14 May 2014

The Truth About China's Economy

Some say it could pass the U.S. by the end of the year. There might be an even bigger story behind the scenes.

May 9, 2014 

The World Bank just put out a report suggesting that the Chinese economy would overtake that of the United States by next year to become the world’s biggest economy measured by its currency's purchasing power. “The estimate by the World Bank's International Comparison Program says that based on 2011 prices, the purchasing power of China's currency, the yuan, was much stronger than was reflected by exchange rates,” says USA Today.

The World Bank report caused quite a fuss in the media, but the methodology behind it is questionable. CNBC reported breathlessly that “China is set to overtake the U.S. as the world's number one economy, while India has jumped into third place ahead of Japan, according to a new study from the world's leading statistical agencies.” Other media outlets that ought to know better followed suit.

First and foremost, using purchasing power parity to make such a comparison confuses apples and oranges in an economic sense. “Living standards of the average Chinese citizen are still far lower than those in many developing countries, let alone in the West,” notes Jamil Anderlini, Beijing bureau chief of the Financial Times who has lived in the country for more than a decade. He continues:

“Today, inequality in this nominally socialist country is now much worse than the US, the epitome of a capitalist country. The level and availability of social services such as health, pensions and unemployment benefits are also much lower proportionally than in the US and even many other developing countries.”

Even the Chinese government itself expressed reservations about the methodology used by the World Bank. But the more fundamental issue for analysts should start with the nature of the Chinese political economy and the veracity of economic data in China. There is no separation between church and state in China. There is only the state.

The economic statistics issued by the Chinese government are designed to help maintain the control of the Chinese Communist Party in a political sense, not to better inform China’s people or foreign investors. The fact that the World Bank, foreign news agencies and investors are willing to take Chinese statistics at face value says more about the credulity of foreign audiences than it does about China’s authoritarian government.

Even if we decide to take Chinese economic statistics at face value, however, prudent analysts still need to ask some basic questions about the fundamental factors behind the claims of job growth and output. China's economy reportedly grew at an annual 7.4 percent in the first quarter of this year, slowing from a 7.7 percent increase in the final quarter of 2013, numbers that seem too good to be true—and they are.

Some of the better alternative sources on the Chinese economy, such as theU.S.-based China Beige Book, reports that “the economy slowed broadly this quarter and saw even starker deceleration on-year. Every sector except transportation slowed from last quarter, with revenue growth in manufacturing and services easing and that in retail, mining, agriculture, and especially real estate weakening more sharply.”

Part of the difficulty facing foreign analysts is that they tend to think of the Chinese economy in their own terms, comparing China to a Western-style market economy with functioning financial institutions and credit markets. Instead, the correct way to view China is closer to the old Soviet allocation model, where the state and the Communist Party make decisions to allocate resources to one sector or region, often based on political consideration rather than any clear economic logic. The fact that half of Chinese GDP is based upon state direct investment is a clear red flag.

James Rickards, author of the new book “The Death of Money” and a long-time China analyst who visits the country regularly, notes that the new, largely empty cities springing up around China are not so much a sign of economic growth as the desperate creation of work and infrastructure that consumes resources and produces no economic output.

Rickards believes that if you discount China’s economic statistics to reflect the cost of malinvestment, corruption and cronyism between members of the Communist Party and state-controlled banks and companies, the actual GDP growth rates are perhaps half the officially claimed rates. Moreover, this type of infrastructure spending is not only wasteful, but it is unsustainable. He notes:

“The threat from malinvestment in infrastructure, asset bubbles, overleverage, corruption and income inequality are routinely downplayed by Chinese authorities. These threats are viewed as growing pains in the birth of a new China as opposed to an existential crisis in the making. The larger issue for China’s leadership is the impossibility of rebalancing the economy from investment to consumption without a sharp decline in growth. This slowdown, in effect the feared hard landing, is an event for which neither the Communists nor the world at large are prepared.”

In a macroeconomic sense, the collapse of the U.S. real-estate bubble that began with the 2007-2009 subprime crisis also marked the end of a period of malinvestment by China in the U.S. economy. Following classical mercantilist models, China earned foreign exchange from the massive trade deficit it ran with the Western consumer nations, then reinvested these surpluses in mortgage securities that helped to fuel the accumulation of trillions of dollars’ worth of bad debt on the balance sheets of the United States and EU nations.

With the sharp decline in Western demand for cheap exports, the Chinese Communist Party has used massive “investment” in the form of internal-infrastructure spending and debt to prevent a large decline in domestic employment, an eventuality that conjures up ancient fears of political instability and social unrest. China’s leaders are loath to admit that they have a problem much less publish statistics that would confirm such fears.

China Beige Book reports that the Chinese economy is actually decelerating after years of artificially induced internal growth. They report:

“The pace of Chinese economic expansion has plainly slowed. Revenues, sales, profits, and wages are all weaker than a year ago. The slowdown is particularly steep in the North and Northeast, and also pronounced in the Beijing and Central Regions. By sector, stable first-quarter growth in manufacturing confirms our long-standing thesis that it is no longer the economy’s bellwether. Instead, a weaker retail performance is the principal driver of the aggregate trend.”

In order to understand the Chinese economy, Western observers need to remember that all decisions in China taken by the Communist Party must be seen in political rather than economic terms. Party cadres justify massive spending on infrastructure as a means of avoiding social unrest, even while they tolerate endemic corruption and capital flight by party members. This paradox stems at least in part from the fact that China’s leaders are bereft of new ideas with which to guide the nation’s growth.

After two centuries of foreign occupation and war, China today is the world’s oldest society and also the largest emerging nation. It’s leaders fear giving their own people freedom to prosper for fear of losing political control, yet they imitate the nations of the West in many respects. The long-awaited transition from an investment-driven economy to a consumer-based economy, for example, implies enormous political change.

Clearly all decisions made by the Chinese Communist Party, whether economic or financial, ultimately come down to retaining and protecting the party’s monopoly on power. Unless you understand this basic fact, none of the other aspects of China’s incredibly diverse political economy make any sense. Indeed, whether or not China’s economy overtakes the United States in terms of size is far less important than how and when the political monopoly of China’s communist rulers will ultimately end.

Christopher Whalen is the author of the 2010 book, “Inflated: How Money and Debt Built the American Dream,” now in its second edition from John Wiley & Sons. He is coming out with a new book co-authored with Frederick Feldkamp entitled “Financial Stability: Fraud, Confidence & the Wealth of Nations” which is scheduled to be published by John Wiley & Sons in the second half of 2014. He tweets at @rcwhalen.

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