3 fault lines running through China's economy
April 21st, 2011
02:35 PM ET

3 fault lines running through China's economy

Editor’s Note: Neil K. Shenai is an Instructor of International Economics and Ph.D. Candidate at the Johns Hopkins School of Advanced International Studies (SAIS).

By Neil K. Shenai, Special to CNN

The notion of “American decline” is once again en vogue. Emerging powers such as Brazil, India, and China pose a threat to U.S. dominance, the argument goes. They undermine U.S. interests while the U.S. battles economic stagnation.

This seems corroborated by the facts: U.S. share of global GDP is down to approximately 19%, from 25% in 2000. China recently replaced Japan as the world’s second-largest economy with current estimates projecting that China’s economy will overtake America’s by 2020.

But Americans should not let paranoia cloud a reasoned appraisal of China’s strengths and weaknesses. China’s economy contains three potential fault lines that threaten its long-term economic stability. Consider the following questions:

1) Can China handle its infrastructure bubble?
2) Can China become an innovation economy?
3) Can China manage its long-term demographic and political challenges?

1) Can China handle Its infrastructure bubble?

Yu Yongding, former Chinese central banker, recently described the U.S. treasury market as a “giant Ponzi scheme,” contending that the Federal Reserve’s asset purchase programs have led to an artificial bubble in U.S. treasuries, seemingly ignoring the fact that treasury prices fell after the Federal Reserve announced Quantitative Easing 2. If Mr. Yongding wants to identify a real Ponzi scheme, he need only look at the Ponzi finance practiced by China’s state-run banks.

In the aftermath of the global financial crisis, China forced its state-run banks to lower lending standards and make as many loans as possible to support infrastructure and real estate development, which according to various estimates accounts for nearly 20% of the Chinese workforce.

Although vast infrastructure investment helped China grow at near double-digit rates, their current spending spree illustrates why it’s sometimes possible to have too much of a good thing (for an example of China’s infrastructure spending run amok, see this see this fine documentary on China’s ghost cities).

Because China’s banks are under state control, they do not face the same liquidity and credit risks as their Western counterparts, as they are forever-backstopped by Chinese taxpayers (at least the Chinese admit that their financial institutions are government-sponsored entities).

This might pay off handsomely in the near-term, as millions of Chinese are put to work building multi-unit apartment buildings, constructing state-of-the-art airports, and laying concrete for highways. Still, China’s domestic lending scheme is Ponzi finance. Consider its financial circularity:

Because of their political control, Chinese banks must lend to ever-more dubious projects for ancillary, non-business reasons. When these investments fail to yield an adequate rate of return, these loans drop in value. To maintain bank lending and thus high levels of employment, China buys up these non-performing loans from the banks and puts them into separate, state-run entities of which the Chinese government is the ultimate creditor. This bank balance sheet cleansing begins the process of lending anew, leading to more loans, more speculation, and ultimately greater defaults. But because they are the ultimate backstop to this speculative lending, the Chinese government is really the sucker in its own Ponzi scheme.

Even though China’s airports and trains are some of the best in the world, countries can still overinvest in productive sectors. In the West, we have markets that help reign in the excesses of imprudent investments (think the bursting of the technology bubble in 2000). Can we really trust the Communist Party to make these same hard decisions, when social order and the Party's hold on power depend on populist lending?

2) Can China become an innovation economy?

China’s rapid growth depends on its access to buoyant global markets and cheap labor. Low wages and an undervalued nominal exchange rate kept Chinese export prices low, flooding global markets with Chinese goods. This process worked well when China had low unit-labor costs and trading partners with an insatiable demand for Chinese goods.

Today, the world is a different place. Advanced economies are over-indebted, underemployed, and generally unable to provide a consumption backstop to Chinese growth. Meanwhile, China’s heretofore quiescent workforce is starting to demand higher wages, having endured rising income inequality and consumer price inflation eroding their real wages. As a result, other emerging economies with lower unit-labor costs such as Vietnam and Indonesia have poached market share from China’s low-end manufacturers.

