China: Vulnerable Giant

U.S. policy through the Bush and Obama administrations was simple. It looked the other way at questionable Chinese trade practices, technology and intellectual property theft, etc. In return the U.S. got cheap manufactured goods and China’s willingness to finance trillions of dollars of U.S. government debt.

But President Trump came along and changed the rules of the game. He’s said lost jobs in the U.S. are not worth the cheap goods and cheap financing. He bet that China had no alternative but to keep producing those goods and keep buying our debt, even if the U.S. imposes tariffs to help create manufacturing jobs here.

Trump is right that China needs the U.S. to sustain economic growth. China’s economy is not just about providing jobs, goods and services. It is about regime survival for a Chinese Communist Party that faces an existential crisis if it fails to deliver.

It is an illegitimate regime that will remain in power only so long as it provides jobs and a rising living standard for the Chinese people. The overriding imperative of the Chinese leadership is to avoid societal unrest.

Once the Chinese job machine stalls out, popular unrest could emerge on a scale much greater than the 1989 Tiananmen Square protests. This is an existential threat to Communist power. It appears that a Tiananmen-type incident will be avoided in Hong Kong. But if a resolution hadn’t been found, it is very likely China would have crushed the protests ruthlessly. It will not tolerate threats to its authority.

But if China encounters a financial crisis, Xi could quickly lose what the Chinese call, “The Mandate of Heaven.” That’s a term that describes the intangible goodwill and popular support needed by emperors to rule China for the past 3,000 years.

If The Mandate of Heaven is lost, a ruler can fall quickly.

The story isn’t new, but China has serious structural economic problems and its internal contradictions that are finally catching up with it.

Economies can grow through consumption, investment, government spending and net exports. The “Chinese miracle” has been mostly a matter of investment and net exports, with minimal spending by consumers.

The investment component was thinly disguised government spending — many of the companies conducting investment in large infrastructure projects were backed directly or indirectly by the government through the banks.

This investment was debt-financed. China is so heavily indebted that it is now at the point where more debt does not produce growth. Adding additional debt today slows the economy and calls into question China’s ability to service its existing debt.

China is now confronting an insolvent banking system, a real estate bubble, and a $1 trillion wealth management product Ponzi scheme that is starting to fall apart.

Up to half of China’s investment is a complete waste. It does produce jobs and utilize inputs like cement, steel, copper and glass. But the finished product, whether a city, train station or sports arena, is often a white elephant that will remain unused.

Chinese growth has been reported in recent years as 6.5–10% but is actually closer to 5% or lower once an adjustment is made for the waste.

The Chinese landscape is littered with “ghost cities” that have resulted from China’s wasted investment and flawed development model. What’s worse is that these white elephants are being financed with debt that can never be repaid. And no allowance has been made for the maintenance that will be needed to keep these white elephants in usable form if demand does rise in the future, which is doubtful.

Essentially, China is on the horns of a dilemma with no good way out. On the one hand, China has driven growth for the past eight years with excessive credit, wasted infrastructure investment and Ponzi schemes.

The Chinese leadership knows this, but they had to keep the growth machine in high gear to create jobs for millions of migrants coming from the countryside to the city and to maintain jobs for the millions more already in the cities.

The two ways to get rid of debt are deflation (which results in write-offs, bankruptcies and unemployment) or inflation (which results in theft of purchasing power, similar to a tax increase).

Both alternatives are unacceptable to the Communists because they lack the political legitimacy to endure either unemployment or inflation. Either policy would cause social unrest and unleash revolutionary potential.

China has hit a wall that development economists refer to as the “middle income trap.” This happens to developing economies when they have exhausted the easy growth potential moving from low income to middle income and then face the far more difficult task of moving from middle income to high income.

The move to high-income status requires far more than simple assembly-style jobs staffed by rural dwellers moving to the cities. It requires the creation and adoption of high-value-added products enabled by high technology.

China has not shown much capacity for developing high technology on its own, but it has been quite effective at stealing such technology from trading partners and applying it through its own system of state-owned enterprises and “national champions” such as Huawei in the telecommunications sector. But now the U.S. and other countries are cracking down on China’s technology theft.

Meanwhile, China’s per capita income is only $11,000 per person compared to per capita income of $65,000 in the United States. Put differently, the U.S. is only 38% richer than China on a gross basis, but it is 500% richer than China on a per capita basis.

Most importantly, at $11,000 per capita GDP, China is stuck squarely in this middle income trap, as defined by development economists. The path from low income (about $5,000 per capita) to middle-income (about $10,000 per capita) is fairly straightforward and mostly involves reduced corruption, direct foreign investment and migration from the countryside to cities to pursue assembly-style jobs.

The path from middle-income to high-income (about $20,000 per capita) is much more difficult and involves creation and deployment of high-technology and manufacture of high-value-added goods.

China remains reliant on assembly-style jobs and has shown no promise of breaking into the high-income ranks.

In short, and despite enormous annual growth in the past twenty years, China remains fundamentally a poor country with limited ability to improve the well-being of its citizens much beyond what has already been achieved.

Among developing economies (excluding oil producers), only Taiwan, Hong Kong, Singapore and South Korea have successfully made this transition since World War II. All other developing economies in Latin America, Africa, South Asia and the Middle East including Brazil and Turkey remain stuck in the middle-income ranks. And that’s where China is right now.

China is confronting social, economic and geopolitical pressures that are testing the legitimacy of the Communist Party leadership and may lead to an economic crisis of the first order in the not distant future.

The trade war is prodding international business to move supply chains from China to Vietnam and elsewhere in South Asia. Once those supply chains move, they will not come back to China for at least ten years if ever. These are permanent losses for the Chinese economy.

My view is that a crisis in China is inevitable based on China’s growth model, the international financial climate and excessive debt. A countdown to crisis has begun.

Regards,

Jim Rickards
for The Daily Reckoning