China Still Vulnerable to Slowdown, Despite Domestic Market 'Buffer'

By Irwin Greenstein

Conventional wisdom has it that China is relatively immune from a global slowdown because of its growing domestic market. The problem with this theory is that many Chinese consumers have lost their shirt on the tanking domestic stock market.

China’s economy is in the midst of a seismic shift whose cracks reveal underlying hazards, according to a new article in the Far Eastern Economic Review.

Titled “The Great Crash of China,” it was written by Brian Klein, an International Affairs Fellow of the Council on Foreign Relations.

Mr. Klein has observed changes in the so-called Chinese Economic Miracle that show China as a precocious adolescent capable of turning into either a rocket scientist or a Communist thug.

He begins with the premise that "China is widely believed to be immune from the economic shock waves making their way around the world from the U.S. to Europe and Japan.”

However, China’s relative immunity from the subprime crash and credit crunch does not mean the country isn’t facing significant economic challenges. In fact, Mr. Klein posits: “China’s economy is actually facing a fundamental structural adjustment that has arrived much earlier than expected.”

Put under his microscope, he saw that China is experiencing “decreasing foreign demand for inexpensive manufactured goods, the misallocation of vital investment, and product safety concerns are straining China’s manufacturing base and challenging the tenuous linkages between continued economic growth and a rising middle-class.”

This new observation leads him to challenge the “conventional wisdom that China’s domestic demand is increasingly responsible for driving growth, not exports, giving the Chinese economy a natural buffer against wild swings in the world economy.”

The conventional wisdom is based on China’s new middle class continuing its consumer spending on very same things American’s bought with their home equity loans: TVs, computers, washing machines and cars.

The difference between the Chinese and American consumers, though, is that while we bought Chinese products, the Chinese consumers are buying domestic products that prop up their own economy.

As Mr. Klein writes:

At first glance the statistics look promising. Consumer spending is up 22%, inflationary pressures are receding as food prices drop, and strong foreign exchange reserves continue to accrue ($1.8 trillion as of July). Fixed asset investment is rising as well (up 27% in the first eight months of 2008) and China’s sovereign debt rating is improving (S&P has raised long term ratings to A+.)

But delving into these numbers, he uncovers a startling trend: “

By the end of 2007 almost half of China’s GDP growth was attributed to exports and government consumption, a dramatic reversal from 2003 when growth was dominated by investment and private consumption.

Apparently, Chinese consumers have put their savings into the stock market and real estate. With the Chinese markets down significantly over the past 12 months, these new capitalists have taken a bath.

At the same time, Chinese investors continue to pour their money into real estate, despite a downturn in both commercial and residential sectors.

The deterioration of real-estate of course hits the economy with a double whammy: losses to investors and unemployment for construction workers.

Suddenly, China and the U.S. are looking very similar through the eyes of consumers. "…Consumer confidence, according to official Chinese statistics, is drifting downwards and Western ratings on Chinese commercial banks, the holders of unused commercial real estate, are being lowered,” he writes. “Those on the cusp of entering the middle class are faring poorly as tens of thousands of small and medium sized enterprises go bankrupt.”

In addition to the stock markets and real estate, investments in manufacturing are slipping. As we have already reported, low-cost manufacturing in China is eroding with those jobs going to countries such as Vietnam, Thailand and even Pakistan.

While the Communist Party wants to China to instead provide high-value manufacturing, the government hasn’t really put in the place the mechanisms for a smooth transition. The consequences are similar to what we experience here in the U.S: a loss of important, but low-paying factory jobs.

Mr. Klein asserts:

Unless current expansionary monetary and fiscal policies are directed at skills development, an expanded intellectual property rights enforcement bureaucracy and research and development capacity, China may be running headlong into a great economic brick wall. Rising middle class expectations, shrinking manufacturing jobs, and a lack of qualified workers are more of a threat to continued economic growth than the People’s Bank of China’s exposure to U.S. Treasury bonds.

In conclusion, he speculates that the success of the Summer Olympics may be China’s last big hurrah for quite a while.

Comments

[investor88:]

Excellent article which takes a penetrating look below the surface of the slogan "unending double digit growth the last bright hot spot in global economics, decoupling". We cannot see the underlying problems but if the Chinese stock market is down 60% in a year, we have to examine deeply.

2008 Oct 03 12:02 AM

[Bobwins:]

The stock market is small in China. There was rampant speculation and that has resulted in a crash, as it usually does.

Your article doesn't mention what I expect will also bolster the Chinese economy. China is like the US in the 50's, 60's and 70's. They are building the infrastructure to support their tremendous growth. We are talking about them dropping below double digit growth for the first time in the decade. We would kill for 5% growth.

The building of freeways, bridges, power grid, dams, nuclear power plants, rail, subway, etc. is a tremendous addition to the Chinese economy. While it won't make up for all the losses in low cost manufacturing jobs, it will be steady due to government funding.

Large infrastructure projects do not stop and start with expectations. They are building them continuously to try to catch up and stay ahead of growth. At this stage in their growth cycle, China is fundamentally a lot stronger than their fledging stock market. Bobwins

2008 Oct 03 11:28 AM

[Urbane Gori...:]

Good article and good observations on Bobwins side. I think China has great possibilities. People like Jim Rogers are very bullish on China. There are other major names that are loooking at getting back in, just because the China market is off by 60%. However, I don't think I'll be alive in 30 years, so I'm more concerned with the nearer future.

Although it is true that China is moving similarly to the US in earlier periods, we also were growing through our own natural resources and innovation. China on the other hand is too heavily invested in marketing their products elsewhere, during a period when their buyers are drying up, and when there seems to be an extreme volatility in basic materials and energy costs. couple that with the shaky IOUs that they have taken on from their major buyers, and I'm guessing we'll see a sideways trend for quite awhile. Sure hope I'm wrong.

jegan ;-)

2008 Oct 03 01:38 PM