Since the liberalizing economic reforms implemented by Deng Xiaoping in 1978, the Chinese economy has grown at an average annual rate of nearly 10 percent. However, as the returns of rapid industrialization and urbanization begin to diminish, this growth has begun to slow. At the same time, massive state-driven investment in manufacturing and infrastructure has contributed to overcapacity problems, and most worrying, the ratio of public and corporate debt to GDP has ballooned to unprecedented levels (260% and 169% respectively). Historically, this kind of debt is generally followed by crisis or sudden slowdown in growth. The Cipher Brief spoke with Scott Kennedy, Director of the Project on Chinese Business and Political Economy at the Center for Strategic & International Studies (CSIS).
The Cipher Brief: What are the greatest threats to China’s economic model and long-term sustainability as you see them?
Scott Kennedy: The biggest problem China has is how inefficient its economy is, particularly the inefficiency of capital. If you go to Chinese factories, Chinese companies, you’ll see people working extremely hard, the efficiency of manufacturing has improved, and they have excellent logistics, but capital in China is wasted in monumental proportions. China spends three to four times as much now as it did eight years ago to generate the same amount of GDP growth.
Why are they so inefficient? Well, they’ve spent a ton of money on infrastructure that hasn’t been used and was built by state owned companies, which don’t have hard budget constraints and have produced far beyond what the market demands. Then you also have extremely onerous regulations on market entry in various sectors that keep private and foreign companies – who would raise the bar in terms of market competitiveness – out. I think that’s the number one problem. It manifests itself in China’s growing debt problem, the challenges they have managing their currency, and the concerns that people have over a financial crisis. So, raising efficiency is job number one for any Chinese leader.
TCB: So you have this inefficiency problem that leads to an overcapacity problem, which then feeds back into the massive debt burden – corporate debt alone stands at nearly 170 percent of GDP. Is this sustainable in your opinion?
SK: It depends on how you look at it. There are other countries around the world where debt of that magnitude has precipitated a financial crisis. China has many of the similar symptoms of those countries: slowing growth, increasing debt, ageing population, concerns about the political system’s fragility, some capital flight, etc. There are also bubbles that pop up in the stock market, housing market, bond market, and beyond.
These things suggest structural problems that could translate into a crisis. On the other hand, China has a lot going for it. The Chinese have massive savings in their banks, and they still hold over three trillion in foreign exchange. In addition to that, the Communist party is extremely powerful, it controls information, it controls the financial system, it controls the flow of money in and out of the country, including the exchange rate. Thus, a lot of the potential triggers for a financial crisis can be managed in one way or another by the party, which makes an all-out crisis unlikely.
Yet that still begs the question: If there is no crisis but China continues along this path, are we just talking about a slow slide into a recession and a Japan-like lost decade or two? I think that’s possible, and even likely, if they don’t embrace substantial policy changes, but I don’t think it’s guaranteed. There is a lot of volatility, and they could well face a real crisis or slip into a structural recession, but they’re not quite there yet.
TCB: What’s the worst case scenario, in your mind, for the Chinese economy?
SK: There are several different scenarios that could look pretty bad. One would be some type of bubble popping, for instance the bubble in real estate prices. Money flows quite freely between the housing and the stock market, so a sudden loss in asset value by Chinese investors and households could precipitate a crisis, a run on the financial system.
A second poor scenario could develop if the governments spends a large amount of money to prevent a crisis, which could translate into inflation, the same feeling of loss of asset value, and could then spiral on itself.
The other risk area that China-watchers need to consider is the danger for China and the world if the country avoids a crisis scenario but continues to grow with volatility. To see how this could be dangerous, just look at China’s move into technologies that have previously been dominated by foreign companies and advanced industrialized countries like the United States, Europe, Japan, South Korea. If China continues to have a financial system and government that overspends and overinvests in new priority areas, the result could be that China does to semiconductor industry what it does to the steel industry. If they do that, the Chinese would unfairly disadvantage efficient foreign competitors, because they wouldn’t be able to absorb the cost competition. This wouldn’t just hurt these western businesses, it would hurt the entire business model of those sectors. This outcome could generate a protectionist backlash, which would limit trade or investment. In this scenario, even a relatively successful China still poses a challenge for everybody else.
