How China fell off the mir­a­cle path

The Jerusalem Post - - COMMENT & FEATURES - • By RUCHIR SHARMA (Stringer/Reuters)

For years now, Don­ald Trump has been sound­ing the alarm on China, call­ing it an eco­nomic bully that has been “eat­ing our lunch.” The crux of Trump’s at­tack is that Bei­jing ma­nip­u­lates its cur­rency to keep it cheap and give Chi­nese ex­ports an un­fair ad­van­tage. But that nar­ra­tive is so last decade. China is now a threat to the United States not be­cause it is strong but be­cause it is frag­ile.

Four key forces have been shap­ing the rise and fall of na­tions since the 2008 fi­nan­cial cri­sis, and none of them bode well for China. Debts have risen dan­ger­ously fast in the emerg­ing world, es­pe­cially in China. Trade growth has col­lapsed ev­ery­where, a sharp blow to lead­ing ex­porters, again led by China. Many coun­tries are re­vert­ing to au­to­cratic rule in an ef­fort to fight the global slow­down, none more self-de­struc­tively than China. And, for rea­sons un­re­lated to the 2008 col­lapse, growth in the world’s work­ing-age pop­u­la­tion is slow­ing, and turned neg­a­tive last year in China, de­plet­ing the work­force.

It will be dif­fi­cult for any coun­try to grow as rapidly as 6 per­cent, and all but im­pos­si­ble for China. Nev­er­the­less, in an ef­fort to ex­ceed that tar­get, Bei­jing is pump­ing debt into waste­ful projects and dig­ging it­self into a hole. The econ­omy is slow­ing and will de­cel­er­ate fur­ther when the coun­try is forced to re­duce its debt bur­den, as in­evitably it will be. The next step could be a deeper slow­down or even a fi­nan­cial cri­sis, which would have global reper­cus­sions be­cause seven years of heavy stimulus has turned the world’s sec­ond largest econ­omy into a bloated gi­ant.

In Bei­jing, con­fi­dence has given way to a case of nerves. Lo­cal res­i­dents of­ten sense trou­ble com­ing be­fore for­eign in­vestors and are the first to flee be­fore a cri­sis. Chi­nese moved a record $675 bil­lion out of the coun­try in 2015, some of it for pur­chases of for­eign real es­tate. If China were eat­ing Amer­ica’s lunch, its peo­ple would not be rush­ing to buy safe-haven apart­ments in New York or San Fran­cisco. Far from con­spir­ing to cheapen its cur­rency, as Trump charges, Bei­jing is strug­gling to keep the weak­en­ing ren­minbi from fall­ing more, which would fur­ther erode lo­cal con­fi­dence and make a cri­sis more likely.

The seeds of China’s cur­rent prob­lems were planted in the months af­ter the global eco­nomic cri­sis of 2008. When I vis­ited Bei­jing in Septem­ber of that year, just be­fore the Wall Street im­plo­sion, the coun­try’s econ­omy was slow­ing, but the city was calm. Bei­jing had hosted the Sum­mer Olympics, and in prepa­ra­tion had tem­po­rar­ily shut­tered smoke­stack in­dus­tries and eased cen­sor­ship. The skies were clear, the con­ver­sa­tion much more can­did than it is to­day.

The na­tion had good rea­son to feel con­fi­dent. Like Ja­pan, South Korea and other Asian “mir­a­cle” economies, China had gen­er­ated a long run of dou­ble-digit growth by in­vest­ing in ex­port in­dus­tries. But Wen Ji­abao, then prime min­is­ter, was not com­pla­cent. He was warn­ing that af­ter three decades of heavy in­dus­tri­al­iza­tion, China was “un­sta­ble” and “un­bal­anced,” with too many fac­to­ries belch­ing too much smog. Many prom­i­nent Chi­nese rec­og­nized that with per capita in­come ris­ing above $8,000, their na­tion would face a nat­u­ral slow­down, as Ja­pan and South Korea had when they reached a sim­i­lar mid­dle-in­come level. Mean­while, among out­siders, there was hope­ful talk of how China would evolve into a democ­racy as it grew richer – again fol­low­ing the path of ear­lier Asian mir­a­cles.

