Many global market observers look to China as the next great bastion of structural economic growth. With one-fifth of the world’s population and an emerging consumer class, many believe that China’s rise to economic dominance is inevitable. While China is currently, and may remain for some time, an engine of global economic growth, there are some fundamental weaknesses underneath the headlines that casual investors either miss or ignore, which could prove detrimental in the years to come. Furthermore, these cracks in the foundation will, in my humble opinion, limit China’s capacity to continue building up their economic house.
The arguments for Chinese dominance are many. And most of these arguments are compelling and factual. The emergence of this economy is truly a structural evolution. It has been a thirty year process, post Mao, that has included a gradual opening of markets to foreigners along with a slowly eroding anti-capitalist sentiment.
Here are some main points of the China dominance supporters:
The Chinese Consumer – They are getting wealthier and want more stuff. A recent study found that there are now more Chinese connected to the Internet than the entire population of the United States. With this connection to global community (as amazingly censored as it is by the Chinese Government) there comes a realization of status in the world, along with a desire and a vehicle to fulfill these new wants. The Chinese urban population is growing exponentially and infrastructure build out of urban and suburban centers are growing accordingly.
The Chinese Surplus and Currency Reserve – China has amassed the world’s largest currency reserve. They are our single largest creditor and have a massive arsenal with which to stoke the economic engine should it show any signs of sputtering. They have also experienced double digit economic growth while running trade surpluses around 10% of GDP per year. Their sovereign wealth funds total over $1 Trillion in assets and could buy over 10% of the entire US stock market.
Now the problems that lurk beneath these seemingly strong endorsements:
Class Struggles – China’s economy is currently still driven by exports…that’s what causes the large trade surpluses. These exports are manufactured by cheap Chinese labor. This labor is so cheap that many American companies have elected to manufacture goods in China and pay to ship them across the Ocean back to the US for sale in our own domestic stores. In fact, I read somewhere that Chinese workers earn about one-third the pay that Mexican workers earn and we all know how well they must be paid in Mexico if their workers are risking lives and freedom to come to the US to earn below our minimum wage! This cheap labor cannot and will not continue indefinitely. We can see this in recent news stories about the surge in strikes at factories across China, like this one from the BBC. And even sadder stories, like this one from CNN, of the various Foxconn workers who committed suicide this year. These add up to a working class that demand better pay and better conditions. This could prove a difficult transition for a country that depends on being the cost leader for manufacturing.
Bubbles – A bubble in real estate has formed…but its not the worst bubble China has to deal with. The biggest problem for China is the bubble in U.S. treasuries. While its no question that the real estate market in China has turned into mass speculation in rapid fashion and could pop at any time, this problem could in theory be contained (its mostly in the luxury segment of the industry) and/or absorbed by government intervention. The truly big problem for China is its holdings in U.S. treasuries.
How many people have heard some version of the theory that China plans to dump huge portions of their US Treasury holdings thereby causing a run on the Federal Reserve? This version of the story is backwards. What happens when China starts to sell some of their reserves? The value of their remaining holdings drop in value and you find a limited number of buyers. Your strength becomes weakness as these holdings are only as valuable as the country which issued them. This massive reserve, which was established to keep the Chinese currency pegged to the dollar, has grown into a $2.4 Trillion anchor.
Now China has tried to address this issue in some ways. The creation of China Investment Corp. (CIC, a sovereign wealth fund run by the impressive Lou Jiwei) has helped China diversify some of its holdings. The problem remains however that until they decide to revalue their currency they need to continue to buy US treasuries, and once they stop or even slow the rate of purchases their currency will appreciate markedly, and the competitive advantage that China has enjoyed over the last 30 years will all but disappear.
The conclusion
I don’t think China will blow up and turn into economic disaster, but I will say that the only other two times in history that a country ran up surpluses of this magnitude was the United States in the 1920’s and Japan in the 1980’s. As I said earlier, cracks in a foundation may not ever cause a collapse, but they can severely limit the amount of building you can safely do on top of it….unfortunately I’m not sure China has figured out fully how to stop.
To sum this whole thing up, (and maybe get some sleep tonight), I’ll end with a fundamental truth of markets. Excessive lending can be just as dangerous, and perhaps even more so, than excessive borrowing; even if this lending is out to the most credit worthy of clients (US creditworthiness is a debate for another day). It is with that thought that I am in full confidence that China cannot surpass the United States in terms of economic power…because Chinese Value is only as good as the American currency its printed on.