The China Syndrome...

The China Syndrome
by Satyajit Das

In 1971, Ralph Lapp, a nuclear physicist, used the term "China syndrome" to describe a hypothetical nuclear reactor meltdown where the molten core breaches containment barriers and melts through the crust of the Earth reaching China. The economic equivalent of the China Syndrome describes a process in which China's strong growth, abundant savings and foreign exchange reserves assists a rapid restoration of global growth.

The nuclear metaphor ignores the geographical fact that the opposite side of the globe from the United States is actually the Indian Ocean and that the entire idea is physically impossible. The economic metaphor conveniently discards some significant doubts about the ability of China to act as a catalyst for global recovery.

The Unbalanced Bicycle
China's economic growth model was a contributing factor in the current Global Financial Crisis (GFC).

Under Deng Xiaoping, leader of the Communist Party from 1978, China undertook Gaige Kaifang (Reforms and Openness) – reform of domestic, social, political and economic policy. Economic stagnation and serious social and institutional woes that could be traced to Mao's Cultural Revolution forced the change.

The centerpiece was economic reforms that combined socialism with elements of the market economy. It entailed engagement with the global economy, reversing the traditional policy of economic self-reliance and a lack of interest in trade.

In embracing markets, Deng famously observed that: "It doesn't matter if a cat is black or white, so long as it catches mice." Deng also embraced a change in philosophy: "Poverty is not socialism. To be rich is glorious."

China's economic reforms coincided with the "Great Moderation" – a period of strong growth in the global economy based on low interest rates, low oil prices and deregulation of key industries such as banking and deregulation. The boom was also based on increases in global trade and investment driven, in part, by the fall of the Berlin Wall, the collapse of the Soviet Union and integration of socialist economies into the world economy.

China's growth model, inspired by the post-war recovery of Japan, used trade to accelerate the growth and modernization of its economy. The economic engine was export driven growth.

The model took advantage of China's large, cheap labor force, and the strategy benefited from rising costs in neighboring Asian countries such as Japan, South Korea, Taiwan, Hong Kong and Singapore. China was able to attract significant foreign investment, technology and management and trading skills from countries keen to outsource manufacturing to lower-cost locations to improve declining competitiveness.

China converted itself, at least parts of the country, into the world's factory of choice. It imported resources and parts that were then assembled or processed and then shipped out again. The Great Moderation ensured a growing market for exports.

Innate conservatism, the desire to maintain Communist Party control of the domestic economy and avoid social disruption favored partial market liberalization. China's need to provide employment for its underemployed population and improve its technology also favored this strategy. China's economy needs to grow 7% to 8% annually to absorb workers entering the formal workforce each year.

The strategy was decidedly "trickle down economics" as Deng himself acknowledged: "Let some people get rich first."

As economic momentum increased, foreign businesses invested in China to take advantage of the growth and rising living standards. Opportunities encouraged Chinese nationals living, studying and working overseas to return.

Over time, a novel liquidity system also accelerated growth to staggering levels.

Liquidity Vortex
Export success created large foreign reserves that now total more than $2 trillion. These reserves became the centre of a gigantic lending scheme in which China would finance and thereby boost global trade flows.

Dollars received from exports and foreign investment have to be exchanged into Renminbi. In order to maintain the competitiveness of its exporters, China invests the foreign currency overseas to mitigate upward pressure on the Renmimbi.

As reserve growth paralleled its growing trade surplus, China invested heavily in dollars, helping to finance America's large trade and budget deficits. It is estimated that China has invested 60% to 70% of its $2 trillion reserves in dollar-denominated investments, primarily U.S. Treasury bonds and other high quality securities.

Chinese funds helped keep American interest rates low, encouraging increasing levels of borrowing, especially among consumers. The increased debt fueled further consumption and housing and stock market bubbles that enabled consumers to decrease savings as the ‘paper' value of investments rose sharply. This consumption, in turn, fed increased imports from China, creating further outflows of dollars via the growing trade deficit. The overvalued dollar and an undervalued Renminbi exacerbated excess U.S. demand for imported goods.