Economic theory postulates that as countries get richer, they move up the “value chain” of production, first from net exporters of raw materials, to manufacturing (China’s current stage), and later to high-end industrial goods with breakthrough technological innovation.

While theoretically straightforward, the actual process of becoming an innovation economy requires several vital institutions, such as a strong intellectual property regime and an efficient domestic capital market to identify and pick path-breaking innovations.

China has a notoriously bad reputation for protecting intellectual property. Counterfeiting and software piracy run rampant in China, for instance. Developing the institutional framework and cultural respect for intellectual property will take time, and there is no guarantee that China can become an innovation economy like the United States.

Meanwhile, China’s state-run banks might not be as efficient at allocating capital as the America’s system of private venture capitalists, whose lending decisions are depoliticized and technocratic. China’s high R&D spending is a step in the right direction, but does not guarantee success without these other institutional ingredients.

Moreover, economic cultures and political cultures are often mutually-reinforcing. As sociologist Max Weber once observed, the cultural gestalt that produces anti-statism in America might also be responsible for Americans’ tolerance of creative destruction and breakthrough innovations. On the other hand, China’s political culture of hierarchy and stability might not cultivate an economic culture of risk-taking and rapid change.

3) Can China manage long-term demographic and political challenges?

There are two oft-cited long-term challenges to China’s economic model that are also worth mentioning. First and perhaps most pressing is their rapidly-aging workforce. China’s dependency ratio (the ratio of non-workers to workers) is expected to climb rapidly because of the after-effects of their one-child policy. Rising dependency ratios usually lead to slower growth and greater demands for public pensions, both of which will tax China’s working age population.

If any of the above factors produce economic instability, the Chinese Communist Party could begin to fall out of favor in China. Senior Chinese leadership is aware that their popularity depends on providing economic opportunities to China’s growing middle class, and this co-optation strategy relies on continued economic growth.

China could prove the exception to this, but there are very few contemporary examples of countries that have modernized economically but maintained single-party authoritarian rule over the long-term, with the lone exception being Singapore, a micro-state with five million people. By comparison, it is estimated that China will have over two hundred cities of over one million people by 2025.

Of course, the answer to all of these questions might be a resounding “yes.” But more often than not, situations that appear too good to be true often are. China has gone through a fantastic growth spurt and poses formidable economic challenges to the United States. Thus far, the Chinese Communist Party has deftly managed China’s economic modernization, replacing their defunct ideology of Marxism with one of pragmatic and gradual change.

But observers in the West should be realistic in their appraisal of the long-term potential of the Chinese economy. China’s ageing workforce, staid political system, opaque banks, and inconsistent intellectual property regime represent concrete challenges for China in the immediate term.

For China to successfully rebalance its economy with more consumption, less dependence on exports, and better institutions for innovation, it needs near-flawless execution on behalf of Chinese leadership.  To reproduce the economic gains seen over the last three decades, the Chinese Communist Party will need to pull off another perfect run of reforms. While certainly possible, Americans should not overestimate the threat China poses to U.S. economic dominance.

Instead of portraying China as an inevitable usurper of United States interests, Americans must realize that China’s rapid ascent and future growth sit on ever-more tenuous foundations.

Instead of looking abroad and demonizing China’s anti-U.S. policies like their currency manipulation, Americans would be better off looking inward, maintaining a quiet confidence in the durability of its economic and political institutions while continuously trying to reform from within, bearing in mind that the internal contradictions of Chinese capitalism will expose themselves over time. This strategy helped the U.S. outlast the Soviet threat, and would serve it well when dealing with a new generation of potential challengers.

The opinions expressed in this article are solely those of Neil Shenai.

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Topics: China • Economy

soundoff (14 Responses)
  1. LOL

    Wait, America could not even predict her own 'non-performing loans' aka complex derivatives linked as sub-prime loans, and now they are project China will have one too.

