To my mind the Chinese economy, the Australian dollar and iron ore prices are all defying gravity at present and all crucially dependant on Chinese policy leaders being able to keep pumping up a bubble in debt-fuelled public sector investment.
The bad news is this growth lacks fundamental drivers and so will eventually end. The good news – at least as regards Chinese growth and commodity prices perhaps – is that China can keep defying fundamentals for a good deal longer.
To be sure, the Chinese growth story of recent decades has been a miracle to behold. Through its opening up to international trade and modest local deregulation, China unleashed its cheap export-focused manufacturing sector, and for a while became the “workshop of the world”.
But as other developing economies before China quickly discovered, this cost-based source of competitive advantage does not last long if an economy is indeed successful in raising living standards. Tightening labour markets and rising incomes soon create rising wages and a less of trade competitiveness.
In China’s case, this has been compounded by relatively high inflation by global standards and a currency that has broadly tracked the US dollar upward in recent years. China’s real exchange trade, accordingly, is well above long-run average levels. Other Asian nations such as Vietnam are stealing this source of advantage.
And in developed economies such as the United States, we’re seeing more “insourcing” as corporate America discovers if increasingly not worth the administrative hassle of making products in China.
Add to this a post-financial crisis slowdown in demand from developed economies, and it’s little wonder China’s once dominant export sector is ailing.
Of course, China’s economy has slowed from double digit rates of growth to around 6-7% (to the extent official statistics can be believed), but conditions would have been much worse if not for measures to pump up the local housing sector and infrastructure related projects.
Chinese policy makers can’t afford the economy to go through too much of a wrenching adjustment, so they’ve been quick to keep the ship afloat through essentially encouraging what’s now a bubble in residential property development and white elephant infrastructure projects. Many projects are getting the greenlight simply because the state-owned banking sector is still prepared to lend to state-owned enterprises – who are making losses and running up debts that are unlikely to be repaid in the process.
The great transition in China is not from investment to consumption: it’s been from private investment to public investment. In the hurry to channel funds into the loss making state enterprises, the private sector – already ailing from weak export markets – is being squeezed out of credit market also.
Since the 2008 financial crisis, total Chinese debt across all areas of the economies has leapt from around 120% of GDP to just over 250%. Much of this growth has some from state firms.
Some fear problems when these firms either admit they can’t pay back their debts or the banks simply stop lending. But this ignores what’s really driving this process: top-down government directives that the banks keep the SOEs alive. It’s effectively State funding intermediated through the banking sector.
After all, companies would not be piling up debts if they were making decent profits from their sales. And banks would not be lending to loss-making companies to build products nobody wants if government authorities were not telling them to.
When push comes to shove we can expect a State financed bailout when the debt mountain implodes. But I don’t expect this to happen anytime soon. Most of this debt is domestically funded. And with still ample foreign reserves and relatively low central government debt, the central government should be able to “re-capitalise” the banks when need be.
How long can the process go for? Well in Japan, which have been playing a similar game with regard to infrastructure projects since its bubble burst almost 30 years ago, total nation-wide debt is now 400% of GDP.
Ideally, China hopes to transition from state-directed capital intensive investment into a more consumer and services orientated economy. That’s easier said than done, although most commentary in Australia seems to assume it’s already well underway and more or less assured.
The problem is that the latter source of economic growth requires cultivating a quite dynamic and entrepreneurial hotbed of small private sector firms – which in turn requires the central and local governments to relinquish more control over the economy.
And it might ultimately require more democratic reform to given the new breed of middle-class small business entrepreneurs some confidence that the law of contract will be upheld – and any hard won business gains they make won’t eventually be taken away by corrupt official and the State-firm cronies.
Given many countries before it have struggled to make the leap from cheap manufacturing centre to a more mature and domestically focused service-intensive economy, it’s hard to be super confident China can either. That also ultimately does not bode well for local regional stability if official resort to naked nationalism to shore up their public support in the face of a faltering economy.
