Why do we keep underestimating the Chinese economy?
FROM THE NEW REPUBLIC | September 17, 2009
It’s now widely believed that the global recession is coming to an end, but the path out has been far from typical: This time around, China, not the U.S. has led the global recovery. With its $600 billion stimulus package and with banks lending with abandon, China has become the engine of global manufacturing and industrial activity. Its demand for commodities, especially copper and iron ore, has driven up prices, and its domestic market has been a rare source of strength for American companies ranging from Caterpillar to Intel, General Motors to Procter & Gamble.
But even after a decade of robust and unexpected Chinese growth, investors and economic analysts still focus on when and how the Chinese miracle will end. It’s not that anyone deeply questions the short-term reality of China’s strength, but no one seems quite able to believe that the locus of the global system has in fact shifted. When global stock markets swooned at the beginning of September, the commentary was abuzz with talk of Asian contagion and the cascade effects of a sharp pullback in Chinese equities. Noted Asia analyst and former strategist for Morgan Stanley Andy Xie announced that, having fallen more than 20 percent in August, Chinese stocks could plunge another 25 percent. His reasoning? China’s economic recovery is likely to stumble badly when the central government attempts to constrict the flow of easy credit. Even in China, when Premier Wen Jiabao cautioned Chinese citizens in late August for being too “blindly optimistic” about China’s economic recovery, that was taken both in China and abroad as further proof that the heady run in China was about to hit a wall. Wen then repeated these concerns to an audience of the World Economic Forum in Dalian on September 10.
All this skepticism is much more than a forecasting problem. China’s economy is showing no signs that it’s about to collapse or even contract. Growth figures have been accelerating, from perhaps 5 percent at the beginning of the year toward 10 percent now. While many question the recipe that China has followed, the results speak for themselves. The problem is that too many are convinced that the growth is a house of cards. It’s a mindset that goes back many years and that has many dangers.
At almost any given point in the past decade, economists and strategists were convinced that good China news was simply a prelude to bubbles and shattered dreams. In part, those beliefs were an outgrowth of past experience with “hot” emerging economies, many of which had succumbed to the runaway inflation that invariably accompanied turbo-charged expansion. The economies of Latin America in the 1970s and of Southern Asia in the late 1990s were taken as harbingers of what China risked, and the fact that so much of China’s growth has been fueled by state-spending channeled through banks to projects of dubious merit was seen as a critical weakness that would end with a banking crisis followed by economic contraction. This doubt was also fueled by a series of false starts in China in the 1980s and early 1990s: China suffered along with the rest of Asia during the currency crisis in 1998, and banking reforms inside of China during those years led to some periods of much slower activity.
Those slowdowns did not seem to have long-term consequences, though. China has produced more growth over the past 25 years than any country, ever (averaging more than 9 percent a year). And after stalling in the fall of 2008 and in the early months of 2009 along with the rest of the world, China has been growing at an astonishing rate in the past six months--manufacturing has been expanding, exports have been surging (more than $20 billion a month to the United States alone), property prices and activity have soared, and stocks are on fire. Interior cities have replaced the coastal provinces as the engine of growth, and that process has barely begun.
But China’s resilience does not seem to have convinced analysts to consider the possibility that China may be on a more stable trajectory today. In the past few years, among those talking down China’s economy has been Stephen Roach, now chairman of Morgan Stanley in Asia and one of the most influential voices in the highest circles of politics and finance. Since 2002, Roach has relentlessly assailed the China growth model; this year he has emphatically warned that China’s response to the financial crisis could be setting the world up for another round of financial shocks next year. Others have echoed those concerns, ranging from Harvard pundit Niall Ferguson to New York Times columnist Paul Krugman. China skepticism is embedded in Wall Street as well.
The most frequent critique of China’s growth is that it’s too dependent on state spending, too reliant on exports to the United States, and not grounded in consumer activity. Or to put it another way, that its growth is fueled by the government and not by the domestic market. A recent McKinsey Report again warned that domestic consumption in China was dangerously low (less than 40 percent of the economy) compared with developed economies in Europe and the United States (where domestic consumption comprises more than 70 percent of the economy). What’s more, financial mavens are almost unified in their belief that Chinese lending this year has been promiscuous and that many of the loans will go bad; that stocks are forming a bubble; and that there still is far too little domestic consumption, especially as the export market once again ticks up as the global economy recovers.
