CHINA: NEXT SUPERPOWER OR NEXT SUPERBUBBLE?

Current economic discourse proceeds on the almost unquestioned assumption that China is on track to become the World’s next superpower. What is in dispute is not if- but when- China will depose the United States, which in recent years has been beset by grave economic dislocation. China’s rapid economic expansion over the last three decades has left many people confident that the once impoverished nation will soon rise to challenge the West’s centuries-long dominance.

Although I have never believed this to be a terribly likely prospect, I have to admit to being ignorant of China’s economic fundamentals for a long time: assuming that popular opinion on China’s economic future- though unrealistic- did have grounding in fact. It was not until the emerging markets rout in late 2013 that I began to have serious misgivings about the integrity of China’s economy. Before I lay down the reasons for said misgivings, let me take you back to the 1980’s: to a case I believe very closely parallels that of China today. History is the best teacher, and I believe that if the past is any guide, the future bears serious agony for China.

In the 1980’s, there was an Asian country that many believed was only one or two decades away from displacing the United States as superpower. The country had risen from a crushing defeat in World War 2 to become one of the world’s major industrial states by the 1970’s. This country’s name is Japan. Japan tripled its real per capita income from less than $5000 in 1960 to more than $15000 in 1980. Along with this came a standard of living that rivaled that of many Western nations. Japanese industry became the bane of American manufacturing: Japanese companies such as Toyota, Mitsubishi, and Sony were able to undercut their American counterparts by matching- even surpassing- their quality and yet offering prices that the Americans could not feasibly match. In 1950, the United States produced 75% of the world’s automobiles while Japan’s automobile output was less than 1% that of the United States. By 1970, Japanese automobile production had reached 75% of U.S. production and by 1980, Japan had outstripped the United States in automobile output.

In the 1980’s, Japan’s climb to the top seemed unstoppable. The Japanese model of state-managed crony capitalism was celebrated by pundits in the U.S., who at the same time decried America’s ‘clumsy’ system of free enterprise with its obsessive focus on short-term profitability. The Japanese model, it was claimed, put long-term goals ahead of short-term profitability. Robert L. Keanes wrote:

“Toshiba and other major Japanese corporations can go flat out for market share and ignore short-term financial considerations because they face little or no risk. There will be no takeovers, no greenmail, no LBOs, and no white knights, because two-thirds of the shares of a Toshiba, or a Sony, or a Toyota are in the hands of other corporations and institutions that are in turn owned on a reciprocal basis. The corporations own each other and are operated not to maximize returns to shareholders, but to minimize risk and thus to maximize long-term earnings. Indeed, there are guarantees against risk.”

What attracted people like Keanes to this system of cronyism and cross-shareholding would shortly turn out to be an Achilles heel that would play a major part in Japan’s fall from grace. Resources in Japan were being allocated, not according to where they were most valuable, but according to the industries that corporate and government leaders believed to be most crucial.

The fanfare surrounding Japan was perhaps best immortalized by Massachusetts Senator Paul Tsongas with his pronouncement: "The Cold War is over; Japan won." Famous last words, as it would shortly turn out. We all know how the story of Japan ends. Loose monetary policy on the part of the Bank of Japan inflates a real estate and stock market bubble that plunges the country into a two-decade long (and counting) recession when it deflates in 1990. By the close of 1990, the stock market had fallen by close to 50% from its 1989 high. The government of Japan tried to jumpstart the economy through monetary and fiscal stimulus but aside from adding a quadrillion dollar yen debt to its bottom line, little else came of these efforts. Although Japan had definitely caught up with the United States in several respects, it could not forge ahead with its system of entrenched cronyism and planned capitalism. The Japanese model was superb for replicating the innovations of the west, but impotent at creating its own. This is hardly surprising, given that America’s greatest innovations of the twentieth century had rarely come from established corporations- much less from government- but from individuals lacking in both pedigree and state backing. Henry Ford, Montgomery Ward, and Bill Gates were not impelled to innovation by government fiat. A system of free enterprise free from overt government favoritism enabled such ordinary blokes to change their respective fields irrevocably.

Let’s return to China. Will China face the same fate as Japan as it approaches the technology frontier? Can China’s system of state-run capitalism propel it to the very top of the global food chain? How sustainable is China’s growth model in the long run? Could China somehow defy the odds and top the economic and political muscle of the west?

