How Bad Is The Chinese Economy? Recent central bank moves and stories from China point to a larger crisis

WASHINGTON – China’s economy is sputtering. There are plenty of bad signs, beginning with slower growth, declining trade figures, and rising numbers of bad loans.

How bad is this?

That said, it is simply impossible to gauge the seriousness of all this. Are we talking about a temporary impasse, or about a systemic deterioration leading to economic stagnation, and possibly decline? In other words, can China overcome its current difficulties and go back to its investment driven high rates of growth?

Rate cuts

We simply do not know this. However, most of the data filtering through a notoriously opaque reporting system (managed by the Communist Party), looks bad. The latest news item is another rate cut decreed by the People’s Bank of China. This seems to be an almost desperate attempt to convince companies to borrow more, in order to re-energize sluggish economic activities.

But the anecdotal evidence is that less profitable banks are unwilling to lend to already highly indebted borrowers; while the potential borrowers, facing declining demand for their products, see very few reason for investing in new production facilities.

Too much debt

In all this, the really big unknown is the actual level of indebtedness at the local level. We know that much of China’s GDP growth was engineered via cozy arrangements between local governments officials, developers, and non official lending institutions. The whole (mostly non transparent) process was led by a seemingly never-ending construction boom.

But now the boom is over. Developers vastly over built, and now they cannot sell their properties at a profit. Local governments cannot pay back their debt with cash coming from fresh deals. There are now plans to have banks buy the bad debt and turn them into loans from the central bank.

Problem or crisis?

In all this, once again, the big unknown is the extent of the bad debt problem and its ramifications. We know that in some cases large borrowers guaranteed additional loans for smaller ones.

In a system that usually does not dish out bad news, simply because it needs to safeguard the polished image of the political leadership, the amount of bad news already out there regarding possible defaults is alarming.

Again, do keep in mind that information about the Chinese economy is managed by political entities determined to sanitize the news. The Communist Party hierarchy has a vested interest in sticking to a script whereby, with a few bumps here and there, all is well in China.

All this notwithstanding, bad news keeps getting out. And this makes me think that the real picture is worse, a lot worse, simply because the truly bad news most likely is withheld from the public.

Look, even if we take all this into account, China is not about to sink. Far from it. It has hundreds of billions of dollars in reserve. These vast cash reserves will work as powerful shock absorbers. China can deal with its bad debt issue. But it is going to cost.

However, while I have no doubt that China can go through this nasty bad patch, it is also true that the leaders in Beijing , contrary to popular opinion, have not discovered the formula for endless high rates of growth. For three decades they managed to take full advantage of the clever combination of extremely low labor costs and huge investments in a modern logistics network. Given its low cost and high efficiency in delivering goods, making things in China became the logical solution for most US, European and Japanese manufacturers bent on cutting costs.

But now this is no longer self-evident. Increased levels of automation are making labor costs less significant in deciding where to locate production facilities. At the same time, traditional export markets are simply saturated.

On the domestic front, the construction boom led to excesses and to the creation of massive over capacity in all the sectors that supported it. Now the managers of the state-owned enterprises, (SOEs), need to deal with all this. But this is tricky.

From a political standpoint, it is hard –in fact impossible– to let workers go. Therefore the SOEs  will have to take losses, while dumping as much as the excess production as possible abroad. This will cause additional frictions with the USA and other trading partners who will be inundated by ultra cheap steel and other products that cannot possibly be sold in China because of falling demand and excessive supply.

Innovation is the answer

What China needs is a new growth model no longer based on outsourcing, but grounded instead on true innovation. We are talking about opening up new sectors that can attract global demand.

But I am skeptical about China’s ability to become an innovation laboratory. China is run by a small political elite primarily concerned with retaining political control over the economy and the broader society.

However, innovation usually thrives in an environment where is plenty of freedom and decentralization. And here is the problem. Control and freedom simply do not go together. Oil and water do not mix.

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