China's economic clay feet

In the 1960s, following Sputnik’s launch, Americans feared that Russia would eat our economic lunch only to find that its planned economy had clay feet. A similar thing happened with Japan in the 1980s during its property-led economic boom that created the so-called Japanese economic miracle. Our fears of a serious Japanese economic challenge were soon assuaged when the Japanese property market bubble burst and Japan experienced a lost economic decade.

Over the past decade, China’s spectacular economic growth has made that country the world’s second largest economy and the world’s main engine of economic growth. This has instilled fear in our political class that China might soon surpass the United States as the world’s largest economy. However, especially in light of our earlier experience with the Russian and Japanese economic challenges, one has to wonder whether the Chinese economy might also soon prove to have clay feet.

One reason to think that the Chinese economic engine might soon run out of steam is that China has been over-reliant on its property sector to generate economic growth. It also has been excessively dependent for that growth on companies such as Evergrande, the world’s most indebted property developer, which now appears to be on the cusp of default.

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The size of the Chinese property bubble certainly has to be of concern. According to Harvard’s Kenneth Rogoff, the Chinese property market has increased to a size that now accounts for almost 30 percent of the Chinese economy. That is roughly double the size of the property sector in most advanced countries. At the same time, Rogoff estimates that around 20 percent of Chinese properties are unoccupied and that Chinese housing prices are now some 40 times household incomes in a number of major Chinese cities such as Beijing, Shanghai and Hong Kong. That is some three times the corresponding ratios for cities like London and New York.

China’s credit market bubble is equally troubling. According to the Bank for International Settlements, over the past decade, Chinese credit to the non-government sector has increased by 100 percent of GDP. That is a faster rate of credit increase than that which preceded Japan’s lost economic decade or the 2006 U.S. housing market bust. Generally, credit bubbles of the size that China is now experiencing are followed by many years of sub-par economic growth.

To be sure, the Chinese government’s control of its banking system makes a U.S.-style housing and credit market bust in China highly improbable. But it is all too probable that, as was the case with Japan before it, China will find its banks’ balance sheets clogged with non-performing loans and its economy characterized by many zombie companies in the property sector. One would think that such a prospect would constitute a major headwind to restoring rapid economic growth.

Further clouding China’s long-term economic growth prospects are President Xi’s recent clampdown on the country’s high-tech sector and the pursuit of his Common Prosperity Program. Those measures appear to be rolling back at least in part Deng Xiaoping’s reforms of the late 1970s that underpinned the country’s economic miracle. And they appear to be doing so at precisely a time that China’s earlier one-child policy is causing a secular decline in the country’s labor force.

How the Chinese economy performs over the next few years will be critical to the rest of the global economy, given that it is the world’s second largest economy and the world’s most important commodity consumer.

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While it is true that the Chinese economy does not have direct financial links to the world’s financial system, a marked slowing in Chinese economic growth would have major spillover effects to the rest of the global economy. No longer would Germany, Australia and China’s Asian economic partners be able to count on a rapidly expanding Chinese economy for their exports. And no longer would the commodity producing countries in Latin America and Africa be able to count on buoyant international commodity markets to support their economies.

All of this suggests that U.S. economic policymakers would be well advised to worry less about China as an economic challenge and more about how the world economy will cope without China as its main engine of economic growth. 

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.