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Generational Dynamics Web Log for 30-Jul-2009
China's bubble economy becomes increasingly unstable.

Web Log - July, 2009

China's bubble economy becomes increasingly unstable.

The Shanghai stock market fell sharply on Wednesday, over investor worries that the stock market is in a bubble, and that a crash is inevitable.

In March, 2007, over two years ago, I quoted Chinese premier Wen Jiabao as saying that China's economy was "unsteady, unbalanced, uncoordinated and unsustainable." It's worthwhile looking again at what he said:

"China's economy has maintained fast yet steady growth in recent years. However, this gives no cause for complacency, neither in the past, nor now, or in the future. My mind is focused on the pressing challenges. "A country that appears peaceful and stable may encounter unexpected crises." There are structural problems in China's economy which cause unsteady, unbalanced, uncoordinated and unsustainable development.

Unsteady development means overheated investment as well as excessive credit supply and liquidity and surplus in foreign trade and international payments.
Unbalanced development means uneven development between urban and rural areas, between different regions and between economic and social development.
Uncoordinated development means that there is lack of proper balance between the primary, secondary and tertiary sectors and between investment and consumption. Economic growth is mainly driven by investment and export.
Unsustainable development means that we have not done well in saving energy and resources and protecting the environment.

All these are pressing problems facing us, which require long-term efforts to resolve."

What's becoming increasingly apparent is that China's economy has become even more unstable and unbalanced since then.

For many years, China has had an export-led economy. This means that China's economy depended on manufacturing products and shipping them to other countries, particularly the US. China would loan us money by purchasing Treasury bonds, now totalling well over $1 trillion, and we would use that money to purchase Chinese goods. This relationship has sometimes been described as a deadly embrace.

Chinese trade balance, in millions of US dollars per month <font size=-2>(Source: econbrowser.com)</font>

Chinese trade balance, in millions of US dollars per month (Source: econbrowser.com)

With the US in recession, and American people's savings rate increasing rapidly, China is purchasing far fewer Chinese products, and this is throwing China's economy into chaos. The adjacent graph shows this quite dramatically.

At the time that Wen gave his news conference, quoted above, China was entering a period of wild thrashing in its balance of trade. There was a huge trade bubble that lasted into 2008, largely propelled by an economic frenzy preparing for the Beijing Olympics in August. The bubble collapsed as August approached.

Last fall I began writing about a major new development: A worldwide collapse in transportation and trade. (See, for example, "World wide transportation and trade sink farther into deep freeze.") I made a comparison to the old science fiction movie, "The Day the Earth Stood Still," except that it wasn't science fiction. You can see from the above graph that China's export trade crashed, going into 2009. And when China's export trade crashed, so did China's entire economy.

That was when the stimulus packages in countries around the world began to kick in, including a $500 billion stimulus package in China. The stimulus package was supposed to restore China's economy. And you can see from the graph that the trade balance has begun to shoot up again in the last few months.

This is a perfect illustration of the Law of Diminishing Returns, which says that when you supply a lot of one resource without supplying the related resources, then the first resource is essentially wasted. There are more and more signs of that in China's economy.

The most obvious problem is that people are simply taking the stimulus money and pouring it into new real estate and stock market bubbles. Chinese officials are expressing concern about exactly that.

More serious is that in the rush to use the stimulus money, a lot of it is being wasted and unneeded or shoddy products.

Shanghai building that toppled over, remaining relatively intact <font size=-2>(Source: wsj.com)</font>

Shanghai building that toppled over, remaining relatively intact (Source: wsj.com)

One spectacular failure is a building in Shanghai that seems to have toppled over on its side but remained intact:

"According to Shanghai Daily, initial investigations attribute the accident to the excavations for the construction of a garage under the collapsed building. Large quantities of earth were removed and dumped in a landfill next to a nearby creek; the weight of the earth caused the river bank to collapse, which, in turn, allowed water to seep into the ground, creating a muddy foundation for the building that toppled."

This is just one example of a widespread problem in Shanghai and throughout China: "While the real estate market appears to be is in the midst of a boom, defaults among developers are also beginning to rise. Small and medium developers are resorting to faking sales to get bank loans to relieve their funding pressure."

This kind of corruption should not be a surprise, since it's generational, and we're seen it in the US as well, and continue to see it. (For more insight into corruption in China, see "A generational view of China's growing melamine food disaster.")

This has led to a Chinese economy that's completely unbalanced, according to one one well-known analyst, Jeremy Grantham, who says, "My colleague, Edward Chancellor, strongly suspects that the Chinese economy is dangerously unbalanced and very likely to come unhinged in the next few quarters, surprising the pants off investors."

What China's officials are trying to do is to convince the Chinese people to start spending more money on consumer goods, so that they can have a consumer-driven economy, rather than an export-led economy. But there's little chance of that happening in the middle of a major generational financial crisis. To the contrary, Generational Dynamics predicts that the Chinese people will change from being savers to being super-savers, just as Americans did in the 1930s.

