By Michael Baxter 2 Aug 2010 [0 Comments | 404 views]
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China has been hit by two bits of rather nasty economic news over the last few days. First there’s news on its manufacturing, which seems to be perilously close to recession. Secondly there are fears it could be hit by a banking crisis of its own making. If these two developments pan out the way some fear, then China, for so long the powerhouse of global economic growth, could hit its toughest economic period for a very long time.
China is a lucky country. In the UK, US and Europe we have to content ourselves with one Purchasing Managers Index (PMI) for Manufacturing. China has got two. It’s got one report produced by the Chinese Federation of Labour, another produced by HSBC and Markit. Yesterday saw the release of the Chinese Federation of Labour measure. This has now fallen to its lowest level in 17 months. The other report is due out later today.
The Chinese PMI fell from 52.1 in June to 51.2 in July. You need to bear the following in mind. Firstly, any score under 50 is meant to indicate recession; secondly, the average in 2009 was between 55 and 56; and thirdly, the index has now fallen for three successive months. In fact, last month, this column picked up on the fall in the index and warned that if there was another drop in July then we know it is time to get concerned.
There are mitigating factors. Well, there is one mitigating factor. Traditionally the May to July period has always been one in which the PMI has performed badly. So, while a further fall in the index over the next few months would point to recession, history tells us it is more likely to rise.
The other piece of worrisome news relates to a rumour flying around last week that only a quarter of bank loans to Chinese local government investment vehicles are likely to be repaid from the projects that the bank loans funded. Of the rest, around half are expected to be repaid, but from non project-related revenues. And around 23 per cent are unlikely to be repaid at all.
Capital Economics has worked out that even if bank loans go bad on that rather horrific scale, the Chinese government can comfortably afford a banking bailout.
But whether China can afford a banking bailout or not, is surely not the point.
The fact that loans to local governments are going so horribly wrong is yet another indication of the Great Bubble of China. Billions of dollars have been invested into projects that seem to be worth nothing. And China sees roads that appear to lead nowhere, shopping malls bereft of customers, and a growing catalogue of investment projects sitting idle.
Combine this with the plight in the PMI, then one is left asking where will future growth come from?
Superficially, the answer is obvious: it’s China’s consumer. This is why news that China’s unions have successfully won big pay awards for the workers they represent is greeted as being good for the economy.
In the longer term the challenge facing China is a bit more complex than that.
Take a sideways move for a moment and consider one of economic theory’s more important ideas: the Solow-Swan growth model. The idea behind this theory is that in a mature economy, new investment has little impact upon economic growth. In such an economy, only innovation can create an environment ripe for growth. It is worth re-reading that, it is an important point: in a mature economy, investment does not lead to growth.
Now that may seem a little daft, but see the theory from the point of view of a farmer. Our farmer has a good, reliable combine harvester, and reckons his farm is about as efficient as it can be. There is no point in the farmer buying another combine harvester, as the second machine would just be lying idle. Sure, the farmer would need to ensure his combine harvester is maintained, and when the machine gets old he may need to replace it, but there would be no need to increase the value of his farm’s capital goods. Only if there is a new innovation leading to more efficient combine harvesters, would there be a good reason to buy a new one. Such a farm is analogous to a mature economy.
At the end of the Second World War none of the world’s economies were at that mature stage. All of them were deficient in capital goods and infrastructure. And so it was that investment led to a rise in production capacity, and the global economy enjoyed a golden age of 25-years of growth. This age surely came to an end when the gap between potential and actual had fallen so that new investment hardly led to more growth at all.
In short, by the mid 1970s, the developed world had become a block of mature economies, reliant on innovation creating the potential for more growth. Alas, consumer demand still continued to rise at the rates seen in the previous quarter of a century; as a result demand outstripped supply, and we got inflation.
China is still way off the mature economy stage. Its potential growth is still very significant.
Sure, it has factories and shopping malls lying idle, and sure, debt levels in some parts of the economy are too high, but China can grow into this spare capacity, in much the same way a child can grow into a coat that initially was too big. As long as growth is greater than the rate of interest, then debts are affordable.
Doubtless house prices may be too high in parts of China, but growth will mean these proprieties will become affordable quite rapidly. If sustainable property prices are defined by the relationship between average wages and average price, and the ratio is too high, then one of two things can happen to bring the ratio back into balance. Either prices can fall, or salaries rise. In the West we don’t really have the luxury of the second option; in China they do.
Clearly China has problems ahead, although an outright recession seems highly unlikely. Clearly the economy is riddled with bubbles, but that is inevitable in any fast growing economy.
But any comparison with Japan twenty years ago, when stellar growth turned to a lost decade, is wrong. Japan had simply moved from developing to mature economy status. Its problems since can be explained in part by the inevitable upheaval that comes when an economy moves into this mature stage, and in part by the ageing of its workforce. China has neither of these two problems, not yet.
China’s challenge is different. It is so large that a question mark hangs over where the consumer demand will come from to meet the rises in potential capacity. We now know that the rest of the world is just too small to provide this demand indefinitely. The economy is now adjusting, with the consumer taking up some of the slack. But it is inevitable that there will be times during this changeover when demand rises either too fast or too slow, and China will need to get used to suffering from an economic cycle, complete with booms and recession, just like the rest of us.
