In the past quarter century, China has made two remarkable achievements:
- They have elevated their population from abject poverty to a global standard of living comparable to other industrialized countries; and
- They have shown that economic development (the real kind, not the sleaze that American politicians engage in when they hand out cash to favored businesses) is possible without the kind of system-threatening political instability we saw in Russia after the collapse of the Soviet Union.
The Chinese have rightfully earned the world’s respect for these two achievements. Unfortunately, it looks like the progress and growth from the past couple of decades may soon be coming to an end. The world’s most populous country appears to have run into the same statist brick wall that we in the West are all too familiar with.
Before I get there, let me first stress what the Chinese did right. Back in the ’90s they watched how the Russians botched their liberalization efforts in the wake of the collapse of the Soviet Union. Based in good part on ill-conceived advice by a couple of impressively stupid Swedish Austrian-theory economists, the Russian leaders abolished existing regulations and overnighted away a government presence that had shaped the nation’s political, social and economic behavior for seven decades.
The result was catastrophic, with mafias forming out of the rubble of the fractured state, the disintegrated Soviet communist party and already-existing crime families throughout the former empire. The totalitarian state was replaced with lawlessness, thuggery, theft and a complete disrespect for the rule of law. It was not until Vladimir Putin ascended to the presidency that Russia began functioning much like every other developed nation.
That is not to say Putin’s Russia is without problem. Corruption and authoritarianism are still staples of Russian life, but under Putin the crooks are at least honest crooks. They are predictable and want the same thing as most people do: a Russia that is strong, prosperous and stable.
Whether or not they can keep it that way is a different story. But the Chinese communist leaders witnessed what happened in Russia and sought a different path. They were given advice on how to do that from a prominent American economist (I have pledged to withhold his name) who told the CCP leadership to more or less use Russia as a reversed indicator on how to reform the country. Maintain a stable, predictable political leadership, keep core functions of government – rule of law and enforcement of contracts – predictable and free of corruption, and deregulate the economy from the ground up.
Which, by and large, is what the Chinese did. That is not to say they have succeeded on every item, but from a macroeconomic and macro-political viewpoint, this was their strategy. Given the impressive transformation of the Chinese economy, initially they were successful. Very successful, in fact.
However, their success story is now coming to an end, and the reasons are – ironically – to be found in the very strategy that generated their impressive economic evolution.
In a thorough and very informative opinion piece in the Epoch Times of September 29 (print ed.), Cheng Xiaonong, a U.S.-based expert on Chinese politics and the Chinese economy, explains the systemic problems of the Chinese economy. Cheng previously served as aide and policy researcher to former Chinese premier Zhao Ziyang. He has also been the chief editor of Modern China Studies.
Cheng exhaustively explains why the Chinese economy is facing fatal imbalances that may bring its epic progress to a halt, and may even throw the country into economic regress. But before I get to Cheng’s analysis, let me first say a few things about the Chinese economy in general.
To begin with, it is notoriously difficult for an outsider to confidently establish any statistical picture of the country. The world has gotten used to hearing all sorts of exceptional numbers coming out of China, not the least of which have had to do with its GDP growth. However, over the years it has become increasingly clear that we should take Chinese national-accounts data with more than a little grain of salt. For example, in 2016 Business Insider Australia reported that the official Chinese GDP numbers for 2015 had “drawn scorn and ridicule from many noted market participants”. Few people seemed to believe that the 6.9-percent reported growth rate was anywhere near accurate.
There seems to be a consensus across the international community of China analysts that Chinese GDP growth is being over-stated by about two percentage points per year. This may sound insignificant, but it quickly balloons into a major statistical black hole: if the real, actual GDP growth of a country is five percent per year over ten years, and it is over-reported by two percentage points – in other words seven percent per year instead of the actual five – then after ten years the statistically inflated economy is more than 20 percent larger than the economy actually is.
This has major consequences, both domestically and internationally. To begin with, you run into all kinds of market forecasting errors. A forecast of future growth in Chinese markets, such as for consumer products, always depends on past performance of the economy in general and the market in question in particular. If that past performance is overstated in official statistics, a forecast of future market performance increasingly decays into guesswork.
As a result, businesses over-commit to a market that may be marginally or substantially smaller, with much less purchasing power, than official statistics would suggest.
