Afinancial crisis in China has become inevitable. If it happens soon, its effects can be contained. But, if policy makers use further doses of stimulus to postpone the day of reckoning, a severe collapse will become unavoidable within a few years.
The country is in the middle of by far the largest monetary expansion in history. On one widely used measure, M2, its money supply has tripled in the past six years, an expansion four times as large as that of the US over the same period.
This unprecedented expansion is at least partly responsible for China’s extraordinary growth rate, which is now running up against a demographic constraint. Last year, for the first time, the working-age population declined, a trend set to continue for the next two decades. Unless the country can keep lifting the labour force participation rate (for example by getting more women into the workforce or persuading older people not to retire), China will struggle to expand its labour force by even 1 per cent per year. To sustain economic growth of more than 7 per cent, productivity would need to grow by 6-7 per cent a year across the entire economy. This would be a tall order in any country. In China, where the labour-intensive services and agriculture sectors make up half the economy, it is well-nigh impossible.
The country suffers from excess capacity in most industrial sectors. Yet investment in fixed assets continues to grow at double-digit rates. The steel sector is a case in point. China has about 1bn tonnes of annual steel-production capacity; about a third of it sits idle. Consequently, the growth statistics present a misleading figure. Output is being produced, sometimes even in the absence of any demand. A continuing burst of credit is needed to help fuel new capital spending to keep the factories busy – but that only adds to the stock of unused capital. It is a similar story with property investment. China is brimming with high-quality housing that is unaffordable. Sharp price declines are needed to clear the market. That will involve severe pain for banks that participated in the monetary expansion.
Observers often cite China’s closed capital account as a blessing that will stave off capital flight. But one consequence is a huge and persistent balance of payments surplus. Foreign money flows into the country to pay for exported goods and investment, and much less flows back out since there are few legal avenues for exit. China’s surplus over the past 10 years has been far larger than Japan’s was in the 1980s – the years when its disastrous asset price bubble was being inflated. This should have caused the currency to rise rapidly. But the renminbi has been pegged to the dollar for most of that period, accumulating a big pile of foreign reserves.
Compounding it all, Chinese investors believe that none of the country’s banks or financial products will go bust because the government stands behind them all. This is partly the legacy of the banking rescue mounted a decade ago, when about 40 per cent of loans belonging to four big government-owned banks were transferred (at face value) to asset-management companies. But the broader problem is the tendency of the party leadership to provide a policy stimulus every time growth dips.
Financial controls are gradually being relaxed. But the offshore market on which the renminbi is now allowed to trade is tiny – less than 5 per cent of the value of China’s foreign reserves. Opening the capital account fully is impossible; it would result in large flows of funds and a loss of control that policy makers cannot countenance.
In a country that already accounts for half of all capital-intensive production globally, and nearly a fifth of all US imports, the growth of manufacturing will inevitably slow. A thriving service sector could pick up some of the slack. But building more houses and railways is not the way to encourage it.
China’s economy is in an unbalanced state. It can stay that way for some time – but the longer it does, the worse the eventual outcome will be. The industrial sector is already plagued by falling prices. To avert a wider deflationary spiral, the country needs to wean itself off the false cure of perpetual policy stimulus.
The writer is founder of RealEconomics.com, an independent economic research firm