By Paolo von Schirach
March 14, 2014
WASHINGTON – Until very recently a large number of Western analysts bought the idea that China created a unique, unprecedented, in fact almost gravity-defying growth model. Its economy is recession proof. And (until very recently) it kept growing and growing at a fantastic 10% rate, year after year, without suffering any of the traditional ailments experienced by its (inferior?) Western counterparts. China had no boom and bust. No inflation or deflation issues. Even though the pace has slowed a bit (from 10% to 7.5%), China keeps investing and it keeps growing. The conclusion reached by many is that the super smart Chinese technocrats, carefully selected and groomed by the ever provident and wise Communist Party, have invented something new, and quite superior.
China’s export-led economy worked well
Well, may be all this optimism was a bit exaggerated. The fact is that China did extremely well until it could expertly exploit unique domestic advantages, most of them resting on abundant, obedient and super cheap labor and on the ability of the state-owned banks to direct mountains of captive private savings pretty much where they wanted.
The export-led model, supported by the rapid modernization of all infrastructure enabling international trade, worked spectacularly well. Amazingly cheap Chinese products, the net effect of cheap labor, destroyed many Western competitors. Chinese manufactures supplied fantastic quantities of basic consumer goods (anything from toasters to T-shirts, vacuum cleaners, toys or silverware) to millions of Americans and Europeans at rock bottom prices. Export markets grew and grew.
The magic is fading
But now the magic has started to fade. Export markets are saturated. They cannot grow by 10% a year, every year. And Chinese labor is not so cheap any more. Wages are going up in China, therefore Chinese goods are no longer super competitive. And in sectors in which labor costs are less relevant most Chinese products (there are exceptions) have few, if any, built-in advantages in terms of superior quality, innovation or design.
Oversized shadow banking
That said, there are other problematic factors. Much of the (now somewhat declining) Chinese growth in recent years has been fueled by oversized investments financed via massive debt. And much of this debt now is held by a growing shadow banking sector that is largely opaque and unregulated. Indeed, as The Financial Times reports, China’s shadow banking is valued at $ 7.62 trillion. Yes, that is trillion. This amounts to almost half the value of US GDP.
The emerging concern, now bordering on fear, is that a significant part of the credit extended through shadow banking may consist of bad and therefore unrecoverable loans. Indeed, one leading US market analyst said recently that “China is a disaster waiting to happen“. Indeed, it would appear that much of the bad debt is the result of excessive lending to saturated sectors already plagued by overcapacity, such as steel.
Imagine this scenario: many Chinese companies go bust causing shareholders losses, shadow banks that lent them money fail, this way ruining investors, while untold numbers of workers are suddenly unemployed, with no place to go because the economy is not expanding anymore as it used to.
A little bit of unraveling just started. Chaori Solar, a relatively small solar panel maker, failed to pay the interest on its bonds. This is the very first time in modern history that China experiences a corporate bond default. And then there is the failure of Haixin Steel.
Now, a couple of defaults in the second largest economy in the world certainly are not enough to create a disaster. Except that this is new in China. In the past, the state would have intervened to save companies. Now it decided not to. The benign interpretation is that (once again very wisely) the Chinese government decided that it is good to purge the system.
Just dead wood?
In fact, in what appears as an attempt to stay ahead of events, Li Keqiang, China’s Prime Minister, publicly stated that going forward a few more bankruptcies are inevitable, and indeed expected. The message is: “Do not worry. We know this is coming; and we shall manage these events so that they will not cause any contagion”.
Some speculate that this new hands-off policy is part of a “detox therapy” that will make China stronger in the long run. Let a few rotting apples be expunged from an otherwise healthy economy. This would be good, in as much as it will eliminate dead wood, while reminding corporations and investors about their responsibilities in properly assessing risk. If it were indeed so, then nothing to worry about. China’s vast economy can easily absorb a few bankruptcies.
What if it is worse than we think?
But some analysts worry. The enormous shadow banking system is largely unregulated. What if the percentage of bad loans is much higher than what the optimists estimate? What if over investments led to massive over capacity in multiple sectors, bound to be followed by a wave of bankruptcies? What about the possible cascading effects of such bankruptcies on the finances of local governments? What about new unemployment caused by factories closing down?
Many of these dire (but not impossible) scenarios are based on speculation. The Chinese authorities do not release much reliable information. Official statistics are notoriously manipulated. Notwithstanding a large and growing private sector, much of the economy is still managed by a relatively small and secretive group of technocrats. They do not operate in a transparent system.
Therefore, while we understand that now there are “problems”, some of them quite novel in a Chinese context, we simply do not know how big and how serious they are.
Well functioning economies thrive in free societies
All this leads me to a general consideration. China’s “dirigiste“, statist economic development model, with its almost statutory top-down management, worked extremely well for almost 30 years. An impressive, in fact unprecedented, record.
But now this model is inadequate. In order to go to the next level, the level of vibrant, bottom-up innovation led by real entrepreneurs relying on modern capital markets, China has to change. There has to be transparency and accountability within a rules-based system that operates according to internationally recognized best practices.
China is not about to announce political reforms
But such a shift to openness and decentralization would be possible only if preceded or accompanied by real political liberalization. And I do not see signs of any such reform process unfolding.
My simple point is that a modern economy grounded on innovation leading to global technological competitiveness can exist only in a context of genuine political freedom. China’s self-appointed technocratic leaders may try to manage the ever more complex system they created.
But they may not succeed.