IMF: China Isn’t Ten Feet Tall

The world’s eyes are riveted on the car crash in Europe, but the troubles in China could be even larger.  An IMF report out this week adds yet another voice to the chorus warning that some very important pieces of China’s boom rest on shaky foundations.  As the NYT reports:

In the 125-page report on China’s financial system, the I.M.F. said that state controls over the economy were partly to blame for soaring property prices, excessive bank lending and mounting local government debt, and that these were among the growing risks that threaten to undermine the country’s economic boom…

“The existing configuration of financial policies fosters high savings, structurally high levels of liquidity and a high risk of capital misallocation and asset bubbles, particularly in real estate,” the report said. “The cost of these distortions is rising over time, posing increasing macro-financial risks.” [...]

The I.M.F. said…that despite the nation’s spectacular growth, the quality of that growth had become increasingly inefficient. It now takes about $5 worth of investment to create $1 of gross domestic product — about 40 percent more than Japan or South Korea — the report said.

China has a complicated economic outlook and forecasting is difficult, but there are four big problems the Chinese must deal with every day.  Everything we know about human nature, financial history and the global economy today points in the same direction: at some point the Chinese authorities will not be able to prevent a serious downturn, and when that happens the new Chinese economic and political order will be tested as never before. While we can’t (at least, we here at Via Meadia can’t) predict when or how the break point will come, we can look at the Fearsome Four and get some insight as the process unfolds.

First, as the IMF report suggests, China faces a dynamic of inexorably mounting complexity: as the Chinese economy grows, the economy and Chinese society become more complicated and harder to manage.  There are more domestic interests that need to be consulted, more economic issues to manage, more complicated interactions between financial markets and the real economy to watch, to regulate and to manage.  Even in the absence of formal democratic structures, the Chinese government is accountable to powerful domestic interest groups and public opinion.  As society grows more complex and new actors become more empowered, it is harder and harder for the government to deliver “pure” technocratic solutions.  It starts having to make the messy compromises and trade-offs found in democratic structures. At the same time it gets harder and harder to figure out what the “right” thing is to do: it is harder to determine the best policy for a very complex system than for a very simple one.

What this means is that over time China has less ability to discern the right policies and less freedom to introduce them.  China is like a juggler on a ship moving from a harbor into open waters: it must juggle an ever growing number of balls while the deck under its feet is beginning to pitch and move.  Sooner or later, something is going to fall.

Second, China’s development model will not work forever.  Every other country that has developed on the basis of an export-oriented manufacturing strategy did spectacularly well for a long time before hitting a wall when lower, slower growth became inevitable.  Look at Japan.  While it is hard to predict exactly when this phase change will come, there is no reason to believe China is exempt and many people in China think it is already starting.  Clearly the response to this must be to shift from exports to the internal market as a chief driver of growth but this is hard to do (more balls to juggle on a more violently pitching deck) and even when success involves the permanent transition to a slower growth path.

Third, over a long period of nearly unbroken prosperity, a lot of bad habits have gotten hardwired into Chinese life.  Banks have made speculative loans to party officials, shady developers and to their own brothers-in-law and over time, with ten percent growth, most of these loans have worked out pretty well.  Prudence and transparency have long been hooted out of town: there has been no interest in being careful for a very long time.  When the music stops, a lot of loans are going, very suddenly, to look terrible.  A lot of local and provincial governments are likely to be left with huge liabilities.  A lot of state owned businesses, after swimming in an ocean of unrestricted liquidity, are going to have a tough time adopting to less forgiving times.  Real estate developers will go belly up; infrastructure projects won’t pay for themselves; revenue forecasts will be drastically wrong.

Financial crashes, big recessions and even panics play a role in the economic ecology similar to the role that wildfires play in many natural systems.  When you don’t have regular small fires that burn out the undergrowth, material piles up and piles up until the inevitable fire does come along.  China is like a California valley that hasn’t burned for decades: the potential for a firestorm is large and it is growing.

Fourth, there is the global situation.  China can’t control the global economy and can’t even influence it very much.  But the mess in Europe, the slow growth in the US and problems like the impact of a US-Iran crisis on world oil prices can all serve as the matches that could ignite a conflagration in China.

Sooner or later, China will undergo a substantial shift in its trajectory and that shift is likely to have political as well as economic repercussions in China as well as abroad.  That sounds very bloodless and abstract; the reality will likely be something else.

The social and economic transformations now taking place in China are the biggest, deepest and fastest transformations that a group of people this large have ever experienced.  Any reading of history would suggest that transformations of this depth and extent do not proceed smoothly for long.  China’s political, social and economic history in the 21st century will likely be tumultuous rather than dull.  The Chinese are living in interesting times; as a result, so are we all.