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BACON: A bubble wrapped inside a mystery

No one knows whether Asian giant’s economy is artificially inflated

- The Washington Times - Wednesday, October 20, 2010

How the world has changed: The decision by China's central bank to raise key interest rates by one-quarter of a percentage point has sparked a worldwide sell-off in stocks, commodities and emerging-markets currencies. Investors have lowered expectations for Chinese growth, which many see as a driver of the global economy.

The rise of China's influence upon the global economy makes long-term prognostications about just about any topic related to trade and capital flows, commodity prices, interest rates and economic growth subject to a crucial caveat: depending on what happens in China.

The difficulty in divining the future is that China is opaque. To borrow Winston Churchill's description of Josef Stalin's Soviet Union, it is a riddle wrapped in a mystery inside an enigma. To be sure, China has opened up since the days of Mao Zedong, but it is still an enigma. Government restricts the flow of news, the economy is built upon crony capitalism and insider dealing, and outsiders are justifiably suspicious of the quality of numbers reported by the Chinese government and corporations. Indeed, I have long suspected that much of the Chinese economic miracle is one big Enron of shady accounting kept aloft by the credulity of investors bedazzled by the country's vast potential.

To be sure, China's economic impact is real. The country has emerged as the world's largest energy consumer. It is the world's second-largest market for automobiles. Its manufacturing economy has a voracious appetite for oil, iron ore and strategic minerals. With increasing buying power, the growing middle class is eating more, influencing global demand for agricultural products. Now that China has emerged as an importer of hen and bird eggs, the old phrase, "What does that have to do with the price of eggs in China?" takes on a new meaning.

But China moves more than commodity prices. The country holds roughly $1 trillion in U.S. government debt, roughly comparable to Japan. China's phenomenal savings rate, approaching 50 percent, helps keep the world flush with investment capital. China also is the world's workshop, an integral part of global supply chains for everything from computers to bedroom suites. China's low manufacturing costs keeps the price of consumer products low - and its huge labor supply depresses wages in countries, like the United States, where corporations are free to outsource jobs.

The prevailing expectation is that China's economy will continue to grow at historical rates of 8 percent to 10 percent annually. China's economic weight on the world stage will equal that of the United States within the next 20 to 30 years. China will drive energy, raw material and agricultural commodity prices higher. It will flood the world with capital, keeping interest rates low. And it will continue exporting more products, eroding America's manufacturing base and threatening more jobs.

But what happens if, contrary to all expectations, China's economy implodes? What if China turns out to be no more of an economic superman than, say, Japan was in the 1980s, when the "smart" money said Japanese-style capitalism and its government-directed industrial policy would supplant American-style free-market capitalism? No country in the modern world has maintained growth rates on the scale of China's without suffering booms and busts along the way.

One must ponder at least the possibility of a Chinese downturn. A recession could trigger a banking collapse if people begin to question the solvency of China's financial institutions. How many "extend and pretend" loans are on the books of Chinese banks? We don't know the answer even for American banks, with all their reporting requirements. We can only assume that the percentage is far higher in a country dotted by vacant office towers and empty malls, a country where banks make shaky loans to government-owned enterprises on the basis of political connections.

What happens if the financial edifice collapses, adding to the misery of an economic downturn? What happens if the population, already restive and prone to violent demonstrations, comes to see the government as illegitimate? What happens if civil turmoil spreads, closing factories, railroads and ports and disrupting the global supply chain? What happens if the Chinese government, resorting to desperate measures, sells off liquid assets around the world - including its U.S. Treasury securities - in order to shore up its situation at home?

If China implodes, everything we thought we knew about our own economy will be subject to change. Insofar as the future of China is a riddle wrapped inside a mystery, so our own future is inscrutable, too.

James A. Bacon is author of "Boomergeddon" (Oaklea Press, 2010) and publisher of the blog of the same name.

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