Bill Emmott - International Author & Adviser


The coming crunch in China
Ushio - June 2007

Everyone who visits China comes back impressed: all the smart new buildings, the wide new roads, the sparkling and efficient airports. They invite a question among foreign admirers: why can’t we organise things as well as the Chinese? This question is often asked amid some coughing and wheezing, thanks to the pollution in Beijing and Shanghai, though the effects of that wear off once the admiring foreigner has returned to Tokyo, London or Washington.

Those who compete with Chinese companies, however, tend to ask a different question. They ask whether China’s economic model can really be sustained, for it seems in many ways to be unreal. The cost of capital for Chinese companies seems to be zero, thanks to stockmarket public offerings, cheap loans and the reserves companies have themselves. There is a seemingly unlimited supply of cheap labour, in the form of migrant workers from rural areas. For exporters, the exchange rate between the Chinese renminbi and other currencies is managed by the authorities in order to keep export prices low.

As a result, China’s central bank has built up the world’s largest reserves of foreign currency, worth $1.2 trillion (Japan’s are about $800 billion), for it has to keep buying foreign currency in order to stop the renminbi rising. Now, the Chinese authorities are talking about investing those funds in more new infrastructure and by buying companies and other assets abroad. So, through this method, China will become even more powerful.

Or will it? For the question of whether China’s current economic model can be sustained indefinitely is a good one. And the absolutely certain answer is that it cannot be sustained. The difficult and highly uncertain questions, however, are how the model will be changed, when that will occur, and what will happen when it does.

The reason why a change is certain is the fact that in economics, there are no true miracles. Economics is more of an art than a science, but nevertheless some things are fixed laws equivalent to the laws of physics. One such law is that even large reserves of cheap labour will not prevent wage rises if demand for workers keeps on rising rapidly. Another, related law is that rapid monetary growth will always, eventually, cause inflation. And a third is that if the cost of capital seems to be zero, then huge amounts of it will be wasted.

These last two laws should be familiar to Japanese readers, for they describe what happened in the bubble economy of the 1980s. Japan had cost-free capital and rapid monetary growth, like China does now, and it also had a low consumer price inflation rate, just as China does now. But the true inflation took place in the stock and property markets, with a boom that burst in 1990. The same is happening in China: last year, the Shanghai stockmarket index rose by more than 160%; so far this year it has risen by more than 40%. By any measure, that means that a bubble is inflating.

There is another parallel between China and Japan, though it is a parallel from Japan in the 1970s, not the late 1980s. Japan’s high-growth years in the 1960s were characterised by a high and rising level of investment. By 1971, investment had grown to a level of nearly 40% of GDP; to understand how extraordinarily high that was, it is worth noting that the level in America today is about 15% and in Japan about 24%. After that peak in 1971, however, investment gradually declined. This was the era when the yen exchange rate had to be revalued, under pressure from Japan’s trading partners, and when the oil shock caused inflation to rise.

China, now, has an even higher level of investment than Japan did in 1971. As a share of GDP, investment has risen to about 43%. Since China’s overall growth rate has stayed at about 10-11% per year, this means that Chinese investment has become less efficient, for it is requiring more and more investment to generate the same rate of economic growth. China is experiencing what economists call “the law of diminishing returns”: as you add more capital investment, so the reward from each extra bit of investment diminishes.

This method of economic development is unsustainable. Investment cannot carry on rising forever. The exchange rate cannot remain fixed and cheap forever, while China’s current account (ie trade in goods and services) surplus rises towards 10% of GDP.

The good news is that the Chinese leadership know very well that the model must change. The Chinese premier, Wen Jiabao, said in March this year, at a press conference, that “There are structural problems in China’s economy which cause unsteady, unbalanced, unco-ordinated and unsustainable development.” The bad news is that the leadership is finding it hard to do anything about it.

What it knows that it should be doing is a mixture of three things: increasing public spending on health, education and social services, in order to boost domestic consumption and improve people’s lives; raising the cost of capital, in order to discourage excessive investment and to prevent inflation; and upvaluing the Chinese currency, in order to help control inflation and to reduce the trade surplus. During the 1970s, Japan followed all of those policies.

The Chinese leadership is, however, facing a lot of opposition to these measures. Powerful interest groups, especially in business and local government, does not want investment to be reduced, as they are profiting hugely from it. Local governments also prefer to spend public money on investment, from which they can make money themselves through corruption, rather than on health and education. And exporters do not want the currency to be upvalued.  

 After the coming summer, the Chinese Communist Party will be holding its 17th party congress. During that meeting, there will be a fierce argument about whether and when to introduce these new policies. Meanwhile, inflation is beginning to appear: the wages of rural migrant workers are rising by 15% per year. The bubble in share prices on the Shanghai stockmarket is growing, drawing in more and more ordinary Chinese investors.

The current Chinese economic model could end with a crash, as Japan’s bubble did in 1990. Or it may be gradually changed, as Japan succeeded in doing during the 1970s, through a change of policies. The fight in this year’s 17th party congress will be well worth watching.


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