But the problem is not limited to consumer markets, which – as we will see in a moment – have been relatively under-developed in China. Inflated economic data lead to errors in forecasting returns on investments in equity markets. Those markets, from real estate to stock, depend on the overall performance of the economy. We may blow a lot of hot air into our stock market by means of artificial liquidity infusions (hello, Fed?) but there always comes a point when the next market investor looks at the P/E ratio and chooses to keep his money in the bank for now.
At that point, the balloon starts to implode.
Which, incidentally, is what we are now beginning to see in the Chinese real-estate market.
However, the errors in macroeconomic data do not just affect investors in equity markets. If you want to build a manufacturing facility in an economy with unreliable data, you have to consider the consequences of compounded statistical errors. When errors begin to multiply and reinforce each other, you gradually lose your ability to navigate your economic environment.
Bluntly, you fly blind in the dark.
I am not saying this is actually the case for all investors in China today, but it is a problem that is reaching systemic proportions. Errors in national accounts have long-term effects, which show up only after a sustained period of time. That said, once they do surface, the error is already significant, as evidenced by a 2019 article in the Financial Times reporting that the Chinese economy is 12 percent smaller than official statistics would suggest. At that point, it is almost impossible for anyone who is not a national-accounts expert to reverse-engineer that error and get a “real” picture of the economy.
In addition to concerns about China’s national accounts, there is also the issue with the nation’s inflation data. In 2019, the Economist Intelligence Unit explained the serious consequences of China’s allegedly manipulated inflation data. Focusing specifically on the GDP deflator, the EIU explained that Chinese officials are not transparent about how the deflator is calculated,
in contrast to the practice in most economies. This generates suspicion that the deflator is manipulated to arrive at a preferred rate of real GDP growth. During economic downturns, the GDP deflator may have been used to artificially lift real GDP growth; during upturns, it may have been used to suppress it.
If official Chinese statistics producers misrepresent the difference between nominal and real GDP, they make price increases look like actual market expansion. This compounds greatly the problems for outsiders in assessing investment and general business opportunities in China. But it also creates problems for the Chinese government, for example in the form of revenue from its value added tax. When inflation numbers are inaccurate, it means that product-price data is misrepresented. If you use erroneous GDP data – real and nominal – you will inevitably miscalculate revenue from taxes such as the VAT.
Down the road, you also get erroneous estimates of all sorts of taxes, from foreign trade to corporate and personal income.
Inaccurate inflation data also casts a shadow over the role of monetary policy. It is well documented that China has engaged in significant monetary expansion for an extended period of time. An economy that is being subjected to this gradually builds up inflationary pressure in both equity markets and consumer markets. While the latter is fairly well known – though again not necessarily well represented in Chinese economic statistics – the latter has been less explored as a genuine threat to the stability and future growth of the Chinese economy.
When money supply expands faster than money demand (as proxied by GDP) there is an increasing amount of idling liquidity in the economy. Liquidity works like water running down a hill: it always finds a way forward. Idle money makes cheap credit, which leads to lending, which leads to inflated calculations of collateral.
Behold real estate values.
But there is also another aspect of inflated equity values that is not as apparent in the economic and financial reporting on China. There is a real oddity in Chinese GDP numbers: an almost artificial trend of growth in business inventory investments. This item, which is part of national accounts, has likely been inflated in the Chinese data because businesses have over-invested in fixed capital. Businesses defer revenue by piling up inventory – actually or statistically.
This over-investment, in turn, is the perfect storm of three factors:
- The aforementioned inflated GDP numbers;
- Access to cheap credit; and
- A national growth policy emphasizing capital formation over domestic absorption.
This last point is very important, probably more important than the other two combined. China has an extremely high level of capital formation: at approximately 40 percent of GDP it is consistently larger than private consumption. This means that businesses in China are building a lot more productive facilities than their domestic economy can possibly provide a market for. But any examination of Chinese GDP data also suggests that exports cannot possibly provide enough revenue to keep the capital stock afloat, especially not from a financial viewpoint.
Bluntly: the Chinese economy suffers from a big over-investment bubble in terms of capital formation, and i t is not limited to the manufacturing sector. As Evergrande has shown, the real estate sector is also heavily over-capitalized.
