It is difficult to go a day without reading scary headlines about China’s economy. The reality is that it is going through major adjustments, and has some serious structural flaws, but that its even greater strengths will almost certainly prevent economic calamity. Troubles will come, and they will be handled with greater or lesser effectiveness, but the system, and those who run it, have the capability to manage the problems without serious risk of the disaster scenarios that some purvey.
China’s economy faces two related types of serious challenges. The most basic, which will continue for years, is that it needs to rebalance the economy. China has relied excessively on massive investment and large trade surpluses, although the latter has moderated from earlier years. Consumption, the other key part of the economy, has been squeezed to low levels by the focus on investment and exports.
This balance is not sustainable for a variety of reasons. Such massive investment cannot be done without substantial waste. One does not have to dig far in China to find examples of serious over-investment. Much of it represents the building of infrastructure now that is not really needed until well in the future, such as many of the high-speed train lines. These projects are often justified by the fact that they will eventually be put to good use, but in the meantime represent “dead money” that could be channeled into much more profitable uses. Other investments are just vainglorious or foolish and will never be worth much. Lower levels of total investment would tend to be considerably more efficient, because it is easier to get funding for smart projects than silly ones.
There are also real limits to the sustainability of large trade surpluses in a world where all nations are looking to increase exports, and the sheer size of China’s economy has grown to the level where other nations will not long accept such an approach. In fact, China is relying substantially less on such trade surpluses now than it did before the global financial crisis.
Pessimists on China tend to believe that the central leadership will be unable or unwilling to guide the economy away from over-investment. I disagree. First, the authorities have the power to change the economy. The pattern of over-investment, trade surpluses, and under-consumption is heavily driven by policy choices. This includes the level and type of spending by central and local governments and the many companies they own, the patterns of funding by state-owned banks, tax policies, and the prices charged for energy and other resources controlled by the authorities, not to mention currency rates that they guide.
Second, anyone who has seriously studied China realizes that the leadership of the Communist Party and of the government is very smart and has analyzed the issues carefully. The path to power and wealth in China generally runs through the State and consequently most of the best minds compete hard for these positions. The Party is also aware that its long-term survival depends on navigating these tricky waters. Thirty years of history since the start of the major reforms has shown that the institutions are capable of dealing with extremely difficult and complex growth challenges and the constant need for transitions as China has transformed. The authorities make mistakes, and external events can surprise them, but at this point, I strongly suggest betting that they will find their way through the current challenges.
The other source of major fears about China is a set of weaknesses in its financial system. The banks doubtless face major loan losses from the stimulus program of 2009, which was mainly accomplished by pushing banks to ramp up their lending dramatically. They are not reporting large bad loans at this point, but I am confident such losses are out there. Many of these ultimately bad loans are to financing vehicles set up by local and regional governments which pursued unsustainable policies, usually under the strain of central government rules that limited their revenue and added to their expenses. Further, China has a large and rapidly growing “shadow banking” system of finance that runs outside of the formal sector. It performs a useful function, because the formal sector is much too wedded to support of firms owned by the State and politically connected individuals. The dynamic private sector, which provides much of the production and most of the employment growth, ends up relying on shadow banks. The problem is that shadow banks tend to be highly levered, opaque, and lightly regulated. The potential for a blow-up in this sector is high.
The reason I am not pessimistic overall is because the Chinese central government has the financial capability and administrative skills to deal with the problems as they arise. The central government has a debt level that is about a quarter of the size of China’s annual output, which is a ratio about three times better than ours. They have organized financial bailouts of the banks in the past and they can rescue both the formal and informal financial sector if necessary.
Equally importantly, the authorities are well aware of the need to rebalance the economy, and to fix weaknesses in the financial system, and have an active program of reforms to do this. There will undoubtedly be resistance to the reforms, mistakes in their execution, and problems of all kinds. However, China’s strengths are formidable and I am confident that the problems will be overcome without disaster. Growth may well suffer for awhile, but without the kind of “hard landing” that many prophesy.
[On the ongoing trade negotiations] If we’re serious about resolving the core issues that the U.S. has with China, then this is going to be a way station that’s going to require a lot more continued focus by the administration for a number of months if not years.