Will China Save the World?

Unfortunately not, but you might think so judging by the outbreak of bullishness from US investment banks. Goldman recently upgraded GDP growth from 6 to 8.3% and Morgan Stanley from 5.5 to 7% on the back of a successful implementation of the $586bn stimulus plan and astonishing bank loan growth of $680bn in Q1.

No worries about money velocity in China; the advantage of being a centrally planned economy with state controlled banks is that money creation can be channeled directly by diktat to consumers and firms (although the quality of those force-fed loans will inevitably be direm I suspect much is leaking into stock market speculation and renewed commodity hoarding). I've never been in the depression/deflation camp and have argued consistently for a muted recovery in the US in 2010 generated by the huge stimulus applied, but the brutal reality is that the Chinese growth model is broken in a sustained deleveraging scenario for its foreign consumers. It is telling that the country's imports from Asia are falling even faster than its exports, and that both commercial and residential real estate prices are slumping on massive excess supply.

China's economy seems to have bounced back in March, thanks to accelerated infrastructure spending by local governments building yet more 'me too' conference centres and business parks but investment productivity has been in relentless decline in China in recent years, and a repeat of the Japanese strategy of simply pouring more concrete is doomed to fail. China's economy remains investment-dominated; in 2008, investment accounted for 43 percent of all spending (measured from the expenditure side of the national accounts). Consumption accounted for just 36 percent, and it's hard to see it rising much as effectively privatized health care and education require huge personal savings to finance.

Additionally, a dysfunctional banking system shuts out most smaller private firms, who are obliged to hoard cash as a consequence. Until these structural impediments are corrected, which will take years, a substantial rebalancing of the Chinese economy will be impossible. That leaves the country critically dependent on a revival of global growth; China cannot lead such a recovery, but simply follow it. As US personal savings begin a structural rise to maybe 7-9%, and the trade deficit tumbles, China is the epicenter of global deflationary forces, saddled with huge structural overcapacity across a range of industrial sectors.

The government's stated effort to boost consumption relative to investment and exports (it has actually been falling since 2000) depends on raising incomes closer to Western levels and completing the social welfare system; neither is likely in the short term. The frantic credit growth led model that is exciting bank strategists cannot sustain the economy beyond the very short-term, and ultimately will trigger the sort of financial crisis in China we have just seen in the West, as non-performing loans soar.

So could China provide a potential downside shock for the global economy later in 2009? One theme I repeatedly emphasize is how important it is to reality check any market consensus, bearish or bullish. Financial analysts are particularly subject to cognitive bias in their assessments, so it's crucial to draw the economic parameters that constrain their forecasts, whether it's a company's market share or a country's growth potential.

The Chinese growth model has involved policies that aim directly or indirectly at boosting savings and channeling huge amounts of subsidized resources into investment and manufacturing capacity, a repeat of the mercantilist Japanese and Korean development models. This combination necessarily involved generating large and consistent trade surpluses; China had to export the difference between consumption and production or they would have been forced to run up ever increasing inventory (which is what has been happening recently I suspect). When a country as large as China pursues policies aimed at generating trade surpluses they run into a very strict economic accounting constraint; another country must be capable and willing to run large corresponding trade deficits, a role played happily by the US until now as importer of last resort until its trade deficit peaked at 7% of GDP in 2007, reflecting an unprecedented 71% share for consumption in the economy.

Now, despite the consumption bounce in Q1's GDP figures, US households are in the process of rebuilding their tattered balance sheets, which in the absence of any new 'windfall' from asset bubble creation implies several years of deleveraging and a reversion to the mean for both savings and consumption. That implies US consumption growing a lot slower than trend US GDP growth it at all, itself pegged to at most 2% by a number of structural constraints, notably a 400% debt/GDP ratio.

Current Chinese policy reflects denial of these new realities. The composition of the recent demand stimulus simply does more of what worked in the past: increased investment in the production of exportable goods and heavy industry , increased production of semi-finished manufactured goods and increased investment in infrastructure. The likely result of this unsustainable investment boom will be increased excess capacity and losses in the export sector, huge bank write-offs over the next several years, and further Soviet scale degradation of the environment into the bargain...