TCB: In essence China has the ability to export its overcapacity problem to the rest of the world.
SK: Yes, it socializes the risk to everybody else. Instead of China adapting to global markets, global markets are forced to adapt to China. China’s size gives it special power; it also gives it special responsibilities.
TCB: So this is the danger for the global economy if the likely scenario of middling growth follows through. What impact would a serious economic crisis have on the global economy?
SK: China accounts for 30-40 percent of the world’s growth right now, so global growth is going slow. We saw that in the last couple years when demand from China dropped precipitously, which affected the economies of countries that provide minerals and resources, like Australia, Brazil, Canada. Similarly, for countries that are at the middle or upper tiers of the value-added chain doing advanced manufacturing equipment – Taiwan, South Korea, the United States, Europe – think China’s slowdown has hurt them.
Obviously, if China were to have a full blown economic meltdown, the consequences would be even larger for those economies, particularly the ones that aren’t diversified and depend heavily on the Chinese growth machine for their own success. In that situation, countries around China’s periphery and others that depend on China like Brazil and Australia would be the hardest hit. For the U.S. and Europe, there would be a substantial direct impact on certain sectors, but I think the bigger challenge for the U.S. and Europe would be the financial contagion. In other words, a loss of confidence, which translates into market volatility and puts stress on interest rates and other tools of macroeconomic policy.
TCB: How do you see the Chinese government trying to tackle these problems, strengthen its economy, and manage against debt crisis?
SK: For the most part, the Chinese are trying to rebalance the economy in ways that make sense. They are rebalancing toward services, advanced manufacturing, innovation, trying to increase efficiency in financial system, shoring up local government and finances, and expanding infrastructure spending to underserved areas. This all makes sense but Beijing is still doing these reforms in a way that involves the heavy hand of the state. In fact, state intervention is now greater than it was before Xi Jinping came into power.
The real question is, how much faith do you have in the Chinese state to achieve the transformation and the rebalancing of the economy? If you have faith in the Chinese state and the Chinese leadership, then you ought to be relatively optimistic. If you are concerned that, not only the Chinese state, but states in general are not good at picking winners, then you should be concerned. Even though the Chinese understand the economic transition they need to make, the political approach that they are taking is likely to generate as many problems as achievements. We have been looking for signs that the Chinese leadership and those around them understand that the market needs to play a much larger role in order to improve efficiency. You certainly hear that language when you talk to people, but it hasn’t been translated into policies, so our concern is that they know how to talk the talk but not walk the walk.
TCB: How will President Donald Trump interact with China, and how will this affect these reforms and problems that we’ve talked about?
SK: One of the interesting things about the Obama administration’s policy vis a vis China was its relative sophistication. The two were able to both cooperate and compete, while preventing tensions from translating into reduced cooperation in areas of strong mutual interests. That was partly the result of good strategic thinking about what the purpose of the relationship was, as well as mechanisms of engagement that the two sides have built up over the eight years of the Obama administration. President Barack Obama and President Xi Jinping, and before him Hu Jintao, met on numerous occasions, and the bureaucracies communicate extensively. This is important not only for cooperation, but for managing areas of tension as well. The relationship is not ideal, but there is a pretty decent balance and equilibrium. There are problems, but overall you’d still have to give them reasonable marks.
I’m expecting a Trump administration to be as volatile as China’s economy. There are signs coming from the Trump camp that they are going to come out guns blazing. There are also signs that they may seek to cut a deal with China on economic issues and security issues. This is all fine, but unlike the Obama administration where there was a coexistence between these things, I expect it to be more volatile under a Trump administration. There will be a swing between moments of serious tensions and then surprising moments of cooperation, but none will last or be stable.
