What is Really Happening in China? The Long-term View
Economically, there are two China’s: the fast-growing capitalistic manufacturer of world goods, and the slow-growing ‘old’ economy of communist China. During my graduate research in China in 1998, these two China’s were evidenced by gleaming electronics manufacturing facilities with workers in blue uniforms on the one hand and rusted out chemical factories with inexplicable green puddles and ancient equipment on the other.
State-run enterprises represent about 25% of China’s economy, over 1,000 companies run by the government – the overwhelming majority by local governments. These State Owned Enterprises are funded in large part by centrally managed state-owned banks. As a result, China’s economy is ‘managed’, in a much more forceful way than that of the developed world. Among other tools the central government adjusts quotas for the amount of money that can be lent to local governments, allowing it to adjust the amount of money that can be invested. If China would like to increase growth it increases lending quotas, allowing investment to increase, and increasing economic growth.
While the ability to ‘manage’ the economy sounds like a wonderful idea, it comes at a significant cost. Every good economist knows that this type of ‘management’ comes with unintended consequences. Since State Owned Enterprises bear no real risk of loss, investment is made whether there is any real economic need or value being created, and as a result, much of the money is wasted and loans face the very real risk of default. Thus the (true) stories of dazzling airports, empty cities, and overbuilt factories.
Investment, whether economically viable or not, is the driving factor in the Chinese economy, not consumption as it is in the US. The long-term view of China is that of conversion from an investment-driven, State-owned Enterprise driven economy to a modern, consumption-driven, capitalistic (or at least more capitalistic) economy. The economic cycle looks something like this: 1) Local government invests in capital projects, resulting in 2) inflation and resource constraints, leading to 3) central government tightening, and 4) investment slowdown, resulting in 5) central government policy relaxation, which leads us back to local government investment in capital projects, and the cycle continues. Through each cycle, China attempts to rebalance the economy to be less dependent on this type of investment-driven growth.
China has been tightening policy for much of the past 2 years, making needed reforms which have at least contributed to this economic slowdown. What we can expect next is central government policy relaxation, which is already beginning to occur this year. In the short term, given the strength of the controls on the Chinese economy, history says that they will be successful in stimulating the economy once again. It is likely that this will be positive for commodities as China’s economy responds. What is more questionable is the long-term viability of this strategy. China’s local governments already owe 30 tr yuan – or about 5 tr USD. The long and the short of it: China’s growth worries are likely to fall out of the news in the next few months, but the long-term story is far from decided.