So much for the superiority of central planning.

Comments

[Ben Gee:]

Overcapacity in the Chinese economy at this point of development is vasely over exaggerated and hoarding resourses when the price is low is a very wise move. Holding on to US dollars is not a good alternative. Buying resourses and resourse companies will also help resourses producing economies with badly needed cash. Growth, even if it is artificiently created will bring growth momentum or will have a multiplying effect. Infrastructure investing in China will not bring overcapasity for a long time to come. China with four times the US population and a bigger and rougher terrain than the US is estimated to have only about 70% of the US capacity after 20 years of rapid development. It will take China another 10-15 years before it reach the same level as the US. By then, China will have to produce machinary to replace an aging and shrinking work force.
China's economy is still too small to save the whole world, but China is big enough to help itself and perhaps a few friendly nations. China still have structual problems with its economy, but almost all other nations would love to have China's problems than their own.

May 03 05:52 AM

[Dave Wrixon:]

Yeah, basically it is all China's fault, but everyone else will do worse than America. Change the record, this one is scratched!

May 03 09:02 AM

[Tony Daltorio:]

I just love these type of articles -- places that are doing relatively well such as China are not places to invest, but the US which is the epicenter of the financial earthquake are places to invest? Keep throwing away your clients' money, Wall Streeter.

May 03 11:17 AM

[Alphameister:]

I don't care whether China can save the world. I'm just grateful that China is in the process of re-building my portfolio. Eventually, the central-planning model is going to come undone, but for now I'm betting that the Chinese will do better with it than Obama and his crew.

May 03 02:49 PM

[coreopsis:]

Sadly I couldn't read any further than the beginning of the second paragraph when I realized that this writer is an amateur. Money velocity is not what he thinks it is (he needs to take Econ 101).

All-in-all, you can believe this pundit or Goldman Sachs.

May 03 07:01 PM

[dybydx:]

i think the author needs to do a lil more than just saying "investment isnt the way to go, cause the japanese tried and failed." japan was already a 1st world contry by 1990 so pumping massive investment may generate diminishing returns. china on the other side remains a 3rd world country today. "building roads to nowhere" might actually work this time.

i am not here to say the author is all wrong, but his arguments lacked support that goes beyond the surface.

May 03 09:36 PM

[hondaicivic:]

China is not a third world country. It's a developing country. Third world countries are countries in sub-saharan africa and the middle east. You should know your economic terminology buddy.


On May 03 09:36 PM dybydx wrote:

> i think the author needs to do a lil more than just saying "investment
> isnt the way to go, cause the japanese tried and failed." japan was
> already a 1st world contry by 1990 so pumping massive investment
> may generate diminishing returns. china on the other side remains
> a 3rd world country today. "building roads to nowhere" might actually
> work this time.
>
> i am not here to say the author is all wrong, but his arguments lacked
> support that goes beyond the surface.

May 03 11:23 PM

[Sutida:]

China has done exceptionally well considering the current economic situation. Central planning, the hoarding of resources and foreign reserves has left the country in a strong position. Although growth has slowed, Asia is still growing in part from the large middle class that has developed over the last 20 years. I would not be too quick to dismiss China or South East Asia as an investment destination.

May 04 01:12 AM

[Freya:]

Sometimes, Being the Only party has its benefits.

May 04 04:33 AM

[Freya:]

China can, if it wishes, reignite inflation across the World.

China can buy all of Opec's daily 25 million or so brls. a day production (if it could find storage for it) for the next 6 months at an average price of $80 using only its USD foreign currency reserves.

They can Build cities large enough to house 20 million people to dot their landscape and leave them vacant waiting for People, Power, water, sewage treatment, highways to catch up. Those employed will eventually occupy them.

They can do whatever they wish to do.

The real question is not what China Can Do but what will we do if China stops buying our debt or even stops exporting their goods to our shores or even stops buying our goods.

May 03 11:04 AM