The current debate on China?s future has two basic camps: the extremely bullish camp and the bearish camp. The extremely bullish camp likes to extrapolate past trends endlessly into the future, forecasting continued growth of 8% or better. The economists who are most bullish on China predict the economy will grow by 15% in dollar terms every year, or 8% growth in GDP plus 5% appreciation of the yuan and 3-4% inflation, which would be enough for China to ?eclipse? the US in a decade. The bulls leave no room for recession or reversal, and they forecast a kind of endless boom in the urban real estate market, assuming that tens of millions of rural Chinese will migrate to the cities over the next two decades as they have done in the last two. The bearish camp was a shrill minority until recently, but it?s growing. One common line of the bearish argument is that China?s over-investment, surging debts, and rising home prices are very similar to what occurred in Thailand and Malaysia before the 1997-1998 Asian crisis, which brought those economies to a grinding halt. I think the truth probably lies in the middle.
Too big to boom
The most likely path for China is the trajectory Japan followed in the early 1970s, when its hot postwar economy began to slow sharply but still grew at a rapid clip, an entirely expected course for any maturing ?miracle? economy. China is on the verge of a natural slowdown that will change the global balance of power, from finance to politics, and take the wind out of many economies that are riding in its draft. The signs of the coming slowdown are already clear, and it is likely to begin in earnest within the next two or three years, cutting China?s growth from 10% to 6 or 7%. As a result the millions of investors and companies betting on near-double-digit growth in China could be wiped out.
It is said that it takes money to make money, but for nations to grow rapidly it is much easier to be poor?the poorer, the better. Per capita income is the critical measure because a growing pie doesn?t change a nation?s circumstances if the number of mouths it needs to feed is growing just as fast. To grow 10% from an average annual personal income of $1,000, a nation needs to earn an extra $100 per person, assuming zero population growth; at $10,000 the nation needs to make an extra $1, 000.
It makes no sense to think of India ($1,400 per capita income, with a high-growth population) in the same way as Russia ($13,000, with a shrinking population). The richer the country, the tougher the growth challenge, and it is possible to be too big to grow fast. It becomes a question not only of scale but also of balance, of devouring an outsized share. In 1998, for China to grow its $1 trillion economy by 10%, it had to expand its economic activities by $100 billion and consume only 10% of the world?s industrial commodities?the raw materials that include everything from oil to copper and steel. In 2011, to grow its $6 trillion economy that fast, it needed to expand by $600 billion a year and suck in more than 30% of global commodity production…
Illusion of China?s $2.5 trillion surplus
The extent of China?s indebtedness is also poorly understood. Because China now sits on $2.5 trillion in foreign-currency reserves, and is a major creditor to the US, no one thinks of it as having a debt problem. But it does. Though official government debt is low (about 30% of GDP), that is a small part of the story. The debt of companies (many of them owned by the government) and households combined amounts to 130% of China?s GDP, among the highest levels in emerging markets, and that is just the official number.
The real number may be much higher because the government data do not count China?s unique and exploding ?shadow banking sector?. Described as ?social financing? by China?s central bank, this sector is not necessarily shady but it is off the official books, and it includes a great variety of sometimes new credit channels that can involve loans from one corporation to another, or one depositor to another, with the bank playing the middle man rather than putting up any money. This gray sector has exploded since 2008, when the state began trying to slow regular bank lending. If the shadow banks are included, the ratio of China?s debt to GDP rises to 200%, off the charts for a developing economy.