People often ask me what's going to happen to China, especially since China has been a creditor nation, while the US has been a debtor nation. The implication was that China would do well, while the US would do poorly. But all you have to do is look at America in the 1930s, to see that a creditor nation suffers just as much in a Great Depression.

We can expect to see stories of China's manufacturers using the stimulus money to produce more and more products that will remain in warehouses, since Chinese people don't want to spend money. One important indicator we're already seeing is copper prices, which have been spiking during the last few months, and which now appear to be peaking. China has been using stimulus money to stockpile copper and other commodities, but by now has stockpiled more than it can use.

Morgan Stanley's China expert, Stephen Roach, expresses even greater concerns:

"On the surface, China appears to be leading the world from recession to recovery. After coming to a virtual standstill in late 2008, at least as measured quarter-to-quarter, economic growth accelerated sharply in spring 2009. ...

The bad news is that China’s recent growth spurt comes at a steep price. Fearful that its recent economic shortfall would deepen, Chinese policymakers have opted for quantity over quality in setting macro-strategy, the centrepiece of which is an enormous surge in infrastructure spending funded by a burst of bank lending.

Sure, developing nations always need more infrastructure. But China has taken this to extremes. Infrastructure expenditure (including Sichuan earthquake reconstruction) accounts for fully 72 per cent of China’s recently enacted Rmb4,000bn ($585bn) stimulus. The government urged the banks to step up and fund the package. And they did. In the first six months of 2009 bank loans totalled Rmb7,400bn – three times the pace in the first half of 2008 and the strongest six-month lending surge on record.

This outsize bank-directed investment stimulus leaves little doubt as to how bad it was in China in late 2008 and early 2009. An unprecedented external demand shock, stemming from rare synchronous recessions in the developed world, devastated the export-led Chinese growth machine. That triggered sackings of more than 20m migrant workers in export-intensive Guangdong province. Long fixated on social stability, Beijing moved quickly with massive firepower to arrest this deterioration. The government was determined to do whatever it took to restore rapid growth.

Yet there can be no avoiding the destabilising consequences of these actions. Surging investment accounted for an unprecedented 88 per cent of Chinese GDP growth in the first half of 2009 – double the average contribution of 43 per cent over the past decade. At the same time, the quality of Chinese bank lending most assuredly suffered from the rash of credit disbursements in the first half of this year – a trend that could sow the seeds for a new wave of non-performing bank loans. Just this week Chinese regulators sounded the alarm – telling banks new loans must be used to bolster the real economy and not for speculation in equities and real estate. ...

Unlike most, I have been a steadfast optimist on China. Yet I am starting to worry. A macro strategy that exacerbates already worrying imbalances is ultimately a recipe for failure."

However, there's another side to this story.

In April, I posted my notes on a lengthy presentation by Richard C. Koo, Chief Economist at Nomura Research Institute, on "Fiscal stimulus programs in 1930s and today." I'd like to quote a few paragraphs from my notes on Koo's presentation:

"Audience question: Where would the stimulus money best be spent? Answer: Historically, the best way is military spending, because it creates demand, without creating supply. That's why economies recover quickly. But if you increase both demand and supply, then they start chasing each other. If you want the smallest budget deficit, and largest bang for money, that's the best way. Koo said he's not here to advocate military spending. "There are lots of roads and bridges here needing repair." ...

Koo's most dramatic remarks came at the very end. FDR's spending programs didn't end the 1930s Depression. World War II did. Spending on the military, according to Koo, gives the highest "bang for the buck."

Koo said Hitler did everything right -- spending massively on the military. (He would be forgiven for not mentioning that probably the Japanese did everything right as well.) He expressed the hope that this worldwide financial crisis would not allow dictatorships to get ahead of democracies.

What dictatorships is he talking about? Well, maybe Russia, but you can be sure that he's thinking of China.

A few days ago, in "New Pentagon report shows China continues to prepare for war with US," I discussed the rapid military buildup that China is pursuing.

China is now embarking on a very aggressive fiscal stimulus plan. China doesn't say how much of the stimulus is going into the military. But China has already been increasing the military budget by 10-20% a year for years, as they prepare for war with the United States. I think it's quite certain that China will take advantage of this fiscal stimulus program to further increase military spending.

In the US, by contrast, President Obama is planning to cut weapons systems. As the world becomes increasingly dangerous, the US is becoming weaker.

I don't know whether Koo intended this when he made those final remarks about Hitler, but he illuminated a fast-approaching world in which the US and the world's democracies will be stumbling forward with social programs and bridges to nowhere, while China is turning into a high-powered military machine, preparing for war.

China does not tell us how much money they're spending on the military, but they're as aware of Koo's theories as anyone else is, and there's little doubt in my mind that a lot of China's stimulus money is going into the military, preparing for war with the US.

(Comments: For reader comments, questions and discussion, see the China thread and the Financial Topics thread of the Generational Dynamics forum.) (30-Jul-2009) Permanent Link
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Generational Dynamics Web Log for 30-Jul-2009 China's bubble economy becomes increasingly unstable.

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Generational Dynamics Web Log for 30-Jul-2009
China's bubble economy becomes increasingly unstable.