In effect, China was lending the funds used to purchase its goods. China never got paid, at least until the loan to America was paid off.

The Asian crisis of 1997-98 encouraged China to build even larger surpluses. Reserves were seen as protection against the destabilizing volatility of short-term foreign capital flows that had almost destroyed many Asian countries during the crisis.

The substantial build-up of foreign reserves in China and the central banks of other emerging countries was a liquidity-creation scheme. The arrangements boosted growth and prosperity in China, other emerging markets and the developed world. Commodity exporters, such as Australia, benefited significantly from the increased demand for commodity and the higher prices for resources.

Fall & Rise
In 2007, unsustainable levels of debt in many economies triggered a near collapse of the global banking system that, in turn, triggered a major slowdown in growth.

The unprecedented external demand shock, with sharp decreases in consumption and investment from synchronous deep recessions in the developed world, affected the Chinese economy. The sudden and precipitous fall in exports led to a significant slowdown in China's stellar growth rates in 2008, triggering sharp declines in stock and property markets.

Job losses in export-intensive Guangdong province were in excess of 20 million migrant workers. Workers and students entering the workforce were unable to find work. Fearful of social instability, the Beijing government moved quickly to restore rapid growth.

Panicked government spending and loose monetary policies increasing available credit are currently driving China's recovery, contributing around 75% of China's growth of 8% to9% in 2009. In the June quarter, Chinese exports (35% to 40% of the economy) decreased by about 20%, implying that the non-export part of the economy grew strongly.

In the first half of 2009, new loans totalled more than $1 trillion. This compares with total loans for all of 2008 year of about $600 billion. Current lending is running at around three times 2008 levels and at a staggering 25% of China's GDP.

The availability of credit is fuelling rampant speculation in stocks, property and commodities. Estimates suggest that 20% to 30% of new bank lending is finding it way into the stock market, driving up values. Record numbers of new trading accounts have been opened, including over 500,000 accounts in one week in July alone, the highest since January 2008.

The market for initial public offerings for new companies has recommenced after being closed for six months. Recent issues have been massively oversubscribed and risen sharply on listing. In July 2009, on the first day of trading, shares in China State Construction Engineering, the country's largest homebuilder, rose by as much as 90%, closing up 56% and reviving memories of the heady days of the previous boom. The shares in Sichuan Expressway tripled on debut before closing up over 200% %. The frenzy has also affected Hong Kong, where China related stocks have risen strongly.

China's recovery, in turn, underpinned the recovery in commodity prices and economies dependent on natural resources. In recent parliamentary testimony, Reserve Bank of Australia Assistant Governor Philip Lowe highlighted the extent to which Australia, a major trading partner of China, was reliant on Chinese demand. Lowe noted that 23% of Australia's total exports went to China in the most recent quarter, up from 4% 10 years ago. China now also takes 80% of Australia's iron ore exports and 20% of coal exports.

While a significant part of the importation of commodities is restocking depleted inventory, abundant and low cost bank finance combined with a deep seated fear of the long-term prospects of U.S. Treasury bonds and the dollar has encouraged speculative stockpiling artificially boosting demand.

Lock & Load
Government spending and bank loans have resulted in sharp increases in fixed asset investments (up more than 30% from 2008). A major component is infrastructure spending, which accounts for more than 70% of the Chinese government's stimulus package. In the first half of 2009, investment accounted for more than 80% of growth, approximately double the 43% average contribution over the last 10 years.

Infrastructure investment is adding to production capacity in a world with sluggish demand and major overcapacity in many industries. In the absence of sufficient domestic demand, the production may be directed into exports increasing the global supply glut and creating deflationary pressures.