Many outside observers remain convinced that Chinese leaders can continue to engineer near-double-digit growth rates, even when those leaders have made it clear that they need to dial back the spending and lending that produced that growth. Talk to Chinese CEOs and big domestic investors, and they don?t share the outsider?s see-no-downside, hear-no-downside optimism. Most outsiders bet on China by buying stocks sold in other countries (say, commodity companies listed in Australia and Canada) because the Shanghai market is still largely closed to outsiders, but that makes Shanghai a very good barometer of domestic investor confidence in the future. The Chinese stock market has flat-lined since late 2006, up 0% through late 2011…
End of the Deng dynasty
If there is a single thread that runs through the 25 years of reform?from 1978 through 2002?it is the Deng dynasty. As Matthew Gertken and Jennifer Richmond of the STRATFOR consulting firm have pointed out, any leader who had Deng?s stamp of approval had broad public legitimacy, and though Deng died in 1997, he not only handpicked his successor as paramount leader, Jiang Zemin, but also was a mentor and guide to Jiang?s successor, the current president Hu Jintao. Deng created tremendous momentum for reform, but it is largely gone. The bold moves?opening to the world, relaxing the internal passport system, allowing increased inequality?have been replaced by efforts to increase social welfare, lower the environmental impact of rapid growth, and redistribute portions of the economic pie. For example, with the exception of the crisis year of 2008, China has raised the minimum wage by 18% or more every year since 2003. Early evidence from the provinces suggested it would rise 21% in 2011. This move?toward reforms that make life easier rather than making the economy more competitive?are quite common as nations grow more wealthy. And after Hu?s presidency, the Deng dynasty and its generations of hard reformers will be history…
There is no magic in the system
The success of command-and-control capitalism in China has set off a vigorous debate over which political system is most likely to produce growth? but it?s not the type of system that matters, it is the stability of the system and, even more important, whether the leaders running it understand the basics of economic reform. The chance that any particular system?democratic, authoritarian, or any other?will have a positive impact on a country?s breakout potential is about 50/50.
I?ve been working by this rule for a long time, but for the purposes of this book I decided to look at high-growth nations?emerging markets growing at a rate better than 5%?for the last three decades. Based on Central Intelligence Agency classifications, my team labelled each country democratic or authoritarian (including monarchies and military governments). We found that in the 1980s, 32 nations were growing at a rate faster than 5%, and 59% of them were democracies; in the 1990s, 59% of the 39 high-growth nations were democracies; and in the 2000s, 43% of 53 were democracies. The total for the three decades: 64 (52%) of 124 high-growth countries were democracies, pretty much what I expected.
Still, there is a widespread belief that political systems matter for economic success. It?s a deep-seated faith of American politics that democracy and capitalism not only are superior systems, but also go hand in hand. Many economists, however, favour the opposite view?that well-managed authoritarian systems are more likely to produce rapid economic growth…
However, a closer look at the countries that have posted high growth since 2000 shows nations in every stage of transition from authoritarian to democratic rule (or from democratic to authoritarian rule). There are democracies in India and Indonesia, autocracies in China and Russia. Even the economies of inept autocracies like Myanmar and Kazakhstan grew at better than 10% for the decade, a sign of how little it took to expand an economy from a small base during this go-go decade…
China slowdown won?t devastate China
The bears are probably as wrong as the bulls, because China still has plenty of room to grow, albeit at a slower rate… The slowdown of China will lower the trajectory of a star that has altered the arc of human progress, for better and worse, rapidly reducing global poverty while rapidly accelerating the threats of environmental destruction and global warming. China is the equivalent of a company with revolutionary technology: it has been highly disruptive, destroying competitors while lifting up nations that supply and feed off its growth momentum. China?s rise as an export-manufacturing power has not slowed the long-term decline of global manufacturing (which has slipped in inflation-adjusted terms from 17.5% to 16.9% of world GDP since 1970); it has simply eaten more and more quickly into the share of steel, TVs, cars, and other goods manufactured in the West. A slower China means a less disruptive China, producing less geopolitical friction, fewer trade battles, and less fear of a rising ?Red Dragon?. So perhaps this is not a bad thing.
If China moves to a 6 to 7% growth path in the coming years, it will first feel like a mild recession for that economy, and there will be some transition pains. But it will hardly be a cataclysmic event for the global economy. After all, as the Chinese proverb goes, ?A dead camel is still larger than a horse.? The bigger picture is that the Chinese economy is now so large?worth around $6 trillion a year?that even at a 6% growth rate, it will remain the largest single contributor to global growth in the coming years. So the shock will be partly psychological: nations, politicians, and investors who feared China?s rise (or its possible collapse) will experience tremendous relief. Those who bet everything on riding the coattails of China growing at 8% or better will face a much nastier surprise.
Breakout Nations: In Pursuit of the Next Economic Miracles has been published by Penguin-Allen Lane.
The author is head of Emerging Market Equities and Global Macro at Morgan Stanley Investment Management