes touchy government. It is perhaps not surprising, therefore, that some of the more “incorrect” analysis has come from Japan and in particular from the Bank of Japan’s research department. The fact that Japan itself experienced what in retrospect was a ruinous episode of overinvestment fuelled by borrowing is no doubt a partial explanation. A 2011 Bank of Japan study by Fukumoto and Muto, “Rebalancing China’s Economic Growth: Some Insights from Japan’s Experience,” provides valuable perspective on the consequences of historical capital spending booms.
Capital investment on the scale seen in China over the last few years has broken all records. In 2011 capital investment accounted for nearly 50 per cent of GDP as China poured resources into new civil and industrial infrastructure. The previous peak, an episode that culminated in the Asian crisis, was Thailand in 1991 where capital spending accounted for 41.5 per cent of output. Japan’s “bubble economy” of the late 1980s saw investment rates in the mid-20s. Economies that are reliant on high levels of capital spending are prone to sudden stops. The reason is simple. Consider car sales and the respective cyclicality of a car dealership and a company that constructs new car plants. If car sales are flat then the car dealership sells the same number of cars and its revenue is constant. The demand for new car factories, however, declines precipitously as there are already enough to meet the current level of demand. Capital investment booms on the scale seen in China in recent years have mostly ended in outright recession.
The other aspect of the Chinese economic miracle that demands attention is the rate of expansion of debt. Rapid increases in the ratio of debt to GDP have tended to be a reliable predictor of financial crises. This is where the most obvious warning signals were to be seen in the run up to the western financial crisis in 2008 and there are many other episodes in which it reliably presaged trouble. Such a jump was also seen before the banking crises in Japan, where the measure rose by 45 percentage points between 1985 and 1990, and South Korea where it surged by 47 percentage points in the years between 1994 and 1998. The credit-to-GDP ratio in China increased by 73 percentage points in the last four years, according to estimates by the ratings agency Fitch. So far debt defaults have been very modest—the first offshore bond default was only a few weeks ago—but, as the recent surge in interest rates (later calmed by the central bank) shows, there are many institutions which will find borrowing hard, if not impossible, as credit conditions tighten.
Over the next few months it will start to become apparent how the new administration intends to deal with China’s planned economic transition. In the process an exacting light will be shone on the country’s “Red Capitalism.” It will become increasingly obvious whether rapid economic growth has disguised fundamental flaws in the political as well as the economic model, particularly as it is a new administration which will be dealing with an economic downturn and assigning blame for its origins.
In a single-party state, politics in the western sense do not exist. Xi Jinping, China’s new President, drew just one “no” vote and three abstentions from the almost 3,000 delegates when he was elected in March. Nevertheless politics do exist, not least in the increasingly divergent interests of the Communist cadre and the new bourgeoisie with their financial powerbase in real estate, local government and the secondary banking system.
The beginning of the process of identifying the causes of the downturn has already begun and will only intensify as conditions deteriorate further. Campaigns against local government corruption, steps to contain real estate inflation and more rigorous controls on secondary banks all serve a broadly defined political as well as an economic agenda. Campaigns such as “operation empty plate” (a “grass roots” reaction to official gluttony) have resurrected a rhetoric reminiscent of the “economic wreckers” to whom the failures of command economies are traditionally attributed. A Xinhua news item, “Secretive government receptions defy China’s central authority,” talked of how, in spite of issuing “cleaner government” regulations, “a cohort of pussyfooters rack their brains to keep their corrupt working practices while maintaining good repute.”
China has been responsible for a large share of global economic growth, particularly in the period since the 2008 financial crisis. Indeed many of the more extreme imbalances in its economy are the consequence of the large stimulus programme on which it embarked as exports to the west collapsed. In some areas, particularly commodities, it is by far the dominant factor; in recent years more than 100 per cent of the rise in demand for some raw materials has come from China.
As recently as a year ago, scepticism about China’s ability to sustain its growth rate was rare. Both an apprehension that growth is slowing and that there are likely to be problems in the banking system are now much more mainstream and their ability to shock correspondingly less. Indeed, it has been this dawning recognition that has been responsible for the heavy falls in commodity prices, commodity-linked currencies like the Australian dollar and Brazilian real and emerging market equities and debt in general. Chinese assets themselves have been a poor investment not only recently but over the long run as well. Since TsingTao Brewery listed its H shares in Hong Kong in 1993, the MSCI China index has returned just 14 per cent. In common with the 19th century’s great emerging market, the US, its citizens have prospered—some outrageously—but foreign investors have shouldered a lot of risk for very little return.
China’s influence on the global economy and investment environment, however, extends well beyond simply these few specific examples. Across the globe, inflation is already very low. If China’s economy slows down, then global inflation is also likely to fall further, meaning that central banks will keep interest rates down. It also makes it more likely that the period of Quantitative Easing and other monetary policy experimentation in the developed world will continue.
