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Kip Beckman
Principal Research Associate
Economic Services |
If you think the world economy is in rough shape now, just imagine what it would be like if the Chinese economy wasn’t clipping along at an 8 per cent plus real growth rate. While the U.S. and European economies are showing signs of life, growth is expected to be tepid over the next few quarters and, consequently, Chinese demand is crucial to ensure global growth remains in positive territory. Also, the United States needs China to keep chugging along to enable it to buy American government securities to finance exploding fiscal deficits.
This raises a troubling question: What if the Chinese economy stumbles and hits a roadblock? While the economy has experienced a 30-year run of spectacular economic growth, history reveals that on the road to economic maturity almost every economy eventually experiences asset bubbles and other economic crisis.
Over the last few decades, China has recorded one of the largest migrations of people in history as millions of Chinese have moved from rural areas of the country to cities. To ensure a successful transition, the government has subsidized exporters by maintaining the value of the yuan at artificially low rates against the U.S. dollar. This has helped support relatively high paying export jobs in China and, while many economists wouldn’t recommend this approach as an ideal model for development, it is difficult to argue with success.
Unfortunately, export subsidies have resulted in over-capacity in a number of sectors in the economy. Also, the housing market shows signs of froth in some cities. Property prices in 70 large Chinese cities increased by close to 4 per cent in October (y/y) on the heels of a 2.8 per cent gain in September. Increases in Beijing and Shanghai have been even greater. Vacancy rates in Shanghai are as high as 50 per cent in some parts of the city, yet construction of new skyscrapers continues unabated. The main factors behind the booming real estate market are a government-led increase in bank lending, low interest rates and the need for smaller down payments for home purchases.
Government planners have attempted to limit investment in sectors of the Chinese economy burdened with unsold products. These efforts have been especially important in the current economic environment where global demand remains weak. Yet, it is extremely challenging to limit investment in sectors of the economy contending with excess capacity. Fiscal credit policies are aimed at creating jobs and ensuring political stability at all costs. In this environment, Chinese authorities are reluctant to cancel projects that are in financial trouble.
The immediate consequences of a much weaker Chinese economy would be rising layoffs and growing unrest in China. It is not unrealistic to assume that a struggling Chinese economy would have less money to lend to the U.S government. Reserve funds might be diverted to address pressing domestic needs and possibly growing social unrest. A sharp reduction in U.S. bond purchases by the Chinese central bank would lead to higher interest rates in the United States, a development that would make it more expensive for the U.S. government to borrow the money required to finance soaring fiscal deficits.
Economics Professor Tyler Cowen contends that the United States should start to plan for a potential crisis in the Chinese economy. The first initiative should be to develop a credible strategy to lower fiscal deficits. While borrowing costs are low at the present time, it would be extremely irresponsible for the federal government to assume that deficit reduction can be put on hold simply because the Chinese government has been willing to lend money to the United States. The shocking events of the fall of 2008 revealed how quickly a financial crisis can emerge with very little warning.
Cowen’s other recommendation is more controversial. For many years the U.S. government has been critical of the Chinese policy of maintaining the yuan at below-market levels in an attempt to stimulate export demand. The Americans contend that this policy is behind the country’s huge trade deficits with China. Cowen feels that the government should back off in demanding concessions regarding the yuan. A slower growing Chinese economy resulting from weaker export growth could be a less desirable outcome for the U.S. economy than a strong Chinese economy fueled by an under-valued yuan – especially if it results in a shut down in the vaunted Chinese lending machine.
The consensus forecast calls for the Chinese economy to keep expanding at a rapid pace; a view that we share as well. However, as we learned the hard way last year, the consensus view is sometimes wrong. Countries overly dependent on China, including the United States, best be prepared.