Progress on shifting the emphasis to domestic consumption has been disappointing. Government incentives, in the form of rebates for purchases of high value durables such as cars and white goods, have increased consumption (up 15% from 2008). But, over the last 25 years, Chinese consumption has declined from around 50% to its current levels of 37%.

The current expansion in lending also risks creating China's own homegrown banking crisis with a rise in non-performing bank loans. The problems of bad debts from loose lending are not new. In the 1990s, similar credit expansion led to an increase in bad debts. The big state-owned Chinese banks had to be substantially recapitalized and restructured at significant cost to the State in a series of steps that ended as recently as 2004.

Chinese bank regulators are concerned that new lending is being used to finance real estate and stock market speculation rather than productive purposes. They have moved to try to reduce speculative lending, but it is likely that the central bank will resolutely maintain its moderately loose monetary policy because of uncertainties in the external and domestic environment.

On August 24, 2009, Chinese Premier Wen Jiabao was reported as saying: "China will maintain its stimulative policy stance because the economy, far from being on solid footing, is facing fresh difficulties ….''

There are also concerns that Chinese statistics are unreliable and frequently manipulated by officials to meet political and personal objectives. One unexplained and nagging discrepancy is the difference between reported growth figures and electricity consumption. It is difficult to reconcile falls in electricity consumption with continued robust economic growth.

Even China's state-controlled media has become increasingly skeptical about the accuracy of statistics. In recent polls, a high percentage of the population doubted official data.

International commentators have become concerned about the quality of the economic data. Commenting on the time taken by China's National Bureau of Statistics (NBS) to compile growth data, Derek Scissors, from the Washington-based Heritage Foundation, wryly observed: "Despite starkly limited resources and a dynamic, complex economy, the state statistical bureau again needed only 15 days to survey the economic progress of 1.3 billion people."

The problems extend to financial information as generally accepted accounting principles are not generally accepted in China. Writing in the August 17, 2009, New York Times, Mark Dixon, a mergers and acquisition advisor in China, expressed surprise that revenue and cost gymnastics were not included as an official event at the Beijing Olympics.

Bounding Mines
China's $2 trillion foreign currency reserves, a large proportion denominated in dollars, may have limited value. They cannot be liquidated or mobilized without massive losses because of their sheer size. Increasingly strident Chinese rhetoric reflects rising concern about the security of these dollar investments as the United States issues massive amounts of debt reducing the value of Treasury bonds and the currency.

"If anything goes wrong in the U.S. financial sector, we are anxious about the safety and security of Chinese capital," China's Premier Wen Jiabao has said. Yu Yindong, a former adviser to the Chinese central bank, has castigated the United States over its "reckless policies." He asked U.S. Treasury Secretary Timothy Geithner to "show us some arithmetic." At the University of Beijing, Mr. Geithner obliged, indicating that the U.S. intended to reduce its budget deficit to 3% of GDP from its current level of 12%, eliciting sceptical laughter from students.

China's position is similar to that of a bank or investor with poor quality assets. China is trying to switch its reserves into real assets – commodities or resource producers where foreign countries will allow.

In the meantime, China continues to purchase more dollars and U.S. Treasury bonds to preserve the value of existing holdings in a surreal logic. On the other side, the United States continues to seek to preserve the status of the dollar as the sole reserve currency in order to enable the Treasury to finance America's budget and trade deficit.

Every lender knows Keynes' famous observation: "If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours." Almost 40 years ago, then-U.S. Treasury Secretary John Connally accurately identified China's problem: "it may be our currency, but it's your problem."

China's position is like that of an unfortunate who has stepped on a type of anti-personnel mine, known as a bounding mine. The mine does not explode when you step on it. Instead, it trips when you step off it as a small charge propels the body of the mine into the air where the explosive charge bursts and sprays fragmentation. China, in building and investing its massive foreign exchange reserves in dollars and U.S. Treasury Bonds, has stepped onto the mine and it cannot step off without serious damage!

