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China’s imbalances threaten plans for global domination

Charles Dumas of Lombard Street Research reckons China will suffer for not tackling its imbalances.

That’s probably true, of course, but like so many other analysts he seems to be comparing China’s problems to those of Japan in the early 1970s.

Domestically, China continues to build up its own bubble of debt that will probably never be repaid in full. And its refusal to reverse the policies that underlie this build-up is why its growth may halve to 5 per cent in the next few years. Without a sharp shift of policy, that 5 per cent may be the upper limit of Chinese growth for the long term, with a plague of banking crises threatening a worse result. This would be a disastrous result for a country whose per capita GDP (at comparable prices) is just 17 per cent of the US level, versus 67 per cent in 1973 in Japan, when its growth likewise halved to 5 per cent.

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Domestically, China continues to build up its own bubble of debt that will probably never be repaid in full. And its refusal to reverse the policies that underlie this build-up is why its growth may halve to 5 per cent in the next few years. Without a sharp shift of policy, that 5 per cent may be the upper limit of Chinese growth for the long term, with a plague of banking crises threatening a worse result. This would be a disastrous result for a country whose per capita GDP (at comparable prices) is just 17 per cent of the US level, versus 67 per cent in 1973 in Japan, when its growth likewise halved to 5 per cent.

The article doesn’t explain the logic of comparing Japan in 1973 to China in 2012. This is odd, because it’s the only real indication of what Dumas reckons is in store for Chinese economic growth — he’s saying that in the future, over an unspecified period of time, China will grow half as fast, compared to an unspecified period in the past.

Nate Silver he ain’t.

Even so, this looks like wishful thinking. Japan’s economy was not significantly imbalanced during the two decades running up to 1970, so there’s little reason to assume that the re-adjustment thereafter is a useful comparison for China today.

A far more sensible yardstick is Japan in the late 1980s, as Michael Pettis wrote a month ago.

The most popular reason for comparing China with Japan of the 1960-70s is that China today is much poorer than Japan in the late 1980s. Japan in the late 1980s was rich, people will say, while China is terribly poor, so there can’t be any useful comparison between Japan in the 1990s and China in the next decade.

This, of course, is silly. If you are arguing about the consequences of imbalanced, investment-driven growth, it isn’t the nominal levels of wealth that need to be compared. After all there are rich as well as poor countries that suffered from this kind of unbalanced, investment-driven growth, and all of them ended up suffering subsequently from the same kinds of economic rebalancing.

What really matters is the extent of the underlying imbalances and the relationship between capital stock and worker productivity. In that light it is just as easy for a poor country to have excess capital stock as it is for a rich country – perhaps even more so.

Many big investors can’t accept this view. They have huge investments in China, they’ve opened offices there, they’ve lobbied the government for licences and quotas, and are committed to a growth rate that justifies this level of investment.

It’s the same with the investment banks. They’re not making any money in China these days, but they’re institutionally geared to being there. Bankers who earned their stripes doing mega Chinese IPOs for the past seven or eight years are now in senior positions, making it extremely difficult for those institutions to change course.

This is how Pettis describes the Japanese imbalances:

  • Japan in the late 1980s grew at extraordinary rates fueled by a credit-backed investment boom funded at artificially low interest rates.
  • Although for many decades much of the investment may have been viable and necessary, by the 1980s investment was increasingly misallocated into expanding unnecessary manufacturing capacity, as well as fueling surges in real estate development and excess spending on infrastructure.
  • Artificially low rates, set nominally by the central bank but in reality by the Ministry of Finance, and coming mainly at the expense of household savers also fueled a bubble in local assets.
  • An artificially low currency fueled very rapid growth in the tradable goods sector while also constraining household income growth.
  • Because the growth model constrained growth in household income and household consumption, it forced up the domestic savings rate to extraordinary levels.
  • The combination of low consumption and excessive manufacturing capacity required a high trade surplus in order to balance production with demand.
  • And finally, and most worryingly, debt levels across the economy began to soar as debt rose much faster than debt servicing capacity.

Remind you of anywhere?

Of course, I don’t know who is right or how things will turn out in China, but I don’t think the big financial institutions are working very hard to challenge their optimistic forecasts. They’re wedded to the dominant narrative of China rising rapidly to take over the world, and clearly feel they have to be there at all costs (which, in effect, means burying their heads in the sand and hoping everything works out).

Meanwhile, many investment banks made more money in Malaysia (population: 30 million) than in China this year. Watch this space.

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