The clouds over the Chinese economy have been growing darker by the day. Look at some of the recent evidence. Economic growth slowed sharply to 7.5% in the second quarter of 2013, and some economists argue that data on electricity consumption shows that economic growth in the world’s second largest economy is even more sluggish than what the official figures suggest. The Chinese financial system is also said to be under immense strain at the end of a massive credit boom, with the recent liquidity crunch in the local money market one among many indicators of financial stress. And Chinese public finances—and thus the ability of the government to go in for a 2009-style fiscal stimulus to boost economic activity—are perhaps far weaker than assumed, once the borrowings of local governments and all sorts of special purpose vehicles are taken into account.
Is this the moment China bears have been waiting for? It is hard to say for sure, but the very fact that Chinese officials have been vigorously brushing aside questions about a hard landing shows that the fears are mounting. And what is beyond doubt is that the successful Chinese economic model based on cheap labour, an undervalued exchange rate, massive exports, over-investment and cheap bank credit is now past its sell-by date. The International Monetary Fund said as much in its latest report on the Chinese economy released last week: “Time is running out on the current model”.
China is currently trapped in a pincer of a Lewis moment and a Minsky moment. The Lewis moment derives its name from the insight of the great development economist Arthur Lewis that poor countries with surplus labour in the traditional sector can provide labour to the modern sector at very low wages; China has grown to a point where wages in its factories have begun to rise rapidly. The Minsky moment derives its name from the once-forgotten but now-popular warning by Hyman Minsky that financial cycles become unstable at the end of a boom because of excess borrowing. So China is battling a structural economic problem as well as a financial instability problem.
The growing economic troubles in China will undoubtedly have an impact on neighbouring India. We would like to point to two large opportunities and two major threats.
The first opportunity is that rising wages are forcing China to exit low-value manufacturing that it now dominates. Such transitions have been seen across Asia. Japan first exited such low-value manufacturing after wages began to rise there in the 1960s. Production facilities moved to the original tiger economies of Taiwan, Singapore, South Korea and Hong Kong—and in later waves to South-East Asia and then China. The rise in Chinese wages will create space for India to get a bigger share of the global manufacturing pie, if the government can get its policy mix right.
The second opportunity is a more immediate one. The superlative growth in China in recent decades was resource-intensive, which lifted global commodity prices. A sharp slowdown in China will likely be bearish for commodity prices and, hence, a relief for countries such as India that are net commodity importers (though individual sectors such as iron ore mining could suffer given the large exports of ore from India to China).
The first threat is that economic instability in China could unsettle capital flows into all emerging markets. Some of the global ardour for emerging market stocks by global investors has already cooled off. An implosion—or even a hard landing—in the most prominent emerging market will likely lead to a further withdrawal of global capital from the asset class, with economies such as India that have high current account deficits under particular pressure.
The second threat is an outlier as of now. But there are fears that the new Chinese leadership may try to calm a restive population by sabre rattling in the neighbourhood. The Chinese communist party has realized that its hold on power is secure as long as the economy is in fine fettle. A sharp slowdown could force it to stir nationalist passions to keep citizens engaged. This is not a likely threat right now, but it is a possibility that Indian strategists may need to take into account if the Chinese economy gets into deep trouble.
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