The Chinese economy has been sprinting toward the Olympics at a blistering pace. But what happens when this summer’s games draw to a close? Most observers assume that China will maintain its double-digit rate of economic growth in the years to come. But not everyone shares this view. Dissenters argue that China’s economy resembles an athlete on steroids. Although its recent performance has been nothing short of miraculous, the Chinese manufacturing juggernaut has been weakened by exertion and may well be on the verge of a serious collapse.
Still, there is no shortage of China cheerleaders out there. Earlier this year, Business Monitor International put out a report with the apparently downbeat title “China: What If We’re All Wrong?” Nevertheless, even BMI anticipates that the Chinese economy will grow at an annual rate close to 10 percent into the foreseeable future. Books such as Jim Rogers’s A Bull in China reflect excitement about the economy, which most forecasts say is set to overtake that of the U.S. within the next couple of decades or so.
This view of China’s prospects may prove correct in the long term, but clouds are appearing on the horizon, says Jim Walker, former chief economist of Hong Kong brokerage CLSA and founder of Hong Kong consulting firm Asianomics. Walker adheres to the Austrian school of economics, whose famous exponents include Ludwig von Mises and Nobel laureate Friedrich von Hayek.
Austrians are obsessed with interest rates and particularly with what happens when central banks apply the wrong rates. When interest rates are too low, they argue, credit expands too rapidly. This stimulates investment and fosters asset price bubbles. Eventually, credit “inflation” shows up in rising consumer prices. But by then it’s too late to stop the damage. The boom ends, revealing the misallocation of capital, or “malinvestment,” as the Austrians call it. There then follows a painful readjustment back to economic equilibrium.
The type of boom described by the Austrians typically occurs when consumer price inflation is quiescent. This allows the authorities to keep rates low and lets credit expand rapidly without any immediate impact on costs. Such were the conditions in the U.S. in the 1920s. William White, an economic adviser at the Bank for International Settlements, says that era was characterized by low inflation, “technological innovation, rising productivity, rapid increases in the prices of equity and real estate and strong fixed investment.” In other words, the U.S. economy in the roaring ’20s had much in common with that of modern China.
Asianomics’ Walker believes that Beijing has allowed an Austrian-style bubble to inflate in China. In equilibrium, he argues, short-term interest rates should be roughly in line with the economy’s nominal GDP growth. But China has actually enjoyed interest rates well below the rate of inflation even as its economy has been expanding rapidly. Negative real rates are a consequence of China’s policy of pegging the yuan to the dollar. To prevent the currency from appreciating, the People’s Bank of China has been forced to acquire ever larger amounts of dollars. The expansionary consequences of this policy could have been neutralized by the PBC’s issuing “sterilization” bonds to soak up yuan issued to buy dollars. But the number of such bonds issued in recent years has been inadequate, says Walker. The result has been strong credit growth. This, in turn, has fueled an extraordinary boom in investment, which has been growing 25 percent a year and constitutes about 40 percent of GDP. Most of the fruit of this new investment has been exported. The trade surpluses have meant more intervention in foreign exchange and further credit growth. For a while this must have seemed like a virtuous cycle. Now it’s turning vicious.
Chinese export growth is set to fall sharply as the credit crunch wreaks havoc on both sides of the Atlantic. Many claim that Chinese domestic consumption will take up the slack, but this seems unrealistic. As Walker points out, the U.K. alone consumes more than China and India do combined. China’s economy has been driven by investment and exports, not by domestic consumption. In fact, consumption in China has failed to keep pace with economic growth, which is why the trade surplus has continued to rise.
There’s another problem. The credit boom has at last erupted in widespread inflation. Reported CPI topped 8 percent in China earlier this year, but in reality it’s a good deal higher, says Walker. The costs of commodities and the wages of workers have soared, leaving the authorities with little choice but to tighten monetary policy. Real credit growth has already slowed sharply, to about 6 percent, suggesting that the economy will be even weaker next year than expected.
After falling for years, the prices of Chinese exports to the U.S. have started to climb. Rising inflation and the revaluation of the yuan against the dollar mean China is losing its position as the world’s low-cost producer in some sectors. Strategic Forecasting, a Texas-based business intelligence agency, recently reported that the textiles industry, which accounts for half of China’s trade surplus, is under stress and clamoring for the reintroduction of export subsidies. Owing to rising costs, Chinese containerboard companies recently stopped shipping abroad, according to management consulting firm Fischer International Corp. U.S. newspapers report that some American companies are moving manufacturing back home from China.
There’s little doubt that many ill-conceived projects were financed during China’s boom. A recent article in the Abu Dhabi–based National newspaper said fewer than a dozen of a projected 1,500 shops are currently open in the South China Mall, the world’s largest, which opened in the southern city of Donnguan in 2005. A May report from Lehman Brothers said “an export-led slowdown could trigger a chain reaction which, in the worst case, could threaten the stability of China’s financial and economic system.”
An Austrian-economics-style analysis suggests that the outlook for Chinese companies is bleak. Profits are set to be crushed by weak export growth and rising input costs when a record amount of new investment is coming onstream. China’s “malinvestment crisis,” as Walker calls it, will not damage the country’s long-term prospects. However, a sharp economic slowdown will dampen the demand for commodities and deal another blow to Shanghai’s beleaguered stock market. It will also make a revaluation of the yuan less certain. As London-based private economist Andrew Hunt notes, the Chinese business cycle normally ends in devaluations, not revaluations, of the currency. Yet in April, with revaluation looking like a sure bet, some $50 billion of hot money entered China. It’s difficult to think of a better way for Beijing to punish noisome speculators than by frustrating such expectations.
Edward Chancellor is the author of Devil Take the Hindmost and a senior member of GMO’s asset allocation team.
