China Not The Savior Some Thought

The economic rise of China over the past twenty years has been nothing less than spectacular, or at least it would seem so on the face of it. Many economists, analysts and political observers alike have been predicting the end of American economic and political dominance in the world in favor of a Chinese rise to power based on China's economic growth. Many others are pining hope on the so called mighty Chinese economy to rescue the world from its financial and economic doldrums. Is there truth to the thinking that a thriving capitalist economy in a communist political system will come to the rescue of the free world? Not so fast. Remember that China is still a communist country ruled by a one party system that when threatened, or perceived to be threatened, will not hesitate to pull the plug to ensure its existence. Example of this are plentiful, the latest being the squabble with Google. It is ironic to think that the very reason Chinese officials embraced economic reforms- that is survivability- may be the same reason that one day will cause the political elites in China to reverse course or at least take away many of the economic freedoms that lead to such phenomenal growth over the last two decades. There are already powerful voices in China calling for the abandonment of the new found system. The term "paper tiger economy" (no pun intended) may be an appropriate description of the Chinese economy for the following reasons:

While it may be true that the Chinese economy has been firing on all cylinders according to Chinese government figures it is also a fact that China is home to the largest poor population among the countries of the world. The gap between the very few rich and the very many poor is only growing wider and is bound to create social unrest in a country where economists predict the economy needs to grow at 8-10% year just to absorb the 20 million or so new job seekers. It is fairly easy to grow at double digits over a period when credit creation and availability was abundant and cheap; and when the start point was almost zero. That is the same period that the American consumer, by far the biggest spender, had access to unprecedented credit (not anymore, at least for now.) It is not realistic to pin hopes of rescue on a consumer that makes a fraction of what the American consumer makes. It is unrealistic to look up to a "Chinese middle class" (that does not exist) to put growth back into the world economy when the average car price is three times the average annual salary (think credit bubble given the number of cars sold in China over the last 3-5 years) and when the real estate price ratio is even worse. China's enormous currency reserves, which would otherwise give it prominence and power on the global stage, would have to, at least partially, be diverted internally to help create a middle class and to help stem the social tensions and problems created by the widening gap between the haves and the have not in the coming years. Some of this reserve may be converted into gold (see previous post "Does Gold Glitter?"). Even if you believe the Chinese government figures the reality is those figures point to an export lead economy and not an internal consumption driven growth.

The western economies, by far the most consumption oriented,(see previous post "Is There A V-Shaped recovery Of The Consumer Psyche?") are in an economic slowdown and face real deflationary pressure. The EU is the largest trading partner of China. How realistic is it to expect meaningful growth in an export dependent economy at a time when its largest trading partners are forecasting feeble growth at best. While it may be easier for America to go it alone (to decouple somewhat-which I don't think is possible) it is not the case for China because its economy is export driven and because it lacks a meaningful middle class. This is the age of globalization and the world economies are intertwined like it or not. Otherwise how can one explain the phenomena of China acting as America's banker by using American financial innovations (raising and efficiently allocating capital) to sell Chinese goods to American consumers in exchange for their dollars which in turn China uses to extend credit to the same consumer so he/she can go on buying Chinese goods or otherwise finance the American deficit.


While the steps the Chinese government has taken recently to help slowdown the runaway growth may or may not work they point to the problem the Chinese economy is facing in the coming years. Faced with a slowing world economy China pumped huge sums of money to keep its economic engine humming. But because it lacked a consuming middle class China had to direct most of the stimulus money to state owned companies that went on a commodities buying binge and built unneeded factories or entire cities that remain empty to this day. Herein lies the future headache of overcapacity at a time when the rest of the world is being thrifty. The other problem the Chinese will be facing soon is in their banking system. All that crazy lending over the last few years, mostly to state owned companies, is creating a situation not unlike the one we faced in the US, perhaps not in complexity but certainly in terms of simple loans gone bad. China has a bitter experience with such loans, dating back to 1999, which are still on the books of the so called AMCs (Asset Management Companies), otherwise known as "Bad Banks" in the west. A burst of a credit bubble or a real estate bubble will certainly trigger the need to recapitalise Chinese banks unless of course the old communist regime reverts back to its old ways.

Perhaps the most telling of the state of the Chinese economy is the fall in the premium between the A shares of Chinese companies traded on the Shanghai stock exchange and the H shares of the same companies traded in Hong Kong. That premium reached a high of 40% in favor of the A shares over the last three years. This is telling because the A shares are not available to foreigners (for the most part), meaning it is a true reflection of how the average Chinese feels about the economy.


Whether we believe the Chinese government figures or not a simple application of the test of logic should be enough to realize that China will not be the shoulder upon which the rest of the world's burden will come to rest. Rather, the Chinese economy is a paper tiger one waiting to crumble in the short term. Longer term, and after the excesses have been dealt with and as the US and the EU start to emerge out of their slumber, China will have its appropriate role to play on the world economic stage but not one that will upstage the US.