The hope that China will be “decoupled” from America, and so will not feel its looming recession, seemed to take a hit when Premier Wen Jiabao said that 2008 would be “a most difficult year”. Speaking at the State Council meeting that was preparing for the annual parliamentary session in March, he warned that there are “uncertainties in international circumstances and the economic environment, and there are new difficulties and contradictions in the domestic economy.”
For those who believe that China will remain separate from the crisis, including many Australian political leaders, these comments seem to suggest that no one will stay immune from a downturn. We are all global now, even China and its dutiful supplier, Australia.
Yet if the decoupling argument is dead, it is probably a good thing. It was never really alive in the first place. China’s resurgence has not been aligned to Western growth; it was never linked to the developed world’s economic cycles and so cannot be decoupled from them. Since the opening up of the economy in the early 1990s, China’s growth has consistently been two to three times the world average. The country has sustained a steady rise from an impoverished, pre-industrial economy to a rapidly industrialising economy, an achievement that almost no Western analysts predicted. Twenty five years ago, two-thirds of China’s population was living below $US1 a day. Now, only about 14 per cent of the population is at that level, and a massive middle class is emerging.
The decoupling argument also deserves to be scrapped for another reason. It implies that China’s economic integration into the world economy is being reversed. This is not the case. As the senior economist at Morgan Stanley, Steven Roach, comments, it is either globalisation or decoupling; you cannot have both. China may not be linked to the West’s economic swings, but it is certainly linked to Western production systems.
Roach notes that developing Asia remains an externally-dependent economy. Exports hit a record high of 46 per cent of GDP in 2007, more than double the 19 per cent share of 1980. At the same time, private consumption fell to a record low of 48 per cent of pan-regional GDP in 2007 – down sharply from the 66 per cent reading in 1980. This is the opposite of decoupling.
Roach adds that the US consumed over $US9.5 trillion in 2007, six times the combined consumption totals of China ($US1 trillion) and India ($US650 billion). The mythical “Chindian” is not about to compensate for the ailing American consumer.
China may be integrated into the global matrix, but the second part of Wen’s comment, that the problems within China are troubling, is probably more significant. China is emerging as a continental economy like America. Her leaders have long known that the mercantile route taken by Japan – growing wealthy by increasing exports and squeezing out imports – is neither possible nor advisable to attempt. The country is too big.
The challenges facing China are very different. The global downturn will lead to a fall in the country’s export markets in the West, but it will be on the margin. America only buys about a fifth of its exports, and America is the only country with which China has a big trade surplus. Net exports in China are only 7.5 per cent of GDP, despite the country’s trade doubling from $US1.1 trillion in 2005 to $US2.1 trillion in 2007. Trade is booming, but the country is determined not to pursue a mercantile strategy.
The more significant elements of the economy are fixed asset investment, 40 per cent of GDP, and private consumption, also 40 per cent of GDP. In recent years, investment has nudged as high as half GDP, an extremely high level.
Compare this with America or Australia, where consumption is equivalent to over 70 per cent of GDP, and it becomes clear that what determines Chinese prospects is very different to most developed economies where there is a far greater reliance on consumer spending.
There are signs nevertheless that China will slow. According to an ANZ report, about half of China’s fixed asset investment is in real estate and manufacturing. Government polices aimed at cooling real estate investment and the appearance of excess capacity in manufacturing both point to a slowing. There are also some creaks in China’s need to improve rapidly its capital formation. The Shanghai Composite index has fallen by over a quarter, albeit from an absurdly inflated level.
Severe winter storms have occurred unusually far south this year, bringing snow even to Shanghai and Nanjing. This is exacerbating shortages and fuelling inflation, which has been running at over 6 per cent for the past five months.
But if China does experience a downturn, it will be from a very high level. It also has choices. Stimulating consumption within China is at least an option, unlike the heavily indebted Western economies, with their chronically low savings rates. In 2007, when China grew by 11.5 per cent, 9 per cent of growth came from domestic spending and only 2.5 per cent from net exports.
The likelihood is that the Chinese economy will slow from 11.5 per cent to about 10 per cent in 2008 and 9 per cent in 2009. That is far from cause for panic. If anything, it does much to allay the continuing fears about overheating – M2 money supply growth was at over 18 per cent last year. Such growth rates, after all, are still multiples of the world average.
Economic decoupling may be a dubious thesis, but there is some finance decoupling between China and the West. China’s financial structure is still emerging from its communist origins. It is far less integrated into the global structure than its commercial system. To the extent that this protects the country from some of the West’s excesses like securitisation and derivatives trade, this is probably entirely beneficial. But the need to develop a more modern financial structure remains paramount, especially as China will only have one chance to do it before the country’s population ages.
Superficially, the currencies of America and China are coupled; the yuan is still fixed against the US dollar. But in terms of financial development they are a long way apart. The yuan is fixed because China’s financial system is still not yet developed enough to float. This protects Chinese exporters from the effect of a falling greenback; they will not be priced out of the American market, but it is a mark of how different their stage of development is.
China is the opposite of America in terms of fiscal prudence. Whereas America is sucking in about $800 billion, or two thirds of the world’s excess savings, China has amassed almost $US1.5 trillion in foreign exchange reserves.
The underpinning of the banking systems in the two countries is very different. If American banks start to get into problems on their capital adequacy, as is now happening, it is perilous. Some US banks are starting to borrow from the Federal Reserve to bolster their funds, a trend that signals danger to the whole system. China’s banks, although often near insolvency, are backed by the Chinese government, which still has massive land holdings throughout the country that can be sold off if necessary.
The capital markets are very unalike. China is only starting to develop bond markets, and its equity markets are immature. Much is being done with securities regulation and the stockbroking industry to establish a Western-style financial system, but there is a long way to go. One bright sign, however, is the recent sharp rise in profits of state owned enterprises (SOEs), which have been growing at about 50 per cent. This will help deepen the capital base. It may eventually lead to the creation of a social safety net, the absence of which is a big factor influencing China’s high savings rate. As a portion of the SOE’s profits go into a national social security fund, ordinary Chinese might feel it is safer to spend.
Even the much-touted high levels of foreign direct investment (FDI) into China are very unlike Western countries’ FDI. China’s Ministry of Commerce claims that foreign direct investment rose 13.6 per cent to $US74.7 billion last year. But the figure is inflated by mainland Chinese money being sent through offshore tax havens to take advantage of tax incentives for foreign investors. According to the Department of Foreign Investment Administration, investments channelled through havens such as the British Virgin Islands, Cayman Islands, Mauritius and Samoa jumped 37 per cent last year to account for more than a quarter of all the flows. When FDI from Hong Kong is added in, it is estimated that as much as two thirds of FDI is Chinese mainlanders pursuing tax minimisation.
For Australia, which heavily depends on China’s growth continuing, the prospects do not seem as troubling as it would be if the country depended on American growth. Most Australian economists agree that Australia will take some time to be affected by the American downturn. The demand for energy in China will remain, and with such a high proportion of the economy devoted to investment, the surge in demand for minerals is likely to continue. And even if there is a short term easing in commodity prices, the underlying supply and demand patterns suggest it will be only temporary.
The more interesting question is which strategy China will employ in the face of American economic weakness? The openness of the Chinese economy has not been principally designed to attract Western capital, but to instigate a massive technology and knowledge transfer. It has been spectacularly successful.
China now has to develop its own global firms, and start to diversify the investment of its massive financial reserves. The Chinese government has currently purchased about $US800 billion in US Treasury bonds. What will it do with its fast growing foreign exchange reserves? As Western financial institutions increasingly struggle to husband sufficient capital, the prospect for some strategic investments looms.