For years, when asked whether I thought China would experience a hard landing, I would simply answer, “I don’t understand China. Making a prediction would be pretending that I did, so I can’t.” The problem is that today China is the most significant macroeconomic wildcard in the global economy. To understand both the risks and the potential for the future you have to reach some understanding of what is happening in China today. Last week we started a two-part series on what my young associate Worth Wray and I feel is the significant systemic risk that China poses to global growth. We are going to try gamely to finish with China today.
After 34 years of booming economic growth averaging over 9 percent per year (the longest sustained period of rapid economic growth in human history), China’s credit-fueled, investment-driven growth model is exhausted and increasingly unstable. The nation’s credit boom is well past the point of diminishing marginal returns; and no one can deny that the misallocation is widespread, with capacity utilization now below 60 percent.
Moreover, state-perpetuated distortions in the cost and availability of financing are (1) funneling huge amounts of capital toward increasingly unproductive, state-directed investments, and (2) pushing household and private business borrowers into the shadows, where the burden of substantially higher interest rates drags on household consumption.
This kind of structural distortion is a classic symptom of an overextended investment boom and a warning sign that rebalancing – whether it is induced by voluntary reforms or an involuntary debt crisis – will not be easy.
The critical adjustments – gradual deleveraging and structural rebalancing – will require a greater slowdown in economic growth and a sharper fall in still-bubbly asset prices than China’s policymakers are letting on.
It will be a sight to behold if China’s central planners can successfully rebalance the economy away from the exhausted fixed-investment and export growth engines toward a truly consumption-led economy… but they are attempting something that has never been done before, and the odds (and the historical record) are not in their favor.
If China’s GDP growth slows to 2–3 percent (a trend which may already be in progress), a corresponding decline in the nation’s appetite for commodities and other imports could fire a demand shock across its immediate neighbor in East and Southeast Asia, Australia, Brazil and the United States. It will even seriously impact Germany, which simply cannot afford a sudden disruption in its trade surplus if it hopes to preserve the euro system and keep its own banks afloat.
Considering the worst-case-scenario consequences for the world’s leveraged and interconnected financial markets, and the base-case potential for serious demand shocks to many of China’s suppliers, China’s slowdown represents a macro sea change – the kind we cannot ignore.China’s slowdown, deleveraging, and rebalancing are the most important macroeconomic forces in the world today… because they are the biggest unknowns.
No country in the history of the world that I’m aware of has been able to allow a massively leveraged bubble to pop without creating economic turmoil. But then I can’t remember when a country with resources as vast as China’s has tried to proactively manage a bubble. Can a centrally controlled economy (which has never really worked in the long run) pull this off? Can China switch to a consumer-demand-driven, decentralized system without major disruptions?.
The Chinese do have some considerable advantages that should not be readily dismissed. For one, they have a highly educated population. The government consumes a smaller proportion of GDP (if you factor out SOEs), relatively speaking, compared to any of the developed-world countries; taxes are relatively low; and the Chinese people are significant savers, far more so than their Western counterparts, which gives them a large capital base for expansion. They also hold a few trillion dollars in foreign capital (which I expect them to use). And rather than spending their income trying to drive consumption, they are spending on infrastructure that is there to be used by their established businesses and entrepreneurs.
Further, their consumer market is nowhere close to being optimized. There is massive room for growth in the consumption of all types of products and services, which of course makes China ripe for a burst of entrepreneurial growth to counterbalance the significant deleveraging that will be forced upon them as they try to slowly let the air out of their debt bubble.
To be sure, I can’t see a path that will result in 7.5 percent annual growth for the next 10 years. But is there the possibility of more “normal” growth, with the occasional business-cycle recession? If they can continue to unleash the power and drive of their private sector and not continue to prop up failing state-owned enterprises, pumping money into investments that have no final positive economic result, those measures will go a long way to solving the quandary they are in.
The world needs the Chinese to succeed. The world needs a functioning, growing China that is a responsible member of the global community and a force for stability.
If the Chinese get this wrong, we will face one of the most significant macroeconomic upheavals of our lifetimes. If they get it right, they could continue to be a key factor for global GDP growth.
The writer is an author, a commentator and publisher of the Thoughts from the Frontline newsletter.
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