3 fault lines running through China’s economy

Editor’s Note: Neil K. Shenai is an Instructor of International Economics and Ph.D. Candidate at the Johns Hopkins School of Advanced International Studies (SAIS).

By Neil K. Shenai, Special to CNN

The notion of “American decline” is once again en vogue. Emerging powers such as Brazil, India, and China pose a threat to U.S. dominance, the argument goes. They undermine U.S. interests while the U.S. battles economic stagnation.

This seems corroborated by the facts: U.S. share of global GDP is down to approximately 19%, from 25% in 2000. China recently replaced Japan as the world’s second-largest economy with current estimates projecting that China’s economy will overtake America’s by 2020.

But Americans should not let paranoia cloud a reasoned appraisal of China’s strengths and weaknesses. China’s economy contains three potential fault lines that threaten its long-term economic stability. Consider the following questions:

1) Can China handle its infrastructure bubble?

2) Can China become an innovation economy?

3) Can China manage its long-term demographic and political challenges?

1) Can China handle Its infrastructure bubble?

Yu Yongding, former Chinese central banker, recently described the U.S. treasury market as a “giant Ponzi scheme,” contending that the Federal Reserve’s asset purchase programs have led to an artificial bubble in U.S. treasuries, seemingly ignoring the fact that treasury prices fell after the Federal Reserve announced Quantitative Easing 2. If Mr. Yongding wants to identify a real Ponzi scheme, he need only look at the Ponzi finance practiced by China’s state-run banks.

In the aftermath of the global financial crisis, China forced its state-run banks to lower lending standards and make as many loans as possible to support infrastructure and real estate development, which according to various estimates accounts for nearly 20% of the Chinese workforce.

Although vast infrastructure investment helped China grow at near double-digit rates, their current spending spree illustrates why it’s sometimes possible to have too much of a good thing (for an example of China’s infrastructure spending run amok, see this see this fine documentary on China’s ghost cities).

Because China’s banks are under state control, they do not face the same liquidity and credit risks as their Western counterparts, as they are forever-backstopped by Chinese taxpayers (at least the Chinese admit that their financial institutions are government-sponsored entities).

This might pay off handsomely in the near-term, as millions of Chinese are put to work building multi-unit apartment buildings, constructing state-of-the-art airports, and laying concrete for highways. Still, China’s domestic lending scheme is Ponzi finance. Consider its financial circularity:

Because of their political control, Chinese banks must lend to ever-more dubious projects for ancillary, non-business reasons. When these investments fail to yield an adequate rate of return, these loans drop in value. To maintain bank lending and thus high levels of employment, China buys up these non-performing loans from the banks and puts them into separate, state-run entities of which the Chinese government is the ultimate creditor. This bank balance sheet cleansing begins the process of lending anew, leading to more loans, more speculation, and ultimately greater defaults. But because they are the ultimate backstop to this speculative lending, the Chinese government is really the sucker in its own Ponzi scheme.

Even though China’s airports and trains are some of the best in the world, countries can still overinvest in productive sectors. In the West, we have markets that help reign in the excesses of imprudent investments (think the bursting of the technology bubble in 2000). Can we really trust the Communist Party to make these same hard decisions, when social order and the Party’s hold on power depend on populist lending?

2) Can China become an innovation economy?

China’s rapid growth depends on its access to buoyant global markets and cheap labor. Low wages and an undervalued nominal exchange rate kept Chinese export prices low, flooding global markets with Chinese goods. This process worked well when China had low unit-labor costs and trading partners with an insatiable demand for Chinese goods.

Today, the world is a different place. Advanced economies are over-indebted, underemployed, and generally unable to provide a consumption backstop to Chinese growth. Meanwhile, China’s heretofore quiescent workforce is starting to demand higher wages, having endured rising income inequality and consumer price inflation eroding their real wages. As a result, other emerging economies with lower unit-labor costs such as Vietnam and Indonesia have poached market share from China’s low-end manufacturers.

