The biggest question in the global capital markets is what will be the fate of China? The country is in real financial trouble. The claim that the Middle Kingdom is set to take over the role of the world’s biggest and most powerful economy is almost certainly wrong, or at least an exaggeration. In particular, the fact that China’s domestic money supply is two and half times its GDP points to an extreme level of money printing just to keep the banking system going.
China's growth has been based on four elements:
- Mercantilist exports, i.e. industries designed for exports by mercantilist policies such as China's currency peg to the U.S. dollar. That has allowed the country to build up the foreign exchange to support its external currency, the yuan.
All that is genuine wealth, but it is not at the same level as Japan or South Korea’s rise because the traded sector is a smaller sector of the economy. And as China’s economy gets bigger, the traded sector gets proprtionately smaller – it becomes a ‘continental economy’ like the US, in which what happens domestically is far more important than what happens with trade.
Now we get to the more problematic bits. The problem with the first two is that they do not give adequate return on the capital invested, which is why China is printing money so aggressively. It needs to bail out the banks:
- Property development, in which local governments sell development rights to private-sector developers and developers build millions of apartments (typically in high-rise buildings) that are sold to households.
- Infrastructure projects such as subway systems, dams, highways, high-speed rail, airports, sports arenas, etc.
- Debt, which has expanded in all sectors: public, private, corporate and shadow banking/wealth management.
Analyst Charles Hugh-Smith says “the problem is all four are running into diminishing returns that are veering into malinvestment (i.e. money that could have been better spent elsewhere) and systemic fragility.” China is getting into trouble:
“As labor and production costs have risen in China, cheaper competitors have emerged, impacting exports.
Property development is generating systemic fragility due to the initial conditions established in the early days of opening China's economy: all land is owned by the central state, but leases (development rights) are sold by local governments.
The twist that's unique to China is that these development fees are the primary source of local government revenues, as property taxes are negligible. In other words, if development ceases, local governments lose the primary source of the revenues they need to function.
Property values remain high because demand for investment flats has been favorable. For financial and cultural reasons, real estate is strongly favored as a form of savings and investment. Since inhabited apartments are not as valuable as new or never-inhabited, most investment flats are not rented out; they remain empty.
While upper-middle class families already own two or three empty investment flats, the price (hundreds of thousands of dollars in upper-tier cities) is out of reach for typical workers and rural populations.
In effect, the enormous property development sector is dependent on upper-middle class households buying third, fourth and fifth investment flats as the majority of average workers cannot afford to buy an apartment. For an average worker to buy a flat, the entire family's wealth must be assembled and huge debts taken on, often in the unregulated shadow banking system.”
Growth generated from infrastructure is also slowing. About 40% of China’s GDP has come from business investment compared with less than 10% in most developed countries. That is the source of China’s economy miracle: massive investment. But that game is up, and there is not enough consumption to make up the difference;
“Most infrastructure has already been built out, so new projects offer only marginal utility. The new airport, train station or mall is mostly empty, the new sports facility is rarely used, and so on. Once high-utility infrastructure has been built, constructing "bridges to nowhere" creates temporary jobs but adds little or nothing to productivity or well-being.”
And then there is the debt, same problem the world over:
“Debt is another dynamic that has positive results early on but eventually becomes a source of systemic fragility if it continues expanding to serve malinvestments and speculation. One word says it all: EverGrande.
Just as in the U.S., politically powerful "too big to fail" players in China have been bailed out by the central government, generating moral hazard: the disconnection of risk and consequence. These central bank/state bailouts of highly leveraged and indebted developers has encouraged players to extremes of leverage, risk and debt that now pose a systemic threat to China's financial system and public trust.
We've seen where malinvestment, moral hazard, declining exports, ballooning debt, dependence on development and "bridges to nowhere" lead: to decades of stagnation and social depression, i.e. present-day Japan, which failed to transition from an export / development dependent economy that worked brilliantly for three decades (1955 to 1985) but then generated a speculative bubble that popped in 1989 with devastating consequences.
President Xi must foster (or force) a transition to new more sustainable engines of growth, or China will slide down the path to stagnation and speculative bubbles that pop. Xi must also address another source of systemic fragility, soaring wealth inequality, which diverts the lion's share of income and wealth to a thin slice of the super-wealthy while the purchasing power of workers' wages stagnates.
If the purchasing power of wages stagnates, you can kiss your consumer-based economy good-bye. Yes, skyrocketing debt can generate a brief spurt of demand, but this is not sustainable or productive. Wages rise from prudent investments that raise productivity of the labor force and economy, not from building empty flats (China) or speculating in meme stocks (U.S.).
The irony of the rivalry between China and the U.S. is both share the same problems: dependence on systems that no longer improve productivity, soaring wealth inequality, massive malinvestment, skyrocketing systemic fragility, rising costs, unprecedented speculative bubbles and a sclerotic, self-serving parasitic elite that resists much-needed reforms.”
China arguably has deeper problems that the US, and does not have the world’s reserve currency. If things go as expected, then companies that rely on Chinese demand, such as Australia’s big miners, will be adeversely affected.
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