Foremost, China’s economy is nearly as splendid as it may seem at first blush. Although China is the World’s second biggest economy after the U.S. in GDP terms, China holds 20% of all mankind. Accordingly, China’s per capita income is at the level of most Third World states. In 2012, according to World Bank data, China’s per capita income was only $6091; putting it below such countries as Botswana ($7238), Peru ($6798), and Colombia ($7748). It follows then that even assuming that China can sustain past levels of growth over the coming decades, it would have to grow its per capita income eightfold just to match the United States’ current per capita income ($51,749).  How likely the accomplishment of such a feat is cannot be known, but it can easily be surmised based on current global macroeconomic trends.

China began its ferocious economic expansion in the early 1980’s. After close to three decades under Mao Zedong’s calamitous economic policies, Deng Xiaoping- China’s leader after Mao- began China’s transformation from a rigid command economy to a socialist market economy that allowed market forces a greater role in the allocation of resources. Initially beginning with experiments in the provinces, Deng’s administration stretched out the compass of market reforms to virtually the entire country. The results were all but instant. By 1989, China’s grain production had risen 600%. Per capita income rose from roughly $520 in 1980 to upwards of $6000 in 2010 (adjusted for purchasing power parity).

China’s thirty-year run was driven primarily by exports to wealthier states and the asset investment attending the expansion of industry. But when the financial crisis of 2008 hit, the cracks in China’s export-led model began to show. The situation was not helped by the debt crisis in Europe, which dealt another blow to Chinese exports. To forestall a potentially dangerous economic slowdown, the Chinese government turned on the printing press, pumping $586 billion of new money into the economy. The government also relaxed lending standards via state-controlled banks, fuelling a credit and construction boom that has kept the country’s economy expanding. Since 2008, the Chinese government has invested heavily in enormous infrastructure projects. In the Keynesian tradition, the government has in some places torn up usable roads and rebuilt them to create employment.

But these stimulative measures have come at a tremendous cost. Chinese indebtedness has swelled from $9trillion in 2008 to north of $23 trillion today. The expansion of credit has inflated a property bubble whose implosion could see China hit the canvas. Housing prices in China have been rising obscenely since the stimulus began. In the major cities such as Shanghai and Shenzhen, housing prices have been going up by almost twenty percent year-on-year. With returns from bank deposits unable to keep up with inflation, people in China have turned to real estate both for profit and as a store of value. The feeding frenzy in the property market has manifested itself best through the spectacle of ghost cities. Spread across China are dozens of uninhabited see-through cities- many of them more than a few years old. In spite of this apparent oversupply, housing prices have continued to soar as borrowing costs remain low and real estate remains in demand as a speculative vehicle. It is estimated that up to 60% of China’s GDP derives from construction and auxiliary industries. There are about fifty million construction workers.

The fat will hit the fire when borrowing costs rise. Chinese corporations and local governments are highly leveraged and typically rely on new loans to pay off old ones. A rise in interest rates could lead to massive defaults and bankruptcies- and consequently a 2008-style credit crunch. Needless to say, a credit crunch would not just hurt local governments in China; it would knock the bottom out of the property market. A property implosion would devastate commodity exporters such as Australia and Canada. Hedge fund manager James Chanos describes China as being on a ‘treadmill to hell’, with growth being driven primarily by ‘the heroin of property development’. The Chinese Communist party has already begun to tighten its monetary policy: a prudent step in the long run but an extremely dangerous one in the short-term for an economy as leveraged as China’s. Like with Heroin, withdrawing cheap credit is bound to have grave short-term ramifications. Also, the CCP’s action may be coming too late.

The Communist Party’s claim to legitimacy has been China’s exceptional economic rise under its steerage. The CCP knows better than any Western observer just how contingent on China’s economic trajectory its grip on power is. Even its heavy hand would not keep the people away from Tiananmen Square for too long if the economy tumbled. As China continues to prosper and open up to the world, an expanding Chinese middle class is demanding more citizen participation in governance. If numbers say anything, dissatisfaction with the CCP’s authoritarian government is multiplying. In 1993, there were 8700 public protests in China, as against more than 86000 in 2005. To still the public, I feel the Communist Party will do anything to keep the party going. Governments tend to take the easy way out and this is what I expect the CCP to do: to keep the Bubble on life support as long as possible. Should a tighter monetary policy take a bite out of China’s GDP growth, I would expect the government to push interest rates back down.

 
China has been the toast of those looking for an alternative to laissez-faire free market capitalism. For the best part of the last three decades, it seemed as if China had offered an answer to ‘Anglo-saxon capitalism’. But on close scrutiny of China’s economic profile, it becomes apparent that the nation is living on borrowed time- and money.