The Future That Was
China's economic model is reminiscent of 17th century mercantilist policies. Thomas Mun, a director of the East India Company, wrote that the purpose of trade was to export more than you imported. At the same time, a country should amass foreign ‘treasure' that would be the basis of acquiring foreign colonies to allow control of essential natural resources. The strategy required reducing domestic consumption and imports and export of goods manufactured with imported foreign raw materials. China's strategy coincides almost entirely with Mun's views.

China's mercantilist strategies have important implications for other developing countries. Chinese investment in and trade with Latin America and Africa is concentrated on securing access to resources, forcing these nations to specialize in commodities. This reversion to a 19th century trend may not be compatible with Latin American and African long-term development and stability.

The Chinese economic model may be unsustainable. It relies on global trade and investment (much of it export related), which together contribute a high proportion of China's GDP. This trade entails importing foreign components that are then reassembled and then exported. Domestic consumption has been kept low. Treasure has been built up in the form of domestic savings and trade surpluses.

Recently, China announced that its $2 trillion treasure would be used to make foreign acquisitions to secure exclusive access to raw material. The problem is that China's treasure is already invested in assets of dubious value and limited liquidity to finance global consumption.

Chinese Premier Wen Jiabao warned that the Chinese growth was becoming increasingly "unstable, unbalanced, uncoordinated and ultimately unsustainable." That was two years ago! There is broad agreement that a key component of the GFC was the problem of global capital imbalances. A central feature was debt-funded consumption by the United States that allowed 5% of the global population to constitute 25% of its GDP, 15% of consumption and 48% of global current account deficit. Japan, China, Germany and the other savers funded the consumption.

Any lasting solution to the GFC requires this imbalance to be dealt with. The glib solution requires the United States to save more and consume less and the savers to save less and consume more. The problems in implementing the solution are considerable. Timothy Geithner's recent discussion with Chinese officials, to assure his hosts of the safety of their investments in dollars and U.S. Treasury Bonds, reveals the dilemma.

On the one hand, America needs the Chinese to continue and increase their purchase of U.S. government debt to finance its fiscal stimulus and bailouts. On the other hand, America needs China to cut the size of its current account surplus, boost government spending, encourage personal consumption and reduce savings. All this should also occur ideally without any major decline in the value of the dollar or U.S. Treasury bonds or the need for China to liberalize its currency and allow internationalization of the Renminbi.

A cursory look at the respective economies also highlights the magnitude of the task. Consumption's contribution to U.S. GDP is 71%, while in China it is 37%. Given that the GDP of China is around $4 trillion to $5 trillion versus the U.S.'s $15 trillion, and that the average income in China is 10% to 15% of U.S. earnings, the difficulty of using Chinese consumption to drive the global economy becomes apparent.

During the last quarter of century, Chinese savings have risen and exports have been the engine for growth. Given that a significant portion of exports is driven ultimately by American and European buyers, lower global growth and declining consumption creates significant challenges for China.

Dealing with the global imbalance has not been a high priority in the various summits global leaders have shuttled to and from.

In March 2009, in advance of a scheduled G-20 meeting, the Chinese central bank proposed replacing the U.S. dollar as the international reserve currency with a new global system controlled by the International Monetary Fund The United States predictably dismissed the proposal, and The Wall Street Journal argued that, "for all its faults, the dollar is attractive as a reserve currency because it is the common language of global finance and trade. In other words, its appeal is proportionate to how many other market players use it. The unstated reason was the loss of the ability to finance itself in its own currency would significantly disadvantage the US.

In July, 2009, at the G88 Summit in the earthquake-damaged town of L'Aquila in Italy, Dai Bingguo, Chinese state councillor, was again openly critical of the dominant role of the U.S. dollar as a global reserve currency. "We should have a better system for reserve currency issuance and regulation, so that we can maintain relative stability of major reserve currencies exchange rates and promote a diversified and rational international reserve currency system."

