China's economy is tipping into crisis because its economic growth model of export-led, investment-driven growth has taken China as far as it can. In a global economy that is barely growing, there is no one left for China to export more to. The end of the Great China Boom will have a profound impact on every corner of the globe. Here's what's happening.
In the past, very rapid credit growth in the United States fuelled the US economy and pulled in sharply increasing amounts of imports each year. Surging US demand created a bonanza for the global economy as the rest of the world expanded its investment and industrial production to satisfy orders from the United States. No country benefited more than China.
Chinese exports to the US rose from $15 billion in 1990 to $440 billion in 2013; and its trade surplus with the US rose from $10 billion to $318 billion over the same period. China's cumulative trade surplus with the US over those years amounted to $3.3 trillion. As that money entered China's banking system as deposits, it supplied the funding required to build the factories that produced the goods that the Americans wanted to buy. Investment increased at a phenomenal pace, averaging 13.3% a year (in real, inflation-adjusted term) between 1990 and 2012.
With exports and investment booming, China's economic growth exploded. The size of its GDP grew from $350 billion in 1990 to $8.2 trillion in 2012. And, as China's economy grew, it pulled in huge amounts of imports from around the world - raw materials from Australia, South-East Asia, Africa and South America; oil from the Middle-East and Russia; and advanced machinery from Germany and Japan. China became the world's second engine of growth.
China's economy was peculiarly lopsided, however. Investment amounted to 49% of GDP in 2011, whereas household consumption amounted to only 35% of GDP. That is twice the world average for investment and less than half the global average for consumption.
This imbalance between investment and consumption illustrates how dependent China's economy is on demand from the rest of the world.
Export-led, investment-driven growth worked miracles for China for three decades. But the conditions that existed between, say, 1985 and 2007, are no longer in place today. During those years, total debt in the United States increased from $9 trillion to $50 trillion; and the ratio of total debt to GDP rose from 150% to 370%.
Today, the growth of total debt in the US is less than 2% a year (adjusted for inflation). That is too little to generate meaningful economic growth there. Consequently, imports into the US are depressed. Goods imported were flat in 2013 relative to 2012. Therefore, the growth in world trade is weak and the global economy is verging on recession. In this environment, it is not possible for China to continue growing its exports at a double-digit annual pace. During the first two months of this year, China's exports actually contracted by 1.6% compared with the first two months of last year.
China has responded to the crisis in global growth by investing more in domestic infrastructure and by radically expanding domestic credit. Bank loans have increased by 135% since the crisis began and lending by the shadow banking system has grown even more rapidly. However, there is a limit as to how many highways and bridges that China can build. Moreover, the longer the credit binge continues the greater the probability of a systemic banking crisis becomes.
With global demand for Chinese exports saturated, any further investment in factories will only result in losses since China already has enormous excess industrial capacity across almost every industry. Ongoing massive investment in infrastructure is increasingly wasteful. And, the wild lending spree underway is increasingly destabilizing.
To put it mildly, China is in trouble.
To put it mildly, China is in trouble. And that spells trouble for the rest of the world. As a result, the global economy is likely to slow further and the price of commodities such as copper, iron ore and coal are likely to continue to fall. The commodity-exporting economies, like Australia and Brazil, are likely to suffer as a consequence, and their currencies are likely to continue to weaken. With Chinese demand for imports slowing (or falling), global deflationary forces should increase and, if China allows its currency to depreciate (which is a growing possibility), those deflationary forces would intensify. In this scenario, interest rates (i.e. bond yields) would be likely to move lower rather than to rise as most analysts currently expect. Corporate profits would also come under pressure, increasing the chances of a sharp stock market selloff.
The scenario outlined above is more likely to play out gradually rather than overnight. China still has a great deal of scope to stimulate its economy by running very large budget deficits the way Japan has done for the last 24 years. Moreover, in all probability, the Fed and other central banks would respond to this risk of global recession by significantly increasing the amount of fiat money they print each month.
Therefore, while I don't expect the crisis in China's economic growth model to produce an immediate crisis in the global economy, I do believe that it will create very significant headwinds for the rest of the world during the years immediately ahead. This is another reason why Quantitative Easing is unlikely to end any time soon.
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