The crumbling Chinese market
A Chinese financial and economic crisis has been in many analysts’ forecasts for years, including my own.
So far, it has not happened. Does this mean China has solved the problem of how to avoid a crisis? Or is the crisis just a matter of time, set to happen sooner rather than later?
My view is that a crisis in China is inevitable based on China’s growth model, the international financial climate and excessive debt.
Some of the world’s most prominent economists agree. A countdown to crisis has begun.
The middle income trap
Your strategist addressing a conference of the chief economists of major Chinese banks and foreign banks doing business in China. This conference took place in Shanghai and offered great networking opportunities to discuss issues of mutual interest with the top financial economists in China. These meetings included the chance to have breakfast with the heads of precious metals operations of the four largest gold dealers in China.
As I explained above, China has hit a wall that development economists refer to as the ‘middle income trap’.
Again, this happens to developing economies when they have exhausted the easy growth potential moving from low income to middle income, and then face the far more difficult task of moving from middle income to high income.
The move to high-income status requires far more than simple assembly-style jobs staffed by rural dwellers moving to the cities.
It requires the creation and adoption of high-value-added products enabled by high technology.
China has not shown much capacity for developing high technology on its own, but it has been quite effective at stealing such technology from trading partners and applying it through its own system of state-owned enterprises and ‘national champions’, such as Huawei in the telecommunications sector.
Unfortunately for China, this growth by theft has run its course.
China has some bad debts to honour
The US and its allies, such as Canada and the EU, are taking strict steps to limit further theft and are holding China to account for its theft so far by imposing punitive tariffs and banning Chinese companies from participation in critical technology rollouts such as 5G mobile phones.
At the same time, China is facing the consequences of excessive debt.
Economies can grow through consumption, investment, government spending and net exports.
The ‘Chinese miracle’ has been mostly a matter of investment and net exports, with minimal spending by consumers.
The investment component was thinly disguised government spending — many of the companies conducting investment in large infrastructure projects were backed directly or indirectly by the government through the banks.
This investment was debt-financed.
China is so heavily indebted that it is now at the point where more debt does not produce growth.
Adding additional debt today slows the economy and calls into question China’s ability to service its existing debt.
China’s other lifelines were net exports and large current account surpluses.
These were driven by cheap labour, government subsidies and a manipulated currency.
These drivers of growth are also disappearing due to demographics that reduce China’s labour force.
China is facing competition by even cheaper labour from Vietnam and Indonesia.
Trade surpluses are also being hurt by the trade wars and tariffs imposed by the US.
Meanwhile, the debt overhang is growing worse. China’s creditworthiness is now being called into question by international banks and direct foreign investors.
There’s worse to come
The single most important factor right now is the continuation and expansion of the US-China trade war.
When the trade war began in January 2018, the market expectation was that both sides were posturing and that a resolution would be reached quickly.
I took the opposite view. Trump waited a full year from his inauguration before starting the trade war. Trump has given China every opportunity to come to the table and work out a deal acceptable to both sides.
China assumed it was ‘business as usual’, as it had been during the Clinton, Bush 43 and Obama administrations. China assumed it could pay lip service to trading relations and continue down its path of unfair trade practices and theft of intellectual property.
By January 2018, Trump decided he had been patient enough and it was time to show China the US was serious about the trade deficit and China’s digital piracy.
Since the trade war began, the US has suffered only minor impacts, while the impact on China has been overwhelming.
The deteriorating situation in China is summarised nicely in this excerpt from an article dated 5 February 2019, titled ‘The Coming China Shock’, by economists Arvind Subramanian and Josh Felman:
‘Back in September, we saw some discontinuity in China’s economic performance as inevitable.
‘Even if the country was not heading for a full-blown crisis, we believed it would almost certainly experience some combination of rapidly decelerating growth and a sharply depreciating exchange rate.
‘That prognosis has since become even more likely. With global economic growth and exports declining, China’s economy is on track to slow further relative to the 6.4% growth recorded in the fourth quarter of 2018.
‘The double-digit average achieved from the 1980s until recently has never seemed more distant.’
The tariffs imposed by the US on China so far have dramatically slowed the Chinese economy. Yet those tariffs are minor compared with what’s in store.
Truce masks Chinese economic weakness
1 March 2019 was the deadline in the trade war intended to facilitate negotiations.
US demands — especially in the area of verifiable limitations on the theft of US intellectual property — are impossible for China to meet because it depends on such theft to advance its own economic ambitions.
Some minor issues may appear to be resolved for now. The deal of a reduction in the US-China trade deficit through larger purchases of US soybeans by China was expected.
But the big issues — including limits on US investment in China, forced technology transfers to China and theft of intellectual property — will not be resolved.
Either way, China’s export-driven economy will continue to suffer.
Given these economic, trade war and political headwinds, weakness in China is only getting worse.
And China’s leadership can only hope the damage can be limited before the people begin to question its legitimacy.
All the best,