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Matías Vernengo

It has become increasingly common to suggest that on top of the European debacle and the sluggish recovery in the United States, China might be on the verge of a collapse, and with it the last bastion of economic growth in the world economy would also be gone. Not only the center is stagnant, but also the periphery of the global economy is very fragile. But the probability of a Chinese slowdown is greatly exaggerated.

Paul Krugman, who has been correct about the need for fiscal expansion in the United States, and about the European Central Bank (ECB) mismanagement of the Greek crisis, for example, has suggested that China is in the middle of a housing bubble that can burst at any time (see also Jayati Ghosh and C. P. Chandrasekhar here for a similar, but broader view of the dangers in 2012). This view insinuates that growth in China is fundamentally dependent on domestic demand, but that the sources of the expansion are fragile. It, further, suggests that China now looks very similar to the US before the Lehman Brothers crisis in September 2008.

It would be good to check the data, before providing a full reply to the doomsday scenario. First when we look at the decomposition of the sources of growth in China, it becomes clear that since the beginning of the last boom in the periphery the external sector has not been the driving force in China, since imports, particularly of commodities, have grown very fast. Investment and consumption are, on the contrary, the main sources of Chinese growth. So on that one the pessimists’ are correct; growth in China is driven by domestic markets forces (by the way, that makes the complaint that China is not making enough to solve the so-called global imbalances a bit peculiar, to say the least).

Contributions to Growth

Note also, in the graph above, that with the collapse of external demand during the 2007-09 crisis, investment, which corresponds to about 40% of GDP (in the US for comparison is closer to 15%), of which about half is public and good chunk goes to housing, increased to make up the difference.

It is worth noticing that the rise of China as a great trade power, which brought about better economic opportunities for peripheral countries in Africa and Latin America, since its entry in the World Trade Organization (WTO) in December of 2001, has taken place hand in hand with a significant real appreciation of its currency. While the real exchange rate deflated by the Consumer Price Index barely moves (and fits the complaints that China has not done enough to appreciate its currency and solve the global imbalances), the one deflated by Unit Labor Costs (ULC) has appreciated about 100% since the Asian Crisis of 1997.

RER China

Further, as the 3rd graph (below) shows it seems that ULC changes have fundamentally followed the variations of real wages. In other words, the expansion of real wages, which has been one of the pillars of consumption growth, a central component of output growth as we saw in the first graph, has undermined the external competitiveness of China, as it should be expected.

Average Real Wages and Unit Labor Costs

Public investment and domestic consumption, the driving forces of the expansion, are built on a foundation of insignificant foreign borrowing (foreign obligations as a share of reserves are tiny, since international reserves stand at around US$ 3 trillion) and a sustained increase in workers remuneration (for a chart of real wage growth going back to the 1980s go here). In that sense, a fundamental difference of the Chinese boom with respect to other bubble based booms, is that the housing boom was not central to allow the expansion of consumption and there is no imaginable balance of payments problem ahead.

Further, China is going through a long transition from a rural society to an urban industrial one, which would imply that hundreds of millions of people moving to cities in the next couple of decades. Given the size and importance of public investment for the Chinese economy it would surprising if there is no public involvement in the expansion of public housing projects to say the least.

But lets assume that the pessimists are correct and that housing prices collapse in China. Critics suggest that local governments, which are heavily dependent on land sales, and banks, that issued record numbers of home mortgages, will be the first to be hurt by a collapse of the housing market. The government will be forced to rescue banks, and, again like in the US, this would take precedence over growth and employment creation. Yet, I find this scenario very unlikely.

Note that in China and the US the debt is all denominated in domestic currency and, as a result, it is a political decision to rescue banks and creditors, or promote growth and favor debtors. While the expansions in the US have been weak (not just this one, but for 30 years now; see here), and the economic policies have been pro-creditors (Wall Street if you prefer) and anti-labor, the long Chinese boom has not been so. Growth (and direct repression of dissent, one might note) has been the way to sort out social conflicts in China. Nothing indicates that would change in 2012.

Read this post in Portuguese at INESC.

17 Responses to “China on the verge?”

  1. Kevin P. Gallagher says:

    Yu Yongding, my favorite Chinese economist, has a good “cool down folks” piece as well. See:

    http://www.project-syndicate.org/commentary/yu11/English

  2. Thanks for the link Kevin, didn’t know his work. By the way, I mangled the last link in the post. The correct one is here http://nakedkeynesianism.blogspot.com/2011/05/is-american-economy-profit-led.html

  3. anne says:

    Nicely done, and I do agree completely. How much China means to Latin America, directly and as a model is little understood as yet.

  4. anne says:

    By the way the first “here” link and the third bo not work.

  5. anne says:

    Got the first link to work from Truthout, but the final link still does not work. (I am not counting the Krugman link, which I know.)

