China Must Follow Japan to Survive

China has been transformed by a credit-fueled investment boom unlike anything the world has ever seen.

A credit-based economy, built around what has effectively been the dollar standard, made it all possible. There’s no limit to the amount of credit that can be created under a fiat money system. And the dollar standard created a very large global boom, as U.S. dollars flooded into countries like China.

Between 1990 and 2014, investment in China increased a staggering 50-fold. Between 2007 and 2014 alone, investment in China increased by 236%. In the U.S. meanwhile, investment only increased 6% over that same time period.

The Chinese are therefore dependent on the dollar standard. If they could have given it up, they would have. But they can’t. They desperately need a trade surplus with the U.S. and the rest of the world to finance their economy and sustain their jobs. Jobs are the main benefit they receive from the dollar standard. China’s had an explosion in their population in the last three to four decades. Because of the dollar standard, globalization and the growing U.S. trade deficit with China, they’ve been able to keep those people employed, fed, and increasingly prosperous.

China kept the global bubble inflated after the U.S. bubble burst in 2008, through very rapid credit growth and investment growth. But that credit-fueled came into an end sometime in 2014 or 2015. And China faces severe problems as a result. I’m not at all certain China’s economy grew at all last year.

Chinese exports used to grow up to 30% a year. Now they’re contracting. Last year, for example, Chinese imports contracted 17%. The great export surge from 1990-2014 will not be repeated.

There’s simply not enough demand in the entire world to permit China’s investment-driven economy to grow. The global economy now teeters on recession, if not outright depression. In the past, China was able to export most of its excess production to other countries. But now trade is collapsing and global demand is much too weak to absorb further Chinese exports. Meanwhile, U.S. credit growth is too weak to drive growth, at home or abroad. And my projections don’t show those figures changing anytime soon. The bottom line is that China will not be able to sustain its economy through export-led growth.

China’s investment boom has long since outpaced demand. And with exports contracting, that is now resulting in heavy losses in the banking system. Investment is a net good, but only as long as it creates goods that can be sold for more than they cost to make. When investment is too high relative to demand, prices fall and investment results in losses, rather than profits. That’s what China is facing.

China realizes it can’t continue having such massive levels of investment. That investment has already resulted in far too much excess production capacity. Most of it is already generating losses. And the more they invest now, the more wealth they destroy. Further investment in loss-generating enterprises will only result in more losses. But without continued high rates of investment, the Chinese economy will fall into severe recession. That’s the trap.

China invests much more than it consumes, which has led to a severely imbalanced economy. And Chinese per capita income is far too low to consume the nation’s excess capacity. Median Chinese disposable income, for example, is only $8.13 a day. In the U.S, household consumption accounts for 68% of GDP, and investment 18%. In China, consumption only accounts for 38% of GDP, while investment represents 44%. Perhaps not since the Pharaohs built the pyramids in ancient Egypt with slave labor has investment accounted for so much of a country’s GDP, and consumption, so little.

Chinese officials have said they’d like to switch from an export-based system to a consumption-driven model since the export model is too vulnerable to a global slowdown. But this will be a major challenge.  

There’s really no easy way to shift from investment-driven growth to consumption-driven growth, for a number of reasons. If you lay off thousands of steelworkers, for example, those people aren’t going to consume more, they’re going to consume less. If you move those people from manufacturing jobs into service sector jobs, these service sector jobs will pay a lot less than manufacturing sector jobs. To boost consumption, China would need to boost its people’s income dramatically. When disposable personal income per capita is $8.13 a day, those people can’t really consume a great deal.

On the other hand, if China did manage to increase wages and thus consumption, that presents another problem. At present rates, Chinese factory workers are on track to make about $60 a day within ten years. That sounds like a positive. But before long, Chinese wages aren’t going to be globally competitive anymore.

The manufacturing jobs would move out of China into Vietnam, Indonesia, India, and Bangladesh. Exports would plunge and millions of jobs would be lost. There are 100 million Indians that would be happy to work for $5 a day. They haven’t even entered the game, so we’re a long way to go before we run out of $5 a day labor. That’s China’s problem.

Investment in China is going to decrease. So is consumption. That means Chinese government deficit spending is going to have to increase sharply to keep the country out of depression. In other words, it’s going to have to follow the Japanese model of the past 26 years, with soaring debt-to-GDP ratios and much large budget deficits. China’s bust may not turn out to be as severe as Japan’s, but the threat of a full depression cannot be ruled out if the government doesn’t undertake strong measures. And the Chinese government cannot risk that possibility.

The Japanese bubble popped in 1990. And today, 26 years later, its economy is no bigger than it was in 1993 in nominal terms. Japan’s now been in an L-shaped recovery for 26 years. In an L-shaped recovery, the economy declines sharply initially, which is then followed by a long period of flat or stagnant growth. 26 years is a long time of flat or stagnant growth. But Japan managed to avoid a full depression because it increased its debt from 60% of GDP to 250%.

I expect something quite similar to happen in China. Hopefully, with some luck and skill, China will be able to replay the Japanese scenario. Through very large budget deficits and a very large rapid increase in Chinese central government debt, they can avoid collapsing into a Great Depression.

China isn’t going to have very much GDP growth to speak of at all, not for a very long time potentially. Its export-fueled growth of the past 25 years has come to an end. And it’s attempts to transition to more of a consumption-based economy will not be easy. But if China follows the Japanese model, it can hopefully avoid a depression. A Chinese depression would present a great challenge not just for China, but for the entire world.

Regards,

Richard Duncan
for The Daily Reckoning

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