China vs the Business Cycle
There’s a historical narrative that many of us have in the back of our minds when we think of the economic status of China and The West. It goes something like this :
Business cycles have afflicted the world since history began. The search for solutions to manage our periodic transitions from lean years to fat years goes back to the biblical period and beyond. During “The Great Moderation” preceding the Global Financial Crisis it appeared that the problem had solved. Gordon Brown cliamed to have “eliminated boom and bust” but the experience of 2008 has shown us that preceded it in the West was illusory. We are as far from smoothing the business cycle as ever we were.
In the East their experience has been quite different. Up until the late 70s the Chinese Communist Party’s economic mismanagement was unrivalled. By the early 1980s the country was in a state of near total destitution. However in the early 90s this picture began to change completely. Deng’s market reforms changed things decisively for the better. From that date forward there has never been a major economic downturn in China - growth has continued at rates which are envied by the developed world.
Because the Communist party controls all organisations in China via a parallel structure of management, it has been able to monitor and direct the progress of the economy in such a way as to achieve the Holy Grail of all economic management – constant stable growth. For instance, when it was faced with massive disruption to its export markets in 2008, the party responded with rapid action which could not be matched by the slow moving West. China decreed a huge stimulus programme. They also made use of the party cadres embedded within banks and companies to command greater economic activity and prevent recession.
There is every reason to believe that the stable managed growth of the last 20 years will continue for many years to come. Certainly until the level of Chinese development matches that of the developed world.
Those lucky countries that export raw materials that China needs have become rich. They too will grow in tandem with China.
This story is very seductive. As the graph above demonstrates, China’s outperformance of the rest of the world is a fact. However drawing conclusions about future trends based on an extrapolation from this period remains incredible.
First of all, if China really has found a way of managing the cycle then it has achieved something the rest of the world has failed to achieve over millenia. The cycle of fat and lean years was identified in the Biblical period. If we really believe China has cracked this problem, we must draw the conclusion. China has identified something fundamental, the West should seriously consider moving to a hybrid market/command economy on the Chinese model. Are we really ready to concede this ?
There are no really plausible candidates for a magical ingredient X, the remedy to business cycles, discovered by the CCP other than benefits of taking the party jackboot off the throut of your economy and allowing it catch up with the rest of the world. We have no reason to believe that China has solved this ancient conundrum.
Secondly, we know that there are a number of factors supporting stable growth in China which are time limited
- the movement of the rural population to the cities – there are reasons to think that this can not continue forever
- the transfer of entire world industries to China (e.g. toys) will eventually stop - transferring an industry causes strong growth initially as the percentage of the industry within China increases, but once the transfer is complete, growth continues at the slower growth overall rate of the industry
- the competitive cost of Chinese labour – this is now under threat
- the party has been trying to smooth growth rates using methods which can only be temporary
- the growth of exports to heavily indebted countries which can nolonger fund a deficit
- the demographic issues facing China
Thirdly, the sources of Chinese growth are poorly understood. There are 3 components of growth domestic consumption, the export sector and public and private investment. Domestic consumption in China is tiny, approximately the same as France despite a hugely larger population.
As noted above, export growth in China will be held back in future by the levels of public and private debt in its major export markets. Deficit countries are reaching the limits when it comes to financing imports. Investment has been the major provider of Chinese growth since 2008.
Why Chinese growth has been driven by Investment
The goal of Chinese policy makers is to manage the sum of consumption & investment (C&I) in order to maintain the magic 8% growth figure which supports a harmonious society. Stimulating consumption requires redistributional policies to move money from the rich (who save it) to the poor (who spend it). This is not politically acceptable to the party for two reasons.
- Those who would suffer from this policy, the rich, are constitutive of the upper reaches of the party
- Economic emancipation of the poor would almost certainly lead to demands for political emancipation as is now happening in Russia
This means that when (C+I) is looking too low to support employment, China always plumps for boosting investment over consumption.
As there are only ever a limited number of profitable investment opportunities available, boosting investment also increases the proportion of that investment which is wasted. This inevitably increases the number of bad loans sitting on bank balance sheets. These losses have to covered somehow. The Chinese have learnt from experience that printing money to cover these losses causes inflation which is also destabilising.
To cover the bank’s losses from wasted investment China diverts funds from consumers savings via “financial repression”. This involves keeping bank interest rates much lower than the real interest rate and skimming off the spread. To achieve this its necessary to prevent consumers from finding more profitable places to invest outside the banking system. This partly explains the Chinese tendency to invest in real estate, especially in those famously empty apartment blocks. They are desperately seeking stores of value outside a banking system which is rigged against them.
The unfortunate consequence of stiffing savers is to pass on the losses from malinvestment to consumers. This causes consumption to fall yet again, meaning that in the subsequent period the total of C&I is again too low. Facing the same dilemma China again plumps to boost investment … and so on … and on with
- investment of worse quality
– lower levels of consumption
– investment ever higher
What does this mean for China’s future growth?
It means that China has not eliminated the business cycle. It has merely hidden it under a blizzard of investment activity. There will one day be a recession in China. The question is when not whether.