Has China Passed Its Peak?

Jan.25.12 | About: SPDR S&P (GXC)

Most everyone is bullish on China and its future. But maybe that's a mistake?

China will undoubtedly reach a higher peak in terms of its share of global GDP but, has China gotten to a point where it will no longer surpass expectations and will start to have a hard time living up to them? I think so. I think China has reached a point where various kinds of diminishing returns and errant policies are going to start to take their toll.

China: The Enigma

With China, it is often easier to describe what it is not rather than what it is. It may be a Communist country, but not really. It is certainly more authoritarian than Communist, in any true sense. It does not offer freedom, democracy or any reliable legal structure. It is rife with corruption especially at the local level. Firms locating there depend on the protection and advocacy of their own governments more than they do on local law to stick up for their rights.

China: The Oxymoron

China has reached a new a phase and it is a phase that will demand more of China where it is weakest. China will need to reset its economic policy for the future. As China has become a huge industrial power it has remained a highly underdeveloped country with a low per capita income and great stretches of poverty. None of that explain why China maintains the highest foreign exchange reserves in the world, effectively sequestering capital in its least productive form when it could have so many uses for it. In the lexicon of economics China is a country that is relatively abundantly endowed with labor and relatively scarce in capital. So why does it employ its capital resource so poorly?

China has done this to advance its export penetration, to effect a policy that has now run up against brick wall. Exports need foreign demand. But Europe's growth has slowed. The US, after running persisting and growing current account deficits, is no longer going to be the consumer nation of first resort. China is going to have to gear up to exploit its own demand at home. That shift will put new economic and social pressures on it.

Ironically there is another oxymoron at work here. If China wants to develop domestic demand it will have to make that demand effective. That means wages will have to rise. And, so far, China has controlled rising living standards very carefully. Developing domestic demand will be at odds with China keeping its high degree of international competitiveness.

China's Past Policy Mistakes

China also has severe demographic pressures. It claims its one-child policy has cut its population by 400 million births since 1980. A 2008 Stanford study found that China's gender ratio grew from 106 male births per 100 female births in 1975 to over 120 male births per 100 female births by 2005. China has a growing imbalance of males over females that will set the stage for conflict in the years ahead. The policy has resulted in 34 million more men than women in mainland China.

China Is No Incubator

China has not offered protective treatment for intellectual capital. The high-speed train crash in July of last year offers a glimpse into how China will be shackled as it tries to swim upstream to produce more high tech products. China has promoted its high-speed train as the product of its local know-how but its local tech firm, Hollysys, imported technology from Hitachi for the project. Hitachi knowing it could not trust China with its industrial secrets wrapped the technology in 'black box' that performed the required functions but it made it difficult to access the technology itself. Some think Chinese engineers did not fully understand the back box resulting in poor systemic integration. That, coupled with a lightning strike, enabled the train accident. In a more recent example, General Motors is building its electric car of the future in China to cut costs but is not sharing the technology.

With so many pirated-label goods ranging from designer handbags, to clothing, to watches, to CDs, and DVDs, and to software, China is not a place where technology companies will want to let their guard down. While China has been able to ramp up production to fill mass market needs, it will now find that high-income markets are slow-growing and it will run into more competition with other developing economies that also have export-led growth models.

China - Not Alone In Its Dilemma

Oddly the bulk of the world's foreign exchange reserves are with developing countries! These are countries, like China, that could use the capital for other reasons but have instead chosen to accumulate what are largely dollar balances to keep the dollar strong and their currency weak to effect export penetration.

China's Pent Up Demand

But China's worries are not as easily solved as letting the yuan ride up and aiming at the domestic market. What may be even worse is that because China has developed a wealthy-class and middle-class of some size and has not offered freedoms in step, many Chinese want to move themselves and their wealth out of the country. Dropping exchange controls might not simply cause the yuan to float up; it might plunge as wealthy Chinese sell yuan assets to build wealth outside the country.

Halcyon Days Over Already?

China over-accumulated foreign exchange reserves and began to switch to building up a sovereign wealth fund to supplant it. China saw the competition for resources heating up and knew it was deficient. Its lack of key natural resources would limit it, so it has tried to use its sovereign wealth fund to accumulate minerals. China's recent move to limit exports of rare earth, a scarce ingredient in battery-making that China has in abundance, may signal more rivalry and a sharper-elbowed future with a country that is beginning to be hemmed in by its own past success. China needs growth for political stability. It already has looming demographic problems. Its lack of resources has already motivated it to try to muscle in to gain more. China, as I said, is entering a new phase. It won't be nearly as much fun for any of us.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.