Most analysts predict that China will continue to grow at a rate (more than) 7% in 2009. This follows decades of double digit growth, capping an amazing run in economic development. But, while most analysts discuss 7% as the critical growth level to support the massive demand for jobs from an ever-increasing population, it is rarely discussed what would happen if China were to dip much lower than that, and if it actually faced a recession.
What would happen to the global economy if China were to stumble? Imagine growth falling to just 3-4%, or even negative growth for a year or two…would social unrest hit critical levels? Could China deflate its currency enough to drive enough exports to put them back on track? Would that spark a global trade war? What would happen to global commodity prices, and what would be the effect on Latin America/ Africa?
see our wiki discussion “changes are happening in China“
While I may agree with most analysts that forecast 7-10% GDP growth for 2009, I do have to wonder if its possible for China to ALWAYS have this kind of growth. Economic history seems to dictate that ALL economies eventually face recession (not just sub-seven percent growth, but true recessions). China should be no different, in that they should also eventually face recession.
One of the least discussed topics (as far as I know) is “what would happen to the global economy if China were to face a real recession?”. Would they continue buying up US treasuries (and continue financing the US recovery)? If not, would the dollar tumble? Would global supply chains be effected, and if so, how?
The possibility of a Chinese recession should be discussed, and should be planned for. Because if you look seriously at China, you will see that the country’s economy is more fragile and delicately balanced that it may appear at first sight…its based on a series of controls…all of which have to be in place to make the system work. Any of which, if they were to fail, could cause the system to break down…
Currency Controls
The growth model that China has pursued has been one of export-oriented growth, and managed currency exchange rates. The currency is managed vs. the US dollar (as are many Asian and oil-exporting countries currencies). This means that they actively buy up US treasuries (buying dollars and selling local currency) to drive down their local currency. This means that the money they receive from exports is recycled back to the US, and not allowed to stay in China. Investments in China are largely driven by FDI (foreign direct investments).
This relationship between the US and China is fundamental to explain the growth story behind China’s development over the past decades. China is the bank, the USA is the borrower. China is the producer, the USA is the consumer. Think of the relationship like “vendor financing” from the producer to the consumer. They finance, and we purchase.
But what would happen if China were forced to appreciate their currency? Would internal local demand pick up enough to offset the decrease in foreign demand? In 2007 we saw what looked like a substantial movement upward (appreciation) of the Chinese currency vs. the US dollar. This was allowed by the Chinese in an effort to combat local inflation (and perhaps in response to political pressure). But as the economy started to slow, and as massive amounts of people were laid off with factory closings, the Chinese quickly shifted course are depreciated in December of 2008. Local pressure of social unrest is much more powerful than foreign pressure of trade retaliation. Plus, it helped that local inflation pressure eased, thus removing local unrest over rising food prices.
Capital controls:
In order to both control the currency AND also have local monetary policy control, the Chinese must also have in place strict capital controls which limit the flow of money into and out of China. The result (or intention) of this policy is that local Chinese are not able to invest their savings overseas. For foreign investors, it was an attempt to limit the flow of “hot money” into China, which was necessary if you are going to try and keep the value of the currency down, and avoid a rash of inflation.
One fear is that if the capital controls were to break down, that could spell the end of the currency controls. It would also spell the end to the savings controls which I will discuss next…
Savings Controls:
In recent years in China, all savings were basically funneled to the state, who in turn invests that money overseas for them (buying up US treasuries, etc). The machine that drives the finance model in China rests on the fact that local Chinese had very few options with which to save for their future. The only real investment for the future was to give your saving to a government- owned bank which paid tiny returns (like 1-2%). While in recent years there has been some challenges made to this fundamental system (which are good for local Chinese), these changes are a risk to the Chinese model because if local citizens had more options, then the borrowing cost for the government would surely rise (making money more expensive for the Chinese government). The system worked because local Chinese had no choice but to give their money to the government at very low interest rates. In recent years we saw massive bubbles in alternative assets as locals sought other ways to save for the future at higher rates of returns. The stock market (which saw a huge bubble), or in real estate (which also saw a huge bubble).
With the WTO came foreign banks, and with foreign banks comes savings options. But savings options threaten the low cost borrowing scheme of the Chinese model. If there were also to be foreign investment options for Chinese, it could see the end to capital controls / currency controls. All of this must go together in order for it to work…
Mobility Controls:
The engine for economic growth in China has been located along the eastern shoreline. Cities like Shanghai and factories along the coast, however, have been built with labor from the interior of China. These migrant workers were the source of much of China’s cost advantage (along with the managed currency). But, interestingly, these workers are not considered full time residents of these locations, and must be sent back to the country side if the economy were to slow down. They are essentially citizens without rights in the places where they live. Without the rights to find their own apartments, or to seek other jobs (with higher pay) , these workers are forced to accept the pay that comes from the company that sponsors them. This kind of migration control is very critical to economic magic that has powered China’s growth. But, what happens if China goes into recession and massive amounts of people are “ordered” to return back to the country side, and to leave the cities? Will they all obey? Will there be social unrest from urbanized residents that dont want to return?
Bank Fragility
In the US, we have been learning the hard way that banks are fragile by their very nature (borrowing short, and lending long is inherently risky). This is true not only in the US, but the world over, and is especially true in emerging markets where there is less faith in regulatory institutions. Layered on top of this inherent banking fragility is the fact that China’s banks have been flush with cash for so long that they have surely built up portfolios of bad loans. Political pressure has surely played a part, and has added to the fear that China’s regional banks are fragile in spite of a massive foreign-reserve balance on the national level.
Delicate balance…
The risk with China is that they need ALL of these controls to stay in place. If one or more of them were to fall, the entire system may be put at risk.
As long as the economy continues to grow at double digit rates, then it could be possible for China to keep all of these controls in place for many years to come. But, it is possible that someday the economy will to fall into recession (not just below 7% growth, but a true recession). If that day does come, then more discussion is needed to look at how China might change as a result. Will any /all of these controls crumble? If so, then how would that effect the US? Would China still want to purchase US treasuries? Would US interest rates shoot upward? How would global supply chains be reconfigured? Would countries like Brazil become more competitive in manufacturing? Who would take China’s place as the next manufacturing powerhouse?
As of yet, the Chinese have not slowed their purchases of US assets, in spite of what you may have read in the New York Times (here).
(yes, I admit that looking at this scenario is a bit like looking at a “black swan” / “fat-tail” probability in statistics…but so was the global credit crisis)…
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On a personal level, I think China is one the most complex, and interesting cases …and is surely a long-term growth story (as Jim Rogers said, it would be like investing in New York in 1900…if you invest for the long run, its surely one of the best investments out there).
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