    Boy, the fun never stops coming out of America. :-)

    Innovating the wrong stuff I see. :-)

    April 21, 2011 at 4:28 pm | Reply
  2. j. von hettlingen

    What Shenai pointed out in his "3 fault lines" is not new. As the Chinese central government is known for its farsight, I am sure they see the challenges ahead of them and are prepared to weather the storm. Here you see the difference from the mentality of American politicians, who target their issues with a short range scope.

    April 21, 2011 at 5:18 pm | Reply
    • lu

      Just want to point out some funny things you say: "As the Chinese central government is known for its farsight, I am sure they see the challenges ahead of them and are prepared to weather the storm."

      I wanna say that every government or institution has members with farsight. China and America are big beasts, they have other things pulling them in directions that prudent watchers cant stop. The idea that china is run by smarter, longer-range thinking people, is really funny. everyday in china i look around and think, this country is run by the most shortsight idiots. i think chinese officials are generally more short sighted than america because they only need to please their superior one step up in the hierarchy. nothing more. everything is like this, policeman, school administrator, city official, province official. u have every reason to not fix real problems so u can look good until u get a promotion and leave the mess to another person

      "Here you see the difference from the mentality of American politicians, who target their issues with a short range scope."
      I don't really see china here is so much better. it seems like all public officials will have lots of interests to please, some got you into power and some will keep you in power, some can remove your power. chinas system is probably less strong than america in the long range scope because officials have ever reason to become heavily corrupt. people dont lose their job because they are corrupt, no matter what CCTV says. you lose your job in a corruption campaign because your superior was on the wrong side and did not, or could not protect you. few public officials in china will truly get removed because of corruption, even with sanlu milk scandal these people stuck their neck out in arrogance and lost their protection. nobody in china gets in trouble for corruption unless your patron or affiliates have become too weak and it serves their interests to take down your side.

      April 22, 2011 at 12:52 am | Reply
    • T

      Even if you are farsighted and you are right, you cannot change anything if the interests of people in power are against you. Many people from finance saw the derivative crisis but they could do anything because all that was required from them was to have profit now.

      May 27, 2011 at 1:05 pm | Reply
  3. Onesmallvoice

    If America doesn't change it's foreign policies and learn to mind it's own business abroad,it will slip far behind other countries in both economic growth and output. We need to learn how to stay out these of useless wars and curtail our military.

    April 21, 2011 at 5:47 pm | Reply
    • Matt

      Quite true Onesmallvoice,quite true. We need a regime change here in this country and need it bad. The right-wing thugs in Washington have gotten to be too arrogant and self-righteous!!!

      April 22, 2011 at 1:08 am | Reply
  4. Marisa

    I read your article with great interest, but afterwards I thought, "this is nothing new". Nearly everything in this article is a rehash of many other article. Just the "three fault lines" analogy seems to be new. Anyway, it would be best for the world for China to crash causing an overthrow of the CCP. The world can then breathe a sigh of relief. Let's face it, the poliburo and all their cronies are very wicked people and they deserve to all be hung. Just look at what they do to their citizens. The reason why China can treat its citizens this way is because, as far as the Chinese authorities are concerned, Chinese citizens, no matter where they are in the world, are the property of China. They don't have to explain what they do with their citizens. In fact, they don't have to explain what they do with anyone. The Chinese leaders are above the law, any and all law, since they consider themselves gods. After all, they are the richest people in the world. I'm referring to the 9 member politburo which runs the country. They don't think they have to answer to anybody. They are not elected by the people, but make it to the top by being ideologically brutal. The more ideological, the higher they go. They know the formula. Regarding Ai Weiwei, the poltiburo has given orders that he be locked up and while the entire world frets over it, the leaders of China sleep well and smile in their dreams about how miserable they make people who have good hearts towards others.

    April 22, 2011 at 7:20 am | Reply
  5. PaPaPeng`

    When you strip away all the overlying details the great difference, thus China's strength is that her public expenditures are financed from earnings (China's foreign currency holdings exceeded USD 3 trillions in March) while that of the US and the Western countries do so through debt (figures like USD 14 trillions for the US alone have been bandied about. There is little if any prospect of this debt being repaid.) Thus there is a lot of forgiveness in the Chinese universe for big goof-ups while the same goof-up by the US is capable of wiping out the US as a world power.