Yet, what if China isn’t headed for a soft landing or a hard landing? What if it’s headed for no landing?
Of course, just because China did not hit any significant speed bumps earlier in the decade is no predictor of whether it will in the future. But the lessons of past underestimation should be taken seriously. The surge in the price of raw materials in 2007-2008 was based almost entirely on unexpected Chinese demand, and the pattern is beginning to repeat itself: Despite widespread pessimism among mining and oil companies after last year’s financial collapse, China’s huge stimulus package kicked off a flurry of industrial activity that led to massive price spikes in things like copper and iron ore: Copper--the leading indicator of global industrial activity--doubled in price between March and August. Other metals have also been rebounding strongly.
The consequence of these miscalculations in the past has been chronic misjudgment about everything from the price of oil and commodities to the strength of corporate earnings and the level of interest rates. For instance, by failing to factor in China’s growth earlier in this decade, oil companies were left with a serious supply shortfall when China consumption surged. That helped propel oil past $145 a barrel in 2008. Gasoline in the United States then surpassed $4 a gallon, with serious economic and political consequences.
True, this year, as global economies contracted, oil fell and fell hard, to $45 a barrel. And with Americans driving less, prices at the pump came down to earth. But it would be a grave mistake to assume that this is the new normal. The rise in oil past $70 a barrel over the summer occurred against a backdrop of China’s rapid rebound, yet the chronic skepticism of China’s path means that we are once again failing to anticipate just what China’s growth might mean for the world.
China now consumes close to 8 million barrels of oil a day. But what if it grows 10 percent a year and if cars sales expand by double-digits in China (as they have been)? What if China doubles its oil consumption in the next few years, just as it has in the past few years? No one believes that the global supply of oil is ready to provide another 8 million barrels a day. And what about the rapid rise in raw materials? Those costs directly affect the economics of global companies. If China is buying up the world’s available iron ore--and it is--that makes the cost of steel everywhere more expensive. If China is buying up the world’s copper--and it is--that puts pressure on everything from air conditioner systems to housing. And if China needs more fertilizer for the increased appetite of its increasingly affluent populace, that makes it more expensive for food companies to operate.
All of those costs erode the profitability of companies. In years past, companies would have simply raised prices. But in the United States and Europe, they haven’t been able, because consumer wages are flat and their access to credit is limited. So what do they do to remain profitable? They try to become more efficient, and they try to cut costs. And one of the best ways to cut costs is to cut people, which is one reason for the 9.7 percent unemployment in the United States. In short, there is a direct link between Chinese growth, higher input costs and higher unemployment in the United States.
But it isn’t so simple to detach from China and erect trade barriers. Last week’s decision of the Obama administration to impose steep tariffs on Chinese tire imports raised the specter of a trade war, but while auto unions in the United States celebrated the decision, such moves do real harm to the domestic U.S. economy. China’s growth benefits America in manifold and unexpected ways, especially in providing a stream of affordable goods that keep our standards of living from falling off a cliff. In addition, China’s demand for Procter & Gamble sundries, General Electric turbines, and Caterpillar earth movers keeps jobs in the United States that might otherwise not exist. In turn, the earnings of those companies can be much more robust than the U.S. economy more broadly--and the recent strength of corporate earnings bears this out. But here too, if investors--and that includes pension plans and even the U.S. Treasury itself--fail to account for the China effect, then their investment decisions will also be flawed: They will assume that U.S. companies can only be as profitable as the U.S. economy and underestimate just how well they can do because of China.
For now, the political class in Washington seems to be preparing for a slow, unspectacular resumption of growth in America, and the financial class is also anticipating that the China story is headed for problems. The first is likely to be correct, but as the above indicates, the China story may play out quite differently. Some of that has positive effects for the United States; some is more challenging for us. Either way, misjudging the viability of China’s economic path has serious negative consequences. In the past, the failure has had only marginal effects. But with China now assuming a joint role with the United States as a cornerstone of the global economy, getting China wrong could be the difference between prosperity and chaos.