china-faces-its-old-demons

China faces its old demons

Ten years ago, nobody believed in the China success story. Until very recently, everybody believed it. Was it just disaster postponed?
Some of the most entertaining writers of their generations have sharpened their teeth on ChinaÆs unlikely rise from rural poverty to feared superpower-in-waiting.

Gordon Chang wrote The Coming Collapse of China in 2001, while Joe Studwell wrote the bestselling The China Dream a year later, essentially a sophisticated exercise in mockery, as he tried to deflate the dreams of Western businessmen flocking to China.

Chang and Studwell both seemed to take ChinaÆs burst of prosperity as a personal insult and wrote very rude but entertaining books û although Studwell focused more on denying ChinaÆs prospects for reaching Great Power status, rather than on forecasting an economic collapse. In any case, Western businessmen and Chinese officials ignored the artists and set about pushing China into the 21st century.

But economic time is a strange phenomenon. Trends can be detected early or late, but there is always an unpredictable lapse between their detection and their impact. Richard Duncan, for example, wrote a brilliant book a few years ago about the decline of the US dollar. It appears to be right in every detail, apart from the fact that the dollar is currently at its strongest level for years. Of course, the dollar could still crash, but it is safe to say that while insights can be perfectly accurate û they may reach fruition at unexpected times and places.

Chang forecasts three outcomes that could all or separately undermine the Chinese communist state. The first was a disastrous stock market crash; the second was a collapse to African levels of poverty on the back of mis-allocated government resources; and the third was war with Taiwan. ChangÆs forecasts were partly right, but mostly wrong. There was a collapse in the stock market, which is currently down 60% from its peak. But this is the second sharp drop in five years, so itÆs likely investors learnt their lesson the first time around: treat the stock markets like a casino, and not too seriously. As for the infrastructure projects, which Chang predicted would involve massive corruption and waste, they are now the shining jewels in ChinaÆs modernisation. The great highways and giant airports that have sprung up all across China create the impression of a rather special developing country, at least compared to Southeast Asia and India.

ChinaÆs state-owned companies (SOEs), also an object of scorn in 2001, have been reformed, slimmed down and are now profitable and competently run û proof that the communist party has defied its ideological contradictions and injected itself with a substantial measure of market savvy and executive skill.

Two other predictions have also been proved wrong. Chang suggested a collapse led by corruption and inefficiency in the state-owned banking sector. But ChinaÆs government has not only cleaned up, recapitalised and listed its banks abroad, it has also been able to generate genuine growth. The governmentÆs fiscal situation is extremely good, with little debt, and its foreign exchange reserves are bulging. FX reserves are composed of many things, whether foreign direct investment (always a strong point) hot money, income from overseas or a current account surplus, but at some level they are all a vote of confidence in a country. In 2001, ChinaÆs FX reserves were a fraction of what they are now.

But the main aspect that Chang did not foresee was ChinaÆs amazing export performance. Ironically, that was enabled by ChinaÆs earlier massive fixed asset investments û which at one point accounted for 50% of GDP. Exports are officially over 30% of GDP (although some academics dispute this figure) and half of the FX reserves are estimated to come from the trade surplus.

ChinaÆs model of welcoming foreign direct investment and letting foreign firms set up export joint ventures with local firms has proved to be an unqualified success for China, if not always for the foreign partners.

Studwell foresaw this, but claimed that China would never rise beyond foreign-led, low-level exports. In fact, the domestic component of ChinaÆs exports has risen, even though itÆs still less than 50% of the total. High-tech exports show a more pessimistic story. Studwell writes in a recent article for the Far Eastern Economic Review: ôThere is no indication the same trend (of Chinese companies taking export share from foreign-invested companies) may be occurring in high-tech exports.ö

However, in those very exports lie the problems today. Like all Asian countries, ChinaÆs exports are ultimately dependent on credit-drunk countries far to the West of it û the US, mainly, with some help from Europe. But with the current financial crisis causing recessions through the developed world, what will be the effect on China?

If you lose the exports, you get back to the situation described by Chang, at least to a certain extent. You lose a major growth driver, you lose employment and you lose a source of foreign exchange. You are then thrown back on a ferociously competitive domestic market. James Galbraith, son of the famous economist John Kenneth Galbraith, estimates (along with many others) that Chinese firms donÆt make profits domestically. They use their domestic market as a way to generate scale and to experiment. The profits are earned abroad.

So what happens when these small, ferocious firms see their exports dry up? Well, nobody knows. The weak point of the Chinese banking system is providing finance to small and medium-sized enterprises (SMEs). These firms, even more than in other markets, will likely not get a sympathetic ear from their banks. Chinese banks are not known for their credit skills, and they tend to discourage SME customers.

In any case, the banks will be coping with their own inevitable spike in nonperforming loans. Not surprisingly, several reports have already emerged of significant social troubles in the south of China as factories close down. In ChinaÆs favour (and a point Chang did not forecast) is its reserves. With $2 trillion in foreign exchange reserves, a reformed tax system that has brought huge amounts of income, as well as personal incomes growing at 15% a year, China has got a significant financial buffer for riding out the crisis, as well as a relatively unleveraged government balance sheet.

Some analysts forecast a consumer-led economic revolution. Exports could be turned inwards; the currency could appreciate, encouraging cheap imports and raising standards of living; ChinaÆs middle class could become a growth engine in its own right û and behave more like the American economy.

However, not all analysts are optimistic that this outcome will materialise. Stephen Green, Standard Chartered BankÆs China economist in Shanghai, says that China is still a long way from such a state of affairs.

ôLook a bit more closelyàand you will see that a chunk of the consumption spending [for 2007] was government, not household, spending. The latter only accounted for 35% of demand in 2007. We are less excited by a consumption-driven society if it is the government doing all the spending,ö he writes in a recent report. Green goes on to note ChinaÆs critical lack of a social security infrastructure as the element preventing a consumption-led boom. And it could take too long to set up one in time, as the financial crisis gets wider and meaner.

Green has a worryingly low forecast for ChinaÆs economic growth: 8% next year, and 7% the following year. That latter figure is especially troubling, because 8% is a common figure cited as the minimum needed for China to maintain sufficient growth to stifle social problems (such as maintaining employment levels). For comparison purposes, ChinaÆs 2007 growth rate was more than 12%.

There is no denying it. China is facing perilous times. China, Japan, Europe and the US are facing an unprecedented simultaneous economic slowdown, and as a developing nation, China is intrinsically less able to cope. China defied that logic in the Asian financial crisis of the late 1990s, but 10 years later, it may ironically be about to pay the price for a more open, modern and global economy.

This story was first published in the November issue of FinanceAsia magazine.
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