The Chinese economy has been sprinting towards the Olympics at a blistering pace. But what happens when this summer’s games draw to a close? Most observers seem to expect more of the same. They assume China will maintain its double-digit rate of economic growth in the years to come. Not everyone shares this view.
There is no shortage of China cheerleaders out there. Earlier this year, Business Monitor International (BMI) put out a report with the apparently downbeat title, China: What if We’re all Wrong? Still, BMI anticipates the Chinese economy will grow at an annual rate close to 10% into the foreseeable future. A spate of newly published books, such as Jim Rogers’ A Bull in China, reflect widespread excitement about the economy which, according to most forecasts, is set to overtake that of the US within the next couple of decades or so.
While this view of China’s prospects may prove correct in the long term, serious clouds are appearing on the horizon. That’s the view of Jim Walker, former chief economist of CLSA and founder of the Hong Kong-based consulting firm Asianomics. Walker adheres to the Austrian school of economics, whose most famous exponents include Ludwig von Mises and the Nobel laureate Friedrich von Hayek.
Austrians are obsessed with interest rates, and most particularly about what happens when central banks apply the wrong rates. When interest rates are too low, they argue, credit expands too rapidly. This stimulates investment and fosters asset price bubbles. Eventually, credit “inflation” shows up in rising consumer prices. But by then, it’s too late to stop the damage. The end of the boom reveals the misallocation of capital, or “malinvestment” as the Austrians insist on calling it. After which, there follows a painful process as the economy is forced to adjust back to equilibrium.
Walker believes that Beijing has allowed an Austrian-style bubble to inflate in China. In equilibrium, he argues, short-term interest rates should be roughly in line with the economy’s nominal GDP growth. But China has actually enjoyed interest rates well below the rate of inflation at a time when its economy has been expanding rapidly. Negative real rates are a consequence of China’s policy of pegging the renminbi to the dollar. In order to prevent the currency from appreciating, the People’s Bank of China (PBoC) has been forced to acquire ever larger amounts of dollars. The expansionary consequences of this policy could have been neutralised by the PBoC issuing “sterilization” bonds to soak up renminbi issued to buy dollars. But sterilization in recent years has been inadequate, says Walker.
The result has been strong credit growth. This, in turn, has fuelled an extraordinary investment boom. Investment has been growing at 25% a year and constitutes around 40% of GDP. Most of the fruit of this new investment has been exported abroad. The trade surpluses so generated have meant yet more intervention in the foreign exchange markets and further credit growth. For a while, this must have seemed like a virtuous cycle. Now it’s turning vicious.
Chinese export growth is set to fall sharply. Europeans initially took up the slack after the housing bust dented the appetite of American consumers for all things “Made in China.” But the credit crunch is wreaking havoc on both sides of the Atlantic. Recent data suggest that European export demand is slowing.
Many claim that Chinese domestic consumption will take up the slack. This is unrealistic. As Walker points out, the UK alone consumes more than China and India combined. China’s economy has been driven by investment and exports, not by domestic consumption. In fact, consumption in China has failed to keep pace with economic growth, which is why the trade surplus has continued rising.
There’s another problem. The credit boom has finally erupted in widespread inflation. The costs of commodities and wages of semi-skilled workers have been soaring. This leaves authorities with little choice but to tighten monetary policy into a slowdown.
After falling for years, Chinese export prices to the US have started to climb. The combination of rising inflation and the revaluation of the renminbi against the dollar means that China in some sectors is losing its position as the world’s low-cost producer.
An Austrian analysis suggests that the outlook for Chinese companies looks bleak. Profits are set to be crushed by a combination of weak export growth and rising input costs at a time when a record amount of new investment comes on stream. China’s “malinvestment crisis”, as Walker calls it, will not damage the country’s long-term prospects.
But a sharp economic slowdown will dampen the demand for commodities and bring more bad news to Shanghai’s beleaguered stock market. It also makes a revaluation of the renminbi less certain.
As economist Andrew Hunt points out, the Chinese business cycle normally ends in devaluations, not revaluations, of the currency. Yet in April some $50 billion (Rs2.16 trillion) of hot money entered China in the belief that a revaluation was a sure bet. It’s difficult to think of a better way for Beijing to punish noisome speculators than by frustrating such expectations.