The unknown effects of a Chinese slowdown

ChinaFile.com

Barry Naughton

Paul Krugman in a recent post (“How Much Should We Worry About a China Shock?” The New York Times, July 20) tells us NOT to worry about the impact of a slowing China on global exports, but to be worried, very worried about the indirect and unanticipated effects of a Chinese hard landing. Using the scenario of a five percentage point decline in growth rate – which I suppose means growth at 5 per cent next year – Krugman warns of unpredictable, scarcely conceivable, effects on “politics and international stability.” In fact, you don’t need to stray from the realm of economics to see that the unpredictable side of a Chinese slowdown is what is most worrisome.

Krugman takes strong positions on the most important issues of our day: he is sometimes wrong, sometimes right, but always full of insights and is worth reading. In this case, Krugman is right, but for an uncharacteristic reason: his conclusion is one of breath-taking banality. If China crashes, it will not be the direct and predictable effect on export demand that will be most important, it will be the indirect effects.

Yes, indeed. And if you needed Paul Krugman to tell you that, you haven’t been paying attention for the last, oh, seven years, since during that time period the unanticipated and indirect effects of virtually every major economic event have outweighed the direct and predictable effects. China is certainly no exception. Indeed, at least three crucial facts mean that the aftershocks of major problems in China will be extremely hard to predict.

First, China has not experienced a recession in more than twenty years. Most of the economically active people in China today are young people who have never personally experienced an ordinary recession. Every other economy in the history of planet experiences occasional recessions (at least), and China is unlikely to be an exception. This means that when millions of economic actors in China adjust their expectations to encompass, say, eighteen months of economic contraction, the change in behaviour will be massive and intrinsically hard to predict.

Second, China has massive capacity in virtually every industrial sector. If domestic demand in China falters, businesses with excessive capacity will be in severe distress, and will seek to cut their losses by dumping goods on the global market. This creates the potential for enormous downward pressure on goods prices in many global markets, with unknown consequences.

Third, nobody knows how many bankruptcies will appear in a major Chinese downturn, who will end up being implicated, or what the consequences will be for payment and collateral relations. Defaults and missed payments will ripple out through – at a minimum – the East Asian trading economy. Sudden flows of hot money out of – and perhaps into – China will destabilise financial markets in ways that are hard to predict. Indeed, one of the big lessons of the 2008 Lehman bankruptcy is that the entire global economy requires stable collateral and payments to operate (At least we are a bit better prepared for this one than we used to be).

Now, here’s where Krugman is wrong: he conflates two different problems: slowing down an economy that is overly dependent on investment, but now faces new constraints (very difficult); and unwinding a Ponzi scheme (impossible). China is not a ‘Ponzi bicycle’ economy; it is a real economic miracle, with multiple serious and debilitating Ponzi schemes woven deeply into the fabric, especially in the financial sector. There’s no room for complacency; but caricatures don’t help much, even if they’re painted in the brightest of colours.

RESPONSES

Arthur R Kroeber

Krugman, in my opinion, has never had much of interest to say about China, or for that matter about any developing economy. His most famous foray outside the rich economies was his Foreign Affairs essay of 20 years ago, “The Myth of the Asian Miracle”, where he argued that the success of east Asian economies owed far more to factor accumulation than to efficiency gains. While this was broadly true it was also stating the obvious: that’s what developing economies do – mobilise the factors of production. Efficiency-driven growth usually comes later. The more interesting question was why east Asian countries did so much better at this task than many other developing countries. China is just the latest and biggest example of this pattern: it has grown for the past fifteen years mainly by adding physical capital, and now it needs to grow by using its capital more efficiently. That’s a difficult transition. I agree with Barry that our understanding of the risks of this transition is not aided by simplistic caricatures such as Krugman’s.

For me, Barry’s first point – that most people in China have never experienced a recession – is the most interesting. It’s not entirely true – I think the 20 million or so industrial workers who got laid off in Northeast China in the great state enterprise shakeout of the late 1990s and early 2000s saw themselves as living through hard times, and some of them are still economically active. But it’s true enough, and we’ve seen a lot of evidence this year of businesses assuming that a big government stimulus was on its way to restore growth to its former heights. The problem now for the authorities is that they have to let growth slow enough so that businesses have to start focusing on efficiency, but they need to avoid torpedoing business and consumer confidence. That’s a tricky task.

Gordon G Chang

China is approaching the point of “free fall,” the moment when Beijing’s leaders have lost control of the economy.
 
The country is slowing fast. In 2010, China had at least the 10.4 percent growth claimed. Today, among other things, electricity statistics, manufacturing surveys, price indexes, and trade data indicate the country is growing in the very low single digits.
 
Chinese leaders say they will not resort to stimulus, but they are in fact pumping extra cash into the economy through the five largest commercial banks. Moreover, this week’s announcement of new rail construction is, of course, stimulus.
 
Yet state cash is not having the desired effect: these days Beijing gets only 17 cents of output for every dollar of stimulus, down from 83 cents of output in 2007. This means Beijing technocrats are quickly losing the ability to keep the economy going as they essentially have no other tools that can ensure GDP creation. Once this becomes apparent, the Chinese—and foreigners—will lose confidence.

Most analysts expect China to slow gracefully, but the rapid deterioration of growth, which is bound to accelerate, suggests the adjustment will be unexpected, sudden, and catastrophic.
 
So what does this mean for us? First, China’s stockpile of Treasuries in the middle of 2011 was larger than it is today, which means we can finance our deficits without the Chinese. 
 
Second, China is not an engine of global growth. To be such an engine, a country has to buy the products of other countries to stimulate growth elsewhere. Beijing, through predatory policies—intellectual property theft, hidden manufacturing subsidies, and arbitrary administrative actions, among others—has been taking growth from us.
 
Third, China needs us more than we need China. Last year, China’s merchandise trade surplus against the U.S.—a record $315.1 billion—was 136.3 percent of its overall merchandise trade surplus. The Chinese, unfortunately for them, cannot replace the American market, but we can buy goods elsewhere.
 
Fourth, the central government for more than a half decade has been undermining foreign businesses in China, trying through various means to close off opportunities. Foreign companies were never going to have much of a long-term future in the People’s Republic. As soon as a foreign business gets market share, Beijing tries to cut it down to size. Ask Google, for instance. In March, China turned on its propaganda machine against Apple. This month, Chinese regulators are using discriminatory prosecutions to go after international milk, packaging, and pharmaceutical companies.
 
Yes, there will undoubtedly be panic when China fails. But when the dust settles, we will be okay, especially if we understand our relationship with that country.

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