A global financial market sell-off was triggered, among other factors, by a 9 percent market decline in the Shanghai exchange Feb. 27. Was this plunge just a normal correction in a volatile, overheated emerging market exchange, or the harbinger of deeper problems, even the early warning of what some think is a bubble economy? Without pretending to answer this question, it is useful to review some signs of excess in the Chinese economy.
The late Herb Stein, a chairman of President Nixon’s Council of Economic Advisers once remarked: “Things that cannot go on forever, won’t.” Most economists think certain structural elements of the Chinese economy are unsustainable in the medium- to long-term.
China’s economic growth is propelled by fixed investment and exports, as the table shows. Private consumption accounts for barely more than one-third of total output (down from around half in the 1980s), a sharp contrast with more than 70 percent in the United States and more than 60 percent in Japan, Europe and India. Two-thirds of its growth in 2006 was accounted for by the investment and export sectors, instead of private consumption, which typically drives the U.S. economy. Moreover, the sheer size of the investment sector — around 40 percent of output — is unprecedented, even compared with the investment and export-driven Japanese, Korean, and Taiwanese economies of the 1960-2000 period.
What is unbalanced about all this, in addition to a current account surplus nearing 9 percent of gross domestic product (which in itself is fueling a backlash in the United States, Europe and Japan), is the gap between investment and consumption as sources ofgrowth. China’s reliance on investment (and exports, which is related) makes it uniquely vulnerable to swings in the global economy and to an appetite for investment seemingly detached from real demand.
Take the steel sector, for example. China became the world’s largest steel producer, at a bit more than 100 million tons, in 1996. Its capacity has since grown to well more than 500 million tons — double that of the United States and Europe combined. China has around 150 million tons of excess capacity, which results in expanding exports and lower profitability.
In 2005, according to China expert Nicholas Lardy of the Peter G. Peterson Institute for International Economics, the ferroalloy industry operated at 40 percent of capacity, the auto industry at 68 percent of capacity, with similar excess capacity in aluminum, cement and coke. Property markets, too, expand at a dizzying pace.
Fueling this astounding growth in excess capacity is the high personal savings rate in China and the undervalued yuan. These factors discourage domestic consumption, lower interest rates, and, together with tax and political incentives for local development, funnel excess liquidity toward new investment.
In turn, the investment bubble, by lowering profit rates, further weakens an already ailing and dysfunctional banking system, and discourages the politically sensitive leadership from the fundamental reform which would, over time, redress the many imbalances. Instead, the Chinese have tended to employ administrative guidance, tax incentives and new regulations to try to take some steam out of the investment frenzy. A strong yuan would also work to unwind the imbalances, but the authorities fear that moving too quickly will engender a crisis of confidence, undermine the export-led model, and, perhaps, trigger a recession.
China’s leadership has been, thus far, skillful in promoting the unique Chinese model of growth without significant setbacks (except in 1994 when a growth slowdown led it to devalue the currency and embark on an even more explicit export-led growth path). One should not bet against their continued success in managing further economic development, given this nearly 30-year period of unprecedented growth.
However, as China becomes ever more integrated into the global economy, as its citizens taste the benefits of hard work and economic prosperity, and as the idle capacity mounts in industry and real estate and pressures the financial system even further, the model will have to be modified to avoid a very hard landing. Stimulating domestic demand via structural reform, repairing the social safety net and lowering the yuan’s value, make up the best formula for China to unwind these imbalances.
The Chinese are famous for employing long-time horizons in their analysis, but, as implied by Herb Stein, the basic laws of economics (and politics) cannot be forever in grave imbalance.
Thomas J. Duesterberg is president and chief executive officer for Manufacturers Alliance/MAPI Inc.