Then, two weeks af­ter I left, Lehman Broth­ers filed for bank­ruptcy in the United States, tip­ping the global econ­omy into re­ces­sion. De­mand col­lapsed across the world, crush­ing ex­port growth in China. The lead­er­ship in Bei­jing pan­icked, ap­par­ently fear­ing that if the re­ces­sion reached its shores, so­cial un­rest would fol­low. Wen re­versed course and dou­bled down on the old in­dus­trial model – fu­el­ing in­vest­ment in fac­to­ries with tril­lions in state lend­ing and spend­ing.

At first, the bet ap­peared to work. In 2009, China man­aged once again to beat its long-stand­ing growth tar­get of 8 per­cent, as the West strug­gled to re­cover from its deep re­ces­sion. The rapid spend­ing un­leashed by Bei­jing con­trasted sharply with the rel­a­tive grid­lock in Wash­ing­ton, and the global elite, gath­er­ing for their an­nual con­fab in Davos, Switzer­land, in 2011, mar­veled at the ben­e­fits of state cap­i­tal­ism. China, they said, was prov­ing that unchecked au­toc­ra­cies had an ad­van­tage in man­ag­ing the econ­omy, par­tic­u­larly in a cri­sis.

But look­ing back, we can see that this was the mo­ment China be­gan to fall off the mir­a­cle path.

As its debt ma­nia pro­gressed, more of the lend­ing was di­verted into waste­ful spec­u­la­tion. Nor­mally, fren­zied bor­row­ing oc­curs amid ex­cite­ment about a new in­no­va­tion like the in­ter­net. But this spree spread on con­vic­tion that Bei­jing, ob­sessed with hit­ting its growth tar­get, would not let lenders or bor­row­ers fail. More and more un­qual­i­fied play­ers got in the game. The state banks soon had to com­pete with “shadow banks,” in­clud­ing crowd­fund­ing web­sites that of­fered ordinary peo­ple a chance to in­vest in debt for as lit­tle as one ren­minbi (15 cents), promis­ing fan­tas­tic re­turns.

Try as the Chi­nese au­thor­i­ties might to steer the money into in­dus­try, they could never fully com­mit to stop­ping shadow banks from fi­nanc­ing an in­creas­ingly ques­tion­able ar­ray of bor­row­ers spec­u­lat­ing in real es­tate. When I vis­ited Shang­hai in Au­gust 2010, I was stunned to see apart­ment blocks ris­ing two to three rows deep all along the 110-mile route to Hangzhou. Many of the big­gest debtors are front com­pa­nies set up by lo­cal gov­ern­ments to evade na­tional reg­u­la­tors. Small cities are bor­row­ing to build futuristic mu­se­ums, aquatic cen­ters and apart­ment blocks that ex­ceed lo­cal de­mand and are of­ten as empty as ghost towns.

My re­search shows that dur­ing the 30 worst debt ma­nias of the past 50 years, pri­vate debt – which in China is of­ten held by lo­cal gov­ern­ments – rose over five years by at least 40 per­cent­age points as a share of gross domestic prod­uct. In all 30 cases, the econ­omy slowed sharply, typ­i­cally by more than half, in the next five years.

China’s ma­nia is now the largest ever in the post­war emerg­ing world. Af­ter hold­ing steady at around 150 per­cent of GDP for much of the boom, China’s pub­lic and pri­vate debts surged af­ter Wen’s about face in 2008, ris­ing to 230 per­cent of GDP by 2014. That 80-per­cent­age-point in­crease is also more than three times the in­crease in the United States be­fore its bub­ble col­lapsed in 2008. Since then, US debt has held steady as a share of its econ­omy. Though many Amer­i­cans still think the na­tion is drown­ing in debt, its bur­den is much less wor­ri­some than China’s be­cause it is not grow­ing.