Economic theory postulates that as countries get richer, they move up the “value chain” of production, first from net exporters of raw materials, to manufacturing (China’s current stage), and later to high-end industrial goods with breakthrough technological innovation.

While theoretically straightforward, the actual process of becoming an innovation economy requires several vital institutions, such as a strong intellectual property regime and an efficient domestic capital market to identify and pick path-breaking innovations.

China has a notoriously bad reputation for protecting intellectual property. Counterfeiting and software piracy run rampant in China, for instance. Developing the institutional framework and cultural respect for intellectual property will take time, and there is no guarantee that China can become an innovation economy like the United States.

Meanwhile, China’s state-run banks might not be as efficient at allocating capital as the America’s system of private venture capitalists, whose lending decisions are depoliticized and technocratic. China’s high R&D spending is a step in the right direction, but does not guarantee success without these other institutional ingredients.

Moreover, economic cultures and political cultures are often mutually-reinforcing. As sociologist Max Weber once observed, the cultural gestalt that produces anti-statism in America might also be responsible for Americans’ tolerance of creative destruction and breakthrough innovations. On the other hand, China’s political culture of hierarchy and stability might not cultivate an economic culture of risk-taking and rapid change.

3) Can China manage long-term demographic and political challenges?

There are two oft-cited long-term challenges to China’s economic model that are also worth mentioning. First and perhaps most pressing is their rapidly-aging workforce. China’s dependency ratio (the ratio of non-workers to workers) is expected to climb rapidly because of the after-effects of their one-child policy. Rising dependency ratios usually lead to slower growth and greater demands for public pensions, both of which will tax China’s working age population.

If any of the above factors produce economic instability, the Chinese Communist Party could begin to fall out of favor in China. Senior Chinese leadership is aware that their popularity depends on providing economic opportunities to China’s growing middle class, and this co-optation strategy relies on continued economic growth.

China could prove the exception to this, but there are very few contemporary examples of countries that have modernized economically but maintained single-party authoritarian rule over the long-term, with the lone exception being Singapore, a micro-state with five million people. By comparison, it is estimated that China will have over two hundred cities of over one million people by 2025.

Of course, the answer to all of these questions might be a resounding “yes.” But more often than not, situations that appear too good to be true often are. China has gone through a fantastic growth spurt and poses formidable economic challenges to the United States. Thus far, the Chinese Communist Party has deftly managed China’s economic modernization, replacing their defunct ideology of Marxism with one of pragmatic and gradual change.

But observers in the West should be realistic in their appraisal of the long-term potential of the Chinese economy. China’s ageing workforce, staid political system, opaque banks, and inconsistent intellectual property regime represent concrete challenges for China in the immediate term.

For China to successfully rebalance its economy with more consumption, less dependence on exports, and better institutions for innovation, it needs near-flawless execution on behalf of Chinese leadership.  To reproduce the economic gains seen over the last three decades, the Chinese Communist Party will need to pull off another perfect run of reforms. While certainly possible, Americans should not overestimate the threat China poses to U.S. economic dominance.

Instead of portraying China as an inevitable usurper of United States interests, Americans must realize that China’s rapid ascent and future growth sit on ever-more tenuous foundations.

Instead of looking abroad and demonizing China’s anti-U.S. policies like their currency manipulation, Americans would be better off looking inward, maintaining a quiet confidence in the durability of its economic and political institutions while continuously trying to reform from within, bearing in mind that the internal contradictions of Chinese capitalism will expose themselves over time. This strategy helped the U.S. outlast the Soviet threat, and would serve it well when dealing with a new generation of potential challengers.

The opinions expressed in this article are solely those of Neil Shenai.

http://globalpublicsquare.blogs.cnn.com/2011/04/21/china%E2%80%99s-economic-fault-lines-1-its-infrastructure-bubble/

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