  6. Hi Anne, thanks for the comments. First link works, but as it’s a bit old the NYTimes may limit access. Last link was my fault. See may 2nd comment above for the correct link.

  7. Qingdao says:

    I’m sorry, the last paragraph makes no sense. It is NOT a political decision to either bail out the (85% govt controlled) banks or promote growth. The long Chinese boom has not been anti-labor? If by “labor” you mean the relatively highly paid workers at capital intensive SOEs, then maybe; if by “labor” you mean anyone else in China who works – ask a random sampling if they feel they have gotten their “fair share” of the boom. Growth has sorted out social conflicts??

  8. [...] Vernengo at TripleCrisis believes the Chinese economy will avert crisis thanks to increasing domestic demand that isn’t [...]

  9. Qingdao says:

    Minimum wage hike leaves few smiling

    January 4, 2012 3:00 am by Enid Tsui; beyondbrics at FT

  10. [...] Paul Krugman , who has been correct about the need for fiscal expansion in the United States, and about the European Central Bank (ECB) mismanagement of the Greek crisis, for example, has suggested that China is in the middle of a housing bubble that can burst at any time (see also Jayati Ghosh and C. P. Chandrasekhar here for a similar, but broader view of the dangers in 2012). This view insinuates that growth in China is fundamentally dependent on domestic demand, but that the sources of the expansion are fragile. It, further, suggests that China now looks very similar to the US before the Lehman Brothers crisis in September 2008. China on the verge? » TripleCrisis [...]

  11. Hi Quingdao. Thanks for you comments. Here a few replies. First, yes to bail banks and how you bail them (for example in the 1990s Sweden nationalized them) is a political decision. In the US they may have decided to bail out the people loosing their houses not the banks. Second, I didn’t say that income distribution improved. Even in China’s labor market there are winners and loosers. But as you accepted in certain sectors wages have grown incredibly fast (even if from a low basis), which allows for sustainable demand growth (look at the decomposition of growth contributions). Last but not least, minimum wages hikes may not make everybody happy but it sure beats not growth (or a falling one like in the US).

  12. Ah yes. Growth and real wage growth clearly reduces social conflict. Even if the benefits of the boom are unevenly distributed, a boom generates social support from those that benefit. That was a typical argument used to explain why social conflicts didn’t explode in Brazil even though income distribution was dismal.

  13. David Pearson says:

    Matias,
    Consider whether high house/rent prices were becoming a political and economic issue. Migration from rural areas depends on the spread between the higher urban wage and the higher urban cost of living. My understanding is that this migration has slowed as incoming laborers were finding the urban cost of living unaffordable. If this is the case, China is reaching the limits of investment-led growth, as sparking a new rise in house prices will merely either 1) slow down migration; or 2) spark demands for higher wages. Either would decrease export margins and increase inflation. Both are signs of a necessary terms of trade shift between rural and urban China.

    Also, the central government very much depends on municipalities, and the SOE’s and shadow banks they control, as a monetary transmission channel. Once these municipalities and shadow banks are in trouble, its not just a simple matter of recapitalizing large banks through a transfer of wealth.

  14. Hi David. Thanks for your thoughtful comments. Yes there is a long debate on issues of terms of trade between rural and urban areas in development processes. One of the things that it may do is lead to inflationary processes as the old Latin American structuralists pointed out. However, note that I think that what we are observing is more like the Brazilian Miracle (1968-73) in which a middle class with higher and rising wages allows for demand expansion, even with a worsening of income distribution (in the case of China the rural workers that do not get incorporated in the sector with rising living standards). The difference with Brazil is that it is sustainable since there are no balance of payment problems ahead for China. On the shadow banks and municipalities, since transfers are in domestic currency there is no problem. Not sure what additional problems they might generate. Please explain.

  15. Johan Uribe says:

    Matias,
    If you consider that the role of investment in China is primarily geared toward the creation of productive capacity for the external sector, then in the face of a long term persistent slow down of growth in the EU and the US (which I would argue we are clearly facing a race to the bottom, especially in the EU) how can China possibly maintain growth rates of 9+ percent, which are essentially a prerequisite for any semblance of political stability given the CCP’s complete lack of authority on any ground other than economic? The only thing China has been doing for the past four years is replacing the lost demand in the external sector by flushing its domestic economy with money and loans in order to increase investment expenditures. But if external demand is falling, domestic consumption is at best steady, then you CAN NOT just maintain a 40-50% investment share of GDP indefinitely by means of government stimulus, that is just creating a massive build up of excess capacity with no good long term use.

    The government loans that are underwritting this massive build up in domestic investment are already non-performing and literally in default. http://www.ft.com/intl/cms/s/0/08d45414-553c-11e1-b66d-00144feabdc0.html#axzz1n4XhtAlI For how long can China maintain this same policy in the face of stagnant or falling growth in its external sector?

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