Para­dox­i­cally, the au­thor­i­tar­ian form of gov­ern­ment that helped guide China to those years of eco­nomic growth may now be un­der­min­ing its eco­nomic sta­bil­ity. My re­search sug­gests that com­pared with democ­ra­cies, au­toc­ra­cies gen­er­ate far more un­sta­ble growth, and that’s the risk in China now. Look­ing at the avail­able records go­ing back to 1950 shows that ex­treme swings be­tween fast and slow growth are much more com­mon un­der au­to­cratic regimes. On a list of 36 coun­tries that have been whip­sawed be­tween rapid growth and re­ces­sion through­out the post­war era, 3 of 4 were au­toc­ra­cies.

Be­cause these gov­ern­ments face no check on their pow­ers, they can force feed pe­ri­ods of strong growth. But they can also veer off in the wrong di­rec­tion with no one to set them straight. In the early stages of China’s boom un­der Deng Xiaop­ing, Bei­jing did what au­thor­i­tar­ian gov­ern­ments do best, sup­press­ing op­po­si­tion to break­neck devel­op­ment, steer­ing the peo­ple’s sav­ings to­ward build­ing ex­port fac­to­ries and com­man­deer­ing land to build the roads and bridges to bring the man­u­fac­tured goods to mar­ket. But the same de­ci­sion-mak­ing process, cen­tral­ized in a small cir­cle in Bei­jing, al­lowed the gov­ern­ment to im­pul­sively shift course in 2008 and push through the lend­ing cam­paign that put China on the in­creas­ingly un­sta­ble path of more debt, and less growth. ON MY re­cent trips to China, I keep look­ing for Bei­jing to snap back to re­al­ity, but in vain. As the econ­omy grows more un­sta­ble, the au­thor­i­ties have tried to con­trol the busi­ness cy­cle with an in­creas­ingly heavy hand that ex­tends into its fi­nan­cial mar­kets. In late 2014, hop­ing to give its strug­gling com­pa­nies a new lift, Bei­jing be­gan to praise buy­ing stocks as a pa­tri­otic act. Mil­lions of ordinary Chi­nese signed up to play the mar­ket for the first time, many un­aided by a high school de­gree, and started bor­row­ing to buy shares as prices rose. When the bub­ble burst last June, Bei­jing did not let it im­plode, as it had in 2008. It or­dered peo­ple not to sell or even to speak crit­i­cally of stocks. The mar­ket col­lapsed any­way.

Af­ter­ward the Davos crowd fi­nally started to question whether Bei­jing could sim­ply com­mand its econ­omy to grow. It looked as if the les­son might be learned in China, too, but when I vis­ited this April, au­thor­i­ties had be­gun a new stimulus cam­paign, and debt was still grow­ing three times faster than the econ­omy. Against this back­drop, res­i­dents spoke of dizzy­ing price rises in Shang­hai and Bei­jing real es­tate and in ob­scure mar­kets like steel re­bar fu­tures. Their in­ten­tion was to keep danc­ing un­til the bor­rowed money stopped flow­ing.

The sput­ter­ing global econ­omy is one shock away from slip­ping into re­ces­sion. In the post­war pe­riod, ev­ery pre­vi­ous global re­ces­sion started with a down­turn in the United States, but the next one is likely to be­gin with a shock in China. Through heavy stimulus, China was the largest con­trib­u­tor to global growth this decade, but it is frag­ile. China’s mir­a­cle growth pe­riod is over, and it now faces the curse of debt.

Ruchir Sharma is the chief global strate­gist at Mor­gan Stan­ley In­vest­ment Management. This es­say is adapted from the forth­com­ing ‘The Rise and Fall of Na­tions.’

A VEN­DOR waits for cus­tomers at a mar­ket in an ur­ban vil­lage un­der de­mo­li­tion in Zhengzhou, He­nan prov­ince, China, on May 20.

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