Our Opinion: 2022

China’s economic miracle : drawing to an end

There is no painless way for Beijing to deflate the debt bubble.

Chinese president Xi Jinping has a better understanding of the challenges facing his country than most investors. The leader-for-life has warned of the dangers posed by the real-estate bubble, excessive debt levels, widespread corruption and rising inequality. These problems are not unique to the People’s Republic. In the past, every country in the region that adopted the so-called Asian development model has faced similar ones. Xi’s dilemma is that there is no easy way for China to surmount them.

The Asian model has several key features. State-controlled banks supply cheap loans to favoured industries; the currency is kept at an undervalued level to boost exports; consumption is suppressed to create savings for investment; and rapid modernisation is achieved by adopting foreign technologies.

But growth in Asia is inherently unstable. Artificially low interest rates fuel real-estate bubbles, such as Japan experienced in the late 1980s and Thailand in the following decade. Easy money also leads to excessive debts, as occurred across Southeast Asia in the early 1990s. Cheap capital encourages wasteful investments that undermine productivity growth. Suppressing consumption creates an unbalanced economy. Furthermore, opportunities for corruption abound when credit is distributed by state-run banks.

Japan’s long period of economic expansion ended when the Bank of Japan decided in late 1989 to burst the property bubble. The Asian “Tigers” – as the fast- growing economies were called – ran off the cliff a few years later. The economic “miracle” could only be sustained with ever-larger inputs of capital and labour. When foreign creditors withdrew their capital in the mid-1990s, the region experienced a financial crisis.

Now consider China’s predicament. Since the Communist Party embraced economic reform in the late 1970s, it has pursued what Peking University’s Michael Pettis dubs the “Asian development model on steroids”. China’s savings and investment rose to higher levels, and consumption fell lower than any other Asian economy had ever witnessed. The People’s Republic has gorged on debt, which has climbed by 100% (relative to GDP) since 2009. The value of China’s real estate is matched only by Japan’s in 1989.

No wonder Xi bemoans that property is for living in rather than speculation and that the country’s “unbalanced and inadequate development” has not improved the quality of living for many Chinese nationals. He is now calling for “common prosperity”, which entails a reduction in inequality. He also wants to cut excess capacity, reduce leverage and make housing more affordable.

All this is to be achieved while promoting smooth economic growth and avoiding a financial crisis. To appreciate the challenges facing China, consider what happened to its neighbours when their economies abruptly changed direction. After Japan’s real-estate market turned down in 1990, residential properties became more affordable. But the bust produced two banking crises and a persistent deflation that hung over the economy for decades. Beijing does not wish to repeat that experience. When the Asian Tigers ran into trouble in the mid-1990s, they were forced down a different path. After problems emerged in Thailand, foreign creditors rushed for the exits. Contagion spread from one country to another, including Taiwan and South Korea. This was a period of collapsing currencies, widespread bankruptcy and bailouts by the International Monetary Fund.

The Asian crisis had a silver lining, at least. Countries that experienced sharp currency devaluations became much more competitive. In 1999, South Korea’s economy expanded by more than 10%. The yuan is loosely pegged to the US dollar, which gives the US Federal Reserve an inordinate influence over China’s monetary policy. That’s especially problematic since the Fed is set to increase the cost of money next year, while China, with its deflating housing bubble, needs to ease. Ditching the currency peg would return monetary independence to Beijing.

If China devalues the yuan, then its economy might be expected to enjoy a burst of export-driven growth. Whether that will be tolerated is another matter. China is already the world’s leading exporter. If Xi goes for devaluation he will face pushback from the US and its allies in an effort to protect their jobs and economies from cheaper Chinese products.

Never underestimate the ability of Beijing to find policies that keep the Chinese economy moving. But with household and corporate debt at higher levels than in the US on the eve of the subprime crisis and history’s greatest real-estate bubble set to burst, Xi looks to have few options. After four glorious decades, China’s economic miracle looks finally to be ending.

11th April 2022