Ironically, one source of this over-capitalization has been the Chinese government’s determination to use exports as a macroeconomic growth generator. They were successful in this regard: unlike Western welfare states, money is not printed in China to fund government spending. Its is printed to prevent currency appreciation. The Chinese central bank uses a wide range of instruments to sterilize the exchange rate.
However, such currency sterilization measures inevitably flood the banking system with large volumes of liquidity, i.e., cheap credit. To mitigate this problem, the Chinese central banks has been trying to “retrieve” the liquidity and prevent or dampen over-lending. The problem is that over time, this cannot be done without outright confiscation of bank assets; so long as the currency manipulation continues, the resulting monetary expansion will continue to flood credit markets with more cash.
Herein lies a major dilemma for the Chinese government. Aforementioned Chinese policy expert Cheng Xiaonong explains that China has gone through two phases in its economic evolution, the first being led by an exports boom, the second by a capital formation boom:
China’s economic growth and prosperity in the past 20 years mainly relied on the booming of exports and construction projects. Since China became a member of the World Trade Organization (WTO) in 2001, the surge of foreign capital flowing in has since brought its export growth to more than 25 percent annually. The booming of exports drove Chinese economic growth for 10 years.
This, however, was not a sustainable strategy, Cheng notes:
While the regime enjoyed economic growth, it overlooked a problem: China has a big population and the global market is too small. China’s labor force accounts for 26 percent of the global employment population. Even if China occupied the entire global market and all industrialized countries stopped exporting, the export boom could not go on indefinitely.
Having seen the consequences of this crude, one-trick-pony strategy for economic growth in the wake of the Great Recession, when demand for Chinese exports plummeted across the industrialized world, the government in Beijing shifted focus and decided instead to rely on capital formation – business investments – as its new growth generator. Cheng again:
In order to maintain high economic growth, China promoted infrastructure construction and real estate development, thereby stimulating a round of booming construction projects. The construction investment share of GDP rose to 20 percent from 18 percent before 2008, to 35 percent in 2013 and 2014. Although the construction boom has supported Chinese economic growth for another 10 years after the export boom, a real estate bubble has quietly formed.
The same has happened in the manufacturing sector that is dimensioned for rapid, and steady growth in exports.
The one sector the Chinese government appears to have continuously overlooked, is private consumption. As mentioned earlier, this variable, which accounts for 70 percent of GDP in the United States, is smaller in China than business investments. Even the addition of private consumption and net exports cannot provide enough cash flow to merit the Gargantuan capital formation across manufacturing, real estate and infrastructure.
Only one economic agent can balance out the imbalances: government. However, its abilities to do so are limited, simply by virtue of the same laws of public finance and macroeconomics that apply to all economies in the world. Once the Chinese government starts committing to saving financially troubled investments across the economy, it will be faced with two choices:
- Monetize deficits like we have in the United States and Europe, or
- Go cold-turkey on the equity markets and let them fail.
The latter alternative is the only sustainable one, but the Chinese government is unlikely to choose it. The reason is simple: it would lead to major social unrest.
Which brings us back to the systemic error in the Chinese growth strategy itself: to maintain political stability while the economy is deregulated. So long as information control is a key part of political-stability management, the average guy on the street is not going to have a clue as to what major problems his country is facing. We may not have the most intelligent public debate here in America, but it is open and vigorous and provides all sorts of information for anyone willing to search for it.
In short: Americans are much better prepared to deal with systemic crises than people are in China.
On top of this, the maintenance of the communist power structure has kept in place a large bureaucracy that constantly needs to legitimize its existence. With economic liberalization, people begin to see that they can live their lives, provide for their families and go about their daily business without relying on government. Unless this bureaucracy is dismantled, sooner or later it is going to reassert its role in society and in the economy.
How does it do that?
By re-regulating the economy. Which is exactly what is happening now. And it is happening just as the Chinese economy is beginning to pay the price for a growth policy that has promoted everything except the two variables that build an economy from the ground up: private consumption and individual freedom.
In short: China is at a critical point economically. Unless its government re-commits to economic liberalization, and adds the dismantling of its political bureaucracy, the country’s future looks increasingly bleak.