The structure of the Chinese economy is very different from that of the US economy. China’s economy is dominated by and driven by investment. The US economy is dominated by and driven by consumption. As I outlined in Economic Forecasting, 101 (February 15, 2012), the economy of every country is comprised of just four major parts: personal consumption expenditure (how much people spend), business investment, net trade (exports – imports) and government spending. The following table shows the composition of the US economy and the Chinese economy:
The breakdown of the US economy is fairly representative of all developed economies (although a bit heavier on consumption than the average). China’s economy is unique in being so heavily weighted toward investment. The key to China’s rapid economic growth over the last two decades has been its surging trade surplus with the United States, which rose from $10 billion in 1990 to $268 billion in 2008. China’s overall trade surplus with the world, shown as “net trade” in the table above was equivalent to 4% of China’s GDP last year. While 4% is not an insignificant number, it would not seem to be large enough to justify my claim that this has been the driver of China’s rapid economic growth; and taken by itself, it would not be.There is much more to it than that, however.
Consider first that there are millions (if not tens of millions) of Chinese factory workers employed in factories making goods to sell to the United States. Those workers are paid a wage. They consume with that wage. That spending boosts China’s economy and appears as “consumption” in China’s GDP statistics.
Next, hundreds of billions of dollars have been invested to build factories in China each year. Many (most?) of those factories make things to sell to the US. That investment boosts China’s economy and is recorded as a business investment in China’s GDP statistics.
Finally, when Chinese exporters bring back the dollars they earn from selling their goods in the United States, they convert them into the Chinese currency, the Yuan, and deposit them in Chinese banks. This causes very rapid deposit growth, which, in turn, forces the banks to have very rapid loan growth (because the banks must earn interest on the loans to be able to pay interest on the deposits). In that way, the rapid loan growth creates very rapid economic growth.
Therefore, in my assessment, as much as 40% of China’s economy is directly dependent on China’s trade surplus with the United States. Now that the US is in crisis, that trade surplus is not going to continue skyrocketing as it has since 1990. It is going to flatten out; and that will create a much more difficult economic environment for China during the years ahead.
China’s industrial output has expanded by more than 15% a year for two decades. Now, given rapidly slowing export growth, the end of the property construction boom, and following a 60% increase in total bank loans during 2009 and 2010, China has massive excess capacity across almost all its major industries. Therefore, there is little reason for it to invest and create even more excess industrial capacity.
The US is in crisis, so the overly indebted Americans can’t continue buying more Chinese goods. Chinese factory workers don’t earn enough to buy what they make in the factories where they work. In fact, roughly 80% of the people in China earn less than $10 per day. Therefore the Chinese can’t afford to buy any more Chinese goods. So, who will?
If China continues to invest and expand its industrial production at 15% a year as in years past, then in three years from now, China will have 50% more industrial production capacity than it does today. That won’t work. China already has too much capacity. The Americans are no longer able to borrow more and buy it all; and the Chinese don’t earn enough to buy it themselves. This all means that the era of rapidly expanding economic growth – driven by investment and exporting – is coming to an end for China.
Economic booms tend to be followed by economic busts; and big booms tend to be followed by big busts. Thailand’s boom ended in 1997. In 1998, its economy shrank by 10%. Such a severe economic outcome cannot be ruled out for China in the near future. However, given the firm control that China’s leaders have over the economy and the political system, such a severe outcome will probably be avoided. China’s leaders are likely to respond to the crisis in China’s export-led, investment-driven economic model in the same way that the Japanese government did when Japan’s great economic bubble popped in 1990; that is through massive fiscal stimulus financed by government borrowing. When Japan’s bubble popped, the Japanese government borrowed and spent and, in that way, prevented Japan’s economy from collapsing into a depression. As a result, Japanese government debt rose from 60% of GDP in 1990 to 240% now.
China is very likely to follow this Japanese model of post-bubble depression prevention – just as the United States has been doing since its property bubble popped in 2008. And, if China’s government borrows and spends aggressively enough, taking Chinese government debt up to 100% or even 200% of China’s GDP over the next decade, China’s economy is unlikely to contract sharply in the way that Thailand’s did in 1998. In fact, it may even continue to expand. It won’t expand at 10% a year as it has over the past 20 years. Nor will it expand at 7.5% a year as the consensus now expects. It may expand by an average of 3% a year over the next ten years, but such a positive outcome is by no means guaranteed. Considerably worse scenarios are also possible.
The very rapid slowdown in China’s economic growth has come as a severe shock to the financial markets. Most economic prognosticators had extrapolated the high rates of Chinese economic growth into the distant future and concluded that China would become the new engine of economic growth for the world. That conclusion has suddenly been called into question by the facts. During April, China’s imports did not increase relative to the same month in 2011. That means China contributed nothing to the economic growth of the rest of the world during that month. This new reality, a world in which China is not importing more each month, has profound implications for the global economy.
It will mean that China will import far fewer raw materials than previously anticipated. That will put significant downward pressure on most commodity prices, everything from oil to copper to cotton. Lower commodity prices will mean significantly less economic growth in the commodity producing countries such as Australia, Brazil and Indonesia; and slower economic growth there will put downward pressure on their currencies. The countries that export precision machine tools to China – such as Germany, Japan and South Korea – will also be hit by the sudden slowdown of Chinese growth. And, as those countries that benefit from exporting to China get hit, they will buy less from their trading partners, so the contagion will spread throughout the world causing trade volumes to decline.
Finally, the property markets in Hong Kong, Singapore, Vancouver, Sydney and Melbourne, which have been bid up by Chinese millionaires, are likely to begin to fall as that source of money dries up.
China’s growth has been derived from its trade surplus with the United States, which was financed by rapidly increasing US indebtedness. That game is up. The world is in shock. Adjustment to this new reality could be swift and savage.