China continues to be front and center on my list of concerns, even more so than the latest Federal Reserve press release or fluctuations in the Dow.
I believe China is the single biggest risk to world economic equilibrium, even larger than Japan or Europe. This week my young associate, Worth Wray, provides us with a keenly insightful essay on what is happening in China.
China is running up against its debt capacity and its consumption-repressing, credit-fueled, investment-heavy growth model is nearly exhausted.
History suggests that China’s “miracle” could dissipate into a long period of painfully slow growth or terminate abruptly with a banking crisis and sudden collapse.
That said, China’s modern economic transformation has defied historical precedents for decades. However unlikely, China could surprise us again. Miracles will happen in the Age of Transformation.
Before we dive into recent data and explore the transformation taking place across China, let’s step back and think intentionally about the conditions that often set “rich” developed economies apart from their “poor” developing peers.
Becoming a truly developed country depends on far more than just accumulating an abundant capital stock or a highly capable workforce.
Durable growth and sustainable development depend on “social capital” – or institutional structures including property rights, the legal code and the justice system, the financial system, corporate governance, political culture and practice, tax structures, etc – which establish and/or maintain the right incentives for economic resources to be used efficiently, creatively, and ultimately, productively.
Peking University professor Michael Pettis explains: “In a country with highly developed social capital, incentive structures are aligned and frictional costs reduced in such a way that agents are rewarded for innovation and productive activity. The higher the level of social capital, the more likely they are to act individually and creatively to exploit current economic conditions and infrastructure to generate productive growth.”
Extending his argument, John and I would contend that high levels of social capital effectively incubate innovation and entrepreneurship so that, with disciplined savings and investment over time, the right incentives produce lasting wealth and ever higher levels of development.
I think MIT professor Robert Solow would agree with us on this front. Solow’s work on the US economy – which has become a textbook economics lesson – explains that innovation has accounted for more than 80 percent of the long-term growth in US per capita income, with capital investments accounting for only 20 percent of per capita income growth.
In other words, the US and the rest of the post-industrial, developed world owe their epic rise in living standards to the underlying “social capital” that properly incentivized innovation, entrepreneurship, and thus technological transformation over the past two centuries.
The lesson here is powerful. It is not enough just to mobilize resources and direct investments to the “right” sectors as China’s central planners have been doing for the past few decades.
Once the basic building blocks of economic development are at hand, they still need to be used creatively, effectively, and productively.
Like the USSR in the Cold War era, the People’s Republic has been wildly successful in mobilizing resources, but failing to use those resources efficiently may be its downfall.
Today China enjoys access to an abundance of raw materials, a plentiful supply of human capital, a large and growing capital stock and extensive infrastructure assets.
But after decades of policies meant to build up the supply of those basic economic building blocks, the institutions and incentive structures underlying its socialist market economy are deeply and inherently skewed in favor of vested interests at various levels of government.
And this is precisely why Xi Jinping’s widespread crackdown on corruption is so important. Transforming China into a more developed, consumption-driven, service-intensive economy requires that China achieve, according to Pettis, “a dismantling of the distortions and frictions that create rent for the elite, thus undermining the ability of the elite to capture a disproportionate share of the benefits of growth”.
Overcoming vested interests and reforming China’s underlying institutional structures to properly incentivize innovation is absolutely possible but it demands strong and unwavering leadership.
Among the various reforms set forth in last November’s Communist Party Third Plenum, ranging from financial liberalization to a crackdown on corruption and pollution, the most challenging is the gradual deleveraging of the Chinese economy while simultaneously rebalancing the national accounts toward a more sustainable consumption and service-heavy mix.
As John and I have argued for several months, these kinds of liberalizing reforms will not be easy and may require a far greater slowdown than anyone in Beijing publicly admits – but they are China’s only hope of avoiding either a hard landing or a long, frustrating period of depressed growth.
Debt has a cost, and that cost must be paid in one form or another.
Although Xi and China’s State Council members seem to understand this dynamic, they are not following through with timely reforms. After a period of weakness in the first half of the year, the State Council announced what could be best described as a mini stimulus in early April, which in the following months has turned into a full-blown stimulus package.
Rather than encouraging the national economy to rebalance toward domestic consumption or allowing previously misallocated capital to seek out more productive uses in “new economy” sectors like services and technology, China’s State Council is responding to slowing economic growth with more of the same: (1) government spending on railway expansion and shantytown renovations (which may or may not be productive) to replace decelerating private sector demand, (2) “targeted” interest rate cuts to encourage additional credit growth (which will almost certainly be unproductive), (3) last-minute bailouts to prevent corporate defaults (which they told the world to expect a lot more of in 2014), and (4) tax breaks for small and medium-sized enterprises (which remain seriously disadvantaged relative to larger public or state-owned firms).
Since the State Council’s announcement in early April and Premier Li Keqiang’s subsequent guarantee that 2014 economic growth would top 7.5 percent, the so-called “mini stimulus” has led to another surge in lending activity, slightly better real GDP growth (7.5 percent YOY in Q2 compared with 7.4 erpecent YOY in Q1 ), and the strongest manufacturing PMI print in eight months (51.7 in July, compared with 50.4 in April).
And, of course, Chinese stocks are surging on improving “old economy” indicators like industrial activity.
John and I believe this kind of stimulus-fueled “improvement” – although it is boosting China’s economy and lifting Chinese markets in the short term – is a very bearish sign that Beijing is afraid of the short-term pain associated with its admittedly urgent reform agenda.
This kind of about-face may reveal one of two things: (1) the reformers’ resolve is fading, or (2) the economic reality in China is more unstable than we outsiders realize.
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