At first glance, that may sound like a crazy question. The two giants of the global economy appear to be heading in opposite directions. China is the world’s up-and-coming superpower, propelled forward by stratospheric growth, advancing industry, a goal-oriented political system and a supposedly superior form of economic management, “state capitalism.” On the other side of the Pacific, the U.S. looks like a bumbling behemoth, its competitiveness on the wane, its political system paralyzed and its future direction uncertain. What could these two economies possibly have in common?
More than you think. Very rapidly, China is beginning to encounter the same economic pressures as the U.S. Some are simply the natural outgrowth of China’s supercharged development. Others are being brought about by policy errors – similar, in fact, to those made by the West before the 2008 financial crisis. All of these new pressures are serious and, if not handled properly, could alter the course of China’s economic progress.
First of all, China, like the U.S., is facing a challenge from competitors with lower wages. As my colleague Bill Powell recently pointed out, the era of cheap labor in China is over. Wages are growing about 12% a year (in real terms). As a result, China is losing its competitiveness in labor costs to other emerging economies. That puts at risk the low-end, labor-intensive, export-oriented manufacturing (apparel, shoes, electronics) that has created countless jobs and jumpstarted China’s rapid growth. Just like the U.S. has lost factories to lower-wage economies like China, China is already seeing neighbors like Vietnam eat into its dominance in these types of industries.
Such an outcome was an inevitable result of China’s economic advancement. But if that advancement is to continue, the Chinese economy is going to have to move “up the value chain” into higher-tech, more innovative industries. This is exactly what the U.S. needs to do to maintain its competitive edge. Yet that’s a tough leap to make. Building factories where people stitch together blue jeans or build iPhones is easy. China doesn’t require either the technology or design and marketing expertise to generate exports. But to compete in more technologically advanced industries, Chinese firms will have to innovate, improve quality and create brands – just like American companies. If not, China could get stuck in a “middle-income trap,” in which it is more and more difficult to raise the welfare of the middle class – another challenge the U.S. is experiencing today.
Secondly, China is contending with the fallout from fiscal irresponsibility. As Washington is consumed by negotiations over America’s massive national debt, the Chinese are in the process of getting a handle on their own sovereign debt problem. As Roya Wolverson detailed in this space recently, China’s government debt relative to its GDP has escalated alarmingly in recent years. An audit revealed that local governments, which legally aren’t supposed to be able to take on debt at all, