Is the Chinese Economy Out of Control?

Is China trying to take a shortcut to greatness? To understand what's taking place in China today, we need to rewind the clock about a decade.

At that time the Chinese government chose a policy of growth at any cost. It kept its currency, the renminbi, at artificially low levels against the dollar -- this helped already cheap Chinese-made goods become even cheaper than its competitors.

The global consumers were eager to buy them and China turned into a significant exporter to the US.

If free-market economic forces were at work, the renminbi would have appreciated and the US dollar would have declined. However, if China let its currency appreciate, its exports would have become more expensive and the demand for Chinese products would have declined; thus its economy wouldn't have grown at 10% a year.

But China isn't your long standing democracy and using the government-controlled banking system, China accumulated a couple trillion dollars of foreign reserves in US Dollars and Euros. This had unintended consequences in that it helped keep US interest rates at very low levels and lent a friendly hand in the financing of a huge consumption binge by the US consumer, which was China's largest customer.

The more China sold to the US, the more dollars it accumulated and thus the more US Treasuries it bought, driving down the interest rates in the US. The US consumer was in turn happy to leverage its future (through the "always" appreciating asset, its home) and delighted to consume cheap Chinese-made goods.

This match made in heaven between China and the US consumer worked great as long as housing prices kept rising and like an ATM, housing kept supplying dollars to its owners to spend. But all good things come to an end and great things come to an end with a bang.

Let’s now fast-forward a year. Today the global economy is stabilizing but the US consumers of Chinese-made goods are now deleveraging, unemployment is high, and US banks aren't lending.

Despite this, the Chinese export-based economy has reported a growth rate of 8.7% in 2009. The rest of the world looks at the Chinese growth miracle with envy as it seems that China has figured out economics of the next business cycle. But don't hurry to trade your democracy for an authoritarian system. The Chinese grass is not as green as it appears.

First, one should always be skeptical of economic numbers that are put out by any Government, yet alone the Chinese government. The high growth rate of last year in China occurred when its exports were down more than 25%, tonnage of goods shipped through its railroads was down by double digits, and its electricity consumption fell like a rock.

Second, China will do anything to grow its economy, as the alternatives will lead to political unrest. A lot of peasants moved to the cities in search of higher-paying jobs during the go-go times. Because China lacks the social safety-net of the developed world, unemployed people aren't just inconvenienced by the loss of their jobs, they starve (and this helps explains the high savings rate in China) and hungry people don't complain, they riot! Once you look at what's taking place in the Chinese economy through this lens, then the decisions of its leaders start making sense, or at least become understandable.

Unlike Western democracies, where central banks can pump a lot of money into the financial system but can't force banks to lend or consumers and corporations to spend, China can do both very fast. The Chinese government controls the banks. Thus it can make them lend and it can force state-owned enterprises (one-third of the economy) to borrow and to spend. Also, China can spend infrastructure project money very fast -- if a school is in the way of a road the government wants to build, it becomes a casualty for the greater good without a lot of delay due to environmental or society related concerns.

China has spent a tremendous amount of money on infrastructure over the last decade and there are definitely long-term benefits to having better highways, fast railroads, and more hospitals. But any government is horrible at allocating large amounts of capital. Political decisions (driven by the goal of full or near full employment) are often uneconomical and full of corruption and cronyism that result in projects that destroy value.

Infrastructure and real estate projects are where you get your biggest bang for the buck if your goal is to maintain employment, because they require a lot of unskilled labor. This is where in the past a lot of Chinese money was spent. This also explains why the Chinese keep building skyscrapers even though the adjacent ones are still vacant.

In addition, China has built the largest shopping mall in the world, the South China Mall, which is still 99% vacant years after construction. China also built a whole city, Ordos, in Inner Mongolia, on spec for one million residents who never appeared. China is a less shiny but more drastic version of Dubai.

We look at China and are mesmerized by its 1.3 billion people representing huge target markets. There is speculation that the Chinese consumer will pick up the demand slack for the US and European consumers who are deleveraging and buying fewer Chinese-made goods. This may happen but it will take decades. The US and European consumers are two-thirds of much larger economies. The Chinese consumer is only one-third of the Chinese economy.

We have to remember that economic bubbles are usually just a good thing taken too far. This was the case with railroads in the US in the late 19th century. The railroads were supposed to change the landscape of the US, and they did, but that didn't prevent a lot of them from going out of business first. The Internet was supposed to change how we communicate, and it did, but in the process it generated a tremendous bubble, followed by the loss of wealth for many.

The Chinese economy is no exception. Its long-term future may be bright but in the short run we've got a bubble on our hands. The temporary mirage of economic resiliency must be followed by huge pain and drastic consequences because every cycle has an up and a down. This is a law of nature and the laws of economics do not work differently.

I favor a quote from Steve Forbes. Forbes says that pursuing additional financial education and the resulting increase in our financial literacy (including the interaction of the currency and debt markets) will open our eyes to alternative wealth creating strategies and this will be they key to resolving our financial crisis.

As an example of alternative wealth creating strategies … consider investments in precious metals, water rights, oil, natural gas, potash mines, food commodities, or gold mines … perhaps investments in energy assets that are inherently useful like oil rigs, hydropower, or methanol plants … things hard to build, difficult to replace, and costly to substitute … definitely not financial stocks, definitely not retail stocks, definitely not commercial property.

I trust this article provides a little more insight into the global economy and the mutually dependent economies. Due to the size of the stimulus provided in a very short time, by the Chinese government, there will likely be some serious unintended consequences that will manifest themselves, also on the world stage. These consequences could express themselves in terms of foreign policy, such as dangerous undercurrents to Taiwan’s peaceful reunification, or in terms of China becoming more assertive on the global stage because they feel they have little to learn from the rich nations of the West, since they widely believe the financial crisis was caused by a blow-up of the Western World’s financial system.

It is wise to monitor world affairs and consider alternative wealth creating strategies. I will provide updates in future articles and at my blog over the next few weeks.