Western leaders expressed concerns about even raising the issue, fearing that discussion of long-term currency issues could undermine the nascent recovery in markets and economies.

In September 2009, the Americans and Europeans proposed an effort to tackle global economic imbalances at the G-20 summit in Pittsburgh. Against a background of rising trade tensions, China's ambassador to the United States, Zhou Wenzhong, expressed scepticism about the proposals, seeking focus instead on avoiding protectionism.

Still heavily reliant on exports, China was wary of a global push on imbalances that would focus on its large trade surplus (which reached nearly 10 per cent of GDP in 2008). Zhou pointedly blamed the crisis on "the lack of supervision and abuse of the openness of the market, very risky levels of leverage and too much speculation." He proposed improving global financial supervision, strengthening bank capital and creating global early warning systems to identify threats, but resisted action to address the imbalance.

Ironically, recent modest improvements in the global economy potentially risk increasing the same imbalances that were one of the factors that caused the current financial crisis.

Turning Japanese
China's problems, to a degree, mirror earlier problems of Japan, its neighbor and competitor for global influence.

Japan's export driven model successfully generated strong growth of 10% average in the 1960s, 5% in the 1970s and 4% in the 1980s. This growth was driven by a number of factors, including an artificially low exchange Yen rate.

On September 22, 1985, Japan, the United States, the U. K., Germany and France signed the Plaza Accord, agreeing to depreciate the dollar in relation to the Japanese Yen and German Deutsche Mark by intervention in currency markets. The Accord had limited success in reducing the U.S. trade deficit or helping the American economy out of recession.

The Plaza Accord signaled Japan's emergence as an important participant in the international monetary system and global economy. The effects on the Japanese economy were disastrous.

The stronger Yen triggered a recession in Japan's export-dependent economy. In an effort to restart the economy, Japan pursued expansionary monetary policies that led to the Japanese asset price bubble that collapsed in 1989. Economic growth fell sharply and Japan entered an extended period of lower growth and recession, generally referred to as "The Lost Decade."

In the 1990s, Japan ran massive budget deficits to finance large public works programs in a largely unsuccessful attempt to stimulate growth to end the economy's stagnation. Only structural reforms in the late 1990s and early 2000s restored modest rates of growth. Japan's public debt is now approaching 200% of Japan's GDP.

Significant shifts in economic strategy are now necessary. Chinese President Hu Jintao recently noted: "From a long-term perspective, it is necessary to change those models of economic growth that are not sustainable and to address the underlying problems in member economies."

China can try to continue its existing economic strategy, which looks increasingly difficult. Changing its economic model is also difficult if it means a slower rate of growth. China's challenge will be to learn from and avoid the problems and fate of Japan.

History and cultural issues compound China's dilemma. The 1842 Treaty of Nanking entered into at the end of the first Opium War awarded Britain war reparations, eliminated the Chinese Hong monopoly, set Chinese exports and imports at a low rate, provided British access to several Chinese ports and transferred Hong Kong to the English. The humiliation of the Treaty is deeply etched into China's dealing with the West.

China should have heeded the warning of Kang His, emperor of China, on the British presence at Canton in 1717: "There is cause for apprehension lest in centuries or millennia to come China may be endangered by collision with the nations of the West."

The tradeoff between economic and political liberalization may also be problematic. As Fang Li, a renowned astro-physicist often called China's Andrei Sakharov, remarks in dissident author Ma Jian's novel about China "Beijing Coma": "Without a democratic political system in place, [China's] economy will eventually flounder. The people's wealth will be eaten up by the corrupt institutions of this one party state."

There is an apocryphal story about a visiting world leader drawing back the current of his hotel room to be stunned by the futuristic skyline of Shanghai's Pudong Financial District. "How long has this being going on?" he asked. Today, the question might be:
"How long can this go on?"

Satyajit Das is a risk consultant and author of "Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives" (2006, FT-Prentice Hall).