Friday, 5 October 2012

Why China needs a slowdown

The rise of China will be the most momentous shift in economic power of a generation and it is only a matter of time until China will be the largest economy in the world.  For a long time, the concerns regarding China have been over its relentless rise and how its insatiable appetite for raw materials has pushed up commodity prices.  But the world economy has become dependent on China as an engine of growth as economies in Europe and elsewhere stumble.  So the worry now is not about China expanding too fast but China not expanding fast enough as sluggish global demand begins to hurt China’s economy and the Chinese government is not acting to maintain the previous hectic rate of economic growth.

As a capitalist economy with a communist government, China has the best of both worlds.  Rampant entrepreneurism, which Your Neighbourhood Economist has always associated with Chinese people (positive racial stereotyping?), has resulted in wealth creation on a massive scale and dragged millions out of poverty.  Yet, the communist government maintains a level of control over the economy to help the country through a period of unprecedented growth.  As such, the government stepped in when the global financial crisis hit in 2008 with a colossal economic stimulus worth 16% of GDP over two years.  It may seem a strange notion for a communist government to be propping up a capitalist economy but it is the best way for the communists to provide higher income for its citizens and maintain their grip on power.  And a strong central government helps to keep much of the messy politics out of the way (for an example of politics getting in the way - One step forward and two steps backwards)

Yet, as the global economy weakens, China itself is in the midst of a significant economic slowdown but the government has held back from throwing its full weight behind another economic rescue mission.  The Chinese government has the capacity for further action as it does not have the debt of governments in other large economies.  Punters in the media have suggested that it is the change of the top government posts that has resulted in the leaders in China being distracted.  Others have pointed to the possibility that more of a stimulus would not have any further effect.  But Your Neighbourhood Economist would argue that the Chinese government is smarter than that and still has the capacity to generate growth in the economy.

It is not that the Chinese economy wouldn't get a boost from more stimulus but that such measures would create more problems than it would solve.  The economy in China is like a weightlifter on steroids – more steroids would typically help to lift heavier weights but too much can cause severe damage.  Investment is the steroids that have been driving the Chinese economy.  Investment is typically what fuels any economic expansion.  Companies build factories and shops if there are products to make and sell but this will only happen if consumers have enough money to buy the goods.  So investment surges when an economy is booming but companies will stop investing if times turn bad.

Companies in China not only provide goods and services for the 1 billion people that live in China but also export products for retailers across the globe.  As such, investment in China has reached unprecedented levels - around 50% of GDP compared to around 15% in the United States.   Much of the stimulus package in 2008 went toward spending on infrastructure and was combined with lower interest rates and increased lending by state-owned banks.  A bit more of the same has been tried in 2012 but without the same fervour. 

The leaders in China could try more of the same but a further boost to investment may result in one shot of steroids too many.  That is not to say that it would not have an effect but rather than the effect would be to exacerbate imbalances in the Chinese economy.  Investment that outpaces growth in the economy risks not only being a waste of money but distorting the development of the economy.  Excessive spending to build factories which end up producing goods that no one wants will result in bad debts.  Spending on infrastructure is another possible form of investing but this also needs to expand along with a growing economy so as to go to areas where it is actually required rather than roads to nowhere.

Considering that global banking system got in trouble following a period of debt fuelled expansion, Your Neighbourhood Economist hopes that lessons have been learnt and that the Chinese economy is not pushed to expand too rapidly.  But only time will tell – stay posted.