    April 22, 2011 at 1:45 pm | Reply
  6. PaPaPeng`

    There has never been a let up of attacks on China's government and governance from before the CPC came into power in 1949. China was prostrate and destitute after a 30 year Civil War and an invasion and occupation by the Japanese. China was also isolated from the rest of the world and received no aid other than a paltry $500 million loan on stiff terms from the Soviet Union. From that desperate beginning China pulled herself up by her own bootstraps to come to today. We do not owe anything to anyone for what we have achieved.

    In spite of your attempts to demonize China's leaders they are held in high esteem by all Chinese including overseas Chinese who were not born in China and are third or fourth generations immigrants in their adopted lands. This may come across as improbable to you. China has a long history of selfless gentlemen scholars to whom high civil service is an honored calling and one not contingent on acquiring great wealth through office. The leaders China now has are people of that kind and for whom their place in history is a precious legacy. They rose to top leadership through sheer competency and dedication to duty, not through murderous power struggles. Had they sought wealth they could have gotten much more outside government. Not a single one of them has a secret Swiss bank account or can boast of any great wealth. They, other then Mao himself, have all retired peacefully and on schedule to their government apartments where their privilege is in their security and personal needs being taken care of. Are they as virtuous and as capable as I make them out to be? I don't know but the available evidence does make them out to be so. You will have to provide verifiable evidence to the contrary and none have been forthcoming so far. So long as China can keep producing leaders of their caliber we will have a prosperous nation at peace with herself and with the rest of the world.

    April 22, 2011 at 2:38 pm | Reply
    • james2

      The "gentlemen scholars" from the Qing dynasty weren't so selfless. Perhaps apart from America's present campaign finance system, I cannot think of a more corrupt government or bunch of bureaucrats at any other time in history. They mostly rose through the ranks through bribes and connections to their higher-ups. I think Chinese people and other Sinophiles need to come to grips with the fact that despite the Confucianist emphasis on ethics and government service, Chinese leaders are human just like everybody else.

      April 22, 2011 at 5:38 pm | Reply
    • Propaganda_Alert

      Your reply sounds like it was quoted straight out of a Communist Chinese history book.

      How do the Chinese pull themselves up on their own bootstraps when they are freely given, copy (or outright steal) most technology built in China from western companies and countries?? (DId you read the discussion of intellectual property in this article?)

      How many people died under the reign of Mao, or was he not one of the gentlemen scholars who you write about?

      Why do the leaders of the communist party have such a higher standard of living when compared to an average Chinese citizen? They reap the benefits of their political power in just the same way a crime boss would stash money in a Swiss account.

      April 25, 2011 at 10:36 pm | Reply
    • Nick

      gimme a break buddy. How much do they pay you to post this stuff while posing as some regular person?

      It is so obvious that you drink the coolaid that it's just sad.

      April 26, 2011 at 3:23 am | Reply
  7. John

    No matter what else the Chinese may have done, they have not lost sight of their nation's primary interests, unlike American politicians who have sold the American people to the highest bidder over the past 40 years. The US has no real manufacturing base left, education funding has been short-changed to maintain a blue-collar majority, the financial system is a giant rip-off of Joe Public, and the really wealthy find every ruse to pay no taxes whatsoever. When banks can legally charge 79% on tiny lines of credit(see First Premier), the writing is on the wall. Innovation might still take place in America, but the benefits of that innovation will accrue to wealthy Americans(who can invest in them) and the countries where manufacturing is done.

    April 25, 2011 at 6:17 pm | Reply
  8. Blessed Geek

    A bubble is not necessarily a bad thing.

    There was gazillion miles/kilometres of optical fibres/fibers in the US laid but unused called the dark fibres. The dark fibre bubble fueled the rise of internet use.

    Like the dark fibres, China's asset bubble would be an economic and industrial advantage. Unlike the huge giant ponzi scheme we have in the US, where there was actually no real assets behind them.

    April 25, 2011 at 8:06 pm | Reply

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