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China: There May Be Trouble Ahead

December 1, 2009

China: There May Be Trouble AheadMartin McCauley writes: The twenty-five-year economic boom in America and the West is over. It was based on credit, consumption and wild risk taking. A new model is now needed. One based on high employment, innovation, significant reduction of pollution and more moderate risk taking. It may take another decade for this new model to emerge.China also needs a new economic model. To overcome the defects of the old system Beijing has pumped in a fiscal stimulus of about 16 per cent of GDP. Add to that bank lending of about 25 per cent of GDP in the first nine months of this year. The reason why so much money has been poured into the economy is to ensure that the growth rate will be at least 8 per cent this year. Eight is a lucky number in China. However, the creation of excessive credit has its dangers – just look at what happened in Dubai. China cannot simply continue to pour in vast sums of money hoping the world economy will recover to soak up its exports. Investment in the rural economy is vital as is a boost to domestic consumption.

China is one of the most rapidly ageing societies on earth. In 2040, China will have more people over 65 than the United States. Strange as it may seem, a labour shortage is on the horizon, beginning in at least 2020. There is a pool of up to 100 million rural migrant workers but it will dry up over a decade. Two thirds of the labour force still work in the countryside and there is a huge imbalance between the eastern seaboard and the rest of the country in terms of incomes.

China has foreign currency reserves of about $2.3 trillion, with over half of that in US dollar securities. Much of this is in long term US treasury paper or global securities which are still trading far below their 2007 levels. In other words, China has been investing its huge kitty poorly. Lots of money was passed to state companies to acquire natural resources in the developing world. Many of the assets were bought at the top of the market.

Chinese industrial capacity expanded an astonishing 26.9 per cent during the first nine months of this year. Infrastructural investment rose 52.6 per cent year on year during the first nine months of 2009. Railway investment jumped 88 per cent. High speed trains are one of the products of this amazing spending spree. At a time when world demand for industrial products is weak, the only thing to do with the increased output is to stockpile and expand inventories. This makes no economic sense. One Western banker thinks China will invest $2.5 trillion in the years to 2010. One sixth of this will be invested in failing companies which will never repay the loans. This will double the country’s total of non-performing loans to about $1 trillion. China can survive this if the economy can continue to grow by 8 per cent.

However, this is unsustainable. One projection for 2020 is 5 per cent growth. Lax lending criteria have to be curbed. But has the government the willpower to do so? Politically it may feel it dare not restrict credit to large state corporations.

The government needs to make life easier for the vast majority of its citizens. University education, outside the elite centres of learning, is third rate. Huge numbers of graduates are being produced like any other mass produced product. The reality is that jobs for them are drying up. On average they are no better off than skilled workers. Health is a problem. Many families have to borrow in order to pay surgeons to perform operations. Over the last few years, the average worker is finding it harder to make ends meet. The service sector is a state monopoly and hugely inefficient. The government has shied away from introducing competition into goods distribution and logistics. Private entrepreneurs would transform the sector. On the face of it, this unwillingness to permit change is difficult to understand from an economic perspective. However from a political point of view it is quite easy to grasp. The Communist Party of China (CPC) is simply afraid of losing control of the economy. The small reforms of the early Gorbachev years led eventually to the collapse of the Soviet economy. The CPC is terrified that something similar could happen in China.

Hence the present leadership is very nervous about introducing any reform. It feels insecure and prefers to do as little as possible. Asked about their vision for the future, Party officials provide answers which can be paraphrased as ‘more of the same’. In other words, keep everything as it is now. The problem of this is that sooner or later economic reform will be necessary. If it does not come from above, it will come from below. A dangerous scenario for a country that is positioning itself as the world leader of the future.

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