/ 22 August 2009

China speeds towards crisis

China is heading for big trouble. Fearful of a political backlash from the sort of deep recession in the West, Beijing has embarked on a programme of reckless expansion that provides short-term gain with a cost of long-term pain.

This is an unfashionable view. The conventional wisdom is that China has taken the bold steps necessary to tackle the global downturn, and that its mixture of Keynesian pump-priming and Leninist centralised control will help drag the rest of the world back to prosperity.

Strategically, it’s a pivotal moment. It is assumed that, at some point in the 21st century, the United States will cede the role of the world economic (and hence political) superpower to China, and that the slump will hasten this process.

Why? Because traditionally it has been the US that has acted as the locomotive for the rest of the global economy and this time China is in the vanguard. If German manufacturers now look to Guangdong rather than the Midwest to boost their order books, that marks a shift in power.

Half of this argument rings true. The US remains by far the most powerful nation on earth, but bubble economics and military overstretch have sapped its strength.

After years of living beyond their means, American consumers are now cutting back fast. Rising unemployment and pay cuts meant that total pre-tax household income was down 3,4% year on year in June, and even after President Barack Obama’s tax cuts were taken into account disposable income was down 1,3%.

With unemployment likely to hit 10% in coming months and total hours worked in the economy’s private sector down 7% on a year ago, the US is in no position to act as the buyer of last resort for the rest of the world.

The US economy has deep-rooted problems: it has a hollowed-out industrial base, over-indebted consumers and a crippled housing market. To make matters worse it now has an exploding budget deficit and rising long-term interest rates. There is a real risk of a double-dip recession in the US.

All eyes are now on China to see whether the world’s biggest developing country can pick up the baton.

On the face of it, there are encouraging signs. China’s economy bounced back in the second quarter and on some estimates grew at an annual rate of almost 15% in the three months ending in June. Put another way, the global economy grew by 1,6% in the second quarter; without China it would have been flat at best.

The optimistic case is that China is doing the heavy lifting for the rest of the world by pouring trillions of yuan into infrastructure projects and expanding its money supply. Beijing’s actions will provide an outlet for exports from the rest of Asia and from Europe, giving the US time to recuperate.

This is too good to be true. Firstly, China, despite its explosive growth in the past 30 years, remains a much smaller economy than the US. Measured by market exchange rates, the size of its economy is only about 20% that of the US or the European Union, and that limits the extent to which it can act as an economic locomotive. Nor are its economic statistics squeaky-clean.

John Makin, in a piece for the American Enterprise thinktank, says China is having a “bogus boom”. Dodgy accounting practices, he said, meant that goods count as sold when they leave factories, not when they are actually bought by consumers, and bank loans count towards GDP as soon as they are disbursed, even if companies hoard the cash or use the money to buy shares.

Second, China’s growth has been dominated by investment and exports. Consumption has accounted for a declining share of national output, in contrast to the West, which means — as the Marxist writer Chris Harman notes in his forthcoming book Zombie Capitalism — that the colossal increase in production cannot be absorbed domestically. Instead, the surplus goes into still higher levels of investment or is channelled into overseas markets.

Though it is comforting to believe that the leadership of the Chinese Communist party calmly produced a blueprint for global recovery, the reality is different.

President Hu Jintao’s government is petrified by the possibility that recession will lead to social unrest. As Jonathan Fenby put it for Trusted Sources, a research group that specialises in emerging markets: “China’s policy responses to the current economic downturn are being powerfully shaped by political factors, given the regime’s need to maintain its claim to legitimacy through growth.”

In political terms, the policy is working. Opinion polls showed that people in China are far more positive about the prospects for the economy than people in the West. Economically, though, there is a cost. Chucking money at the economy will lead to an even bigger problem of over-investment, an explosion in bad loans and a tendency for a good chunk of the increase in the money supply to leak out into speculation.

This approach to crisis management is nothing new. China has responded in the way that Alan Greenspan did after the dotcom crash: it has solved the problems of one bubble by creating another.

China’s fiscal boost is being spent on domestic infrastructure projects rather than on the military spending and tax cuts favoured by George Bush, but by copying what Washington did between 2001 and 2003, Beijing is running similar risks.

The reports of a spate of fake mortgages to buy flats on bank credit have clear echoes of the sort of malpractice associated with the subprime scandal in the US.

In June, the China Banking Regulatory Commission warned of “grim credit and market risk” as a result of a fall in corporate earnings and excess capacity.

It is encouraging news that Chinese leaders are aware that big trouble could lie ahead. But doing something about it is a different matter. Tackling China’s underlying economic problems will be tough. But if Beijing ducks the economic challenge for political reasons, the consequences could be severe.

Albert Edwards, analyst with Société Générale, says China is now an accident waiting to happen. “If the US in 2007 was a slow-motion train wreck, China will at some point soon be pile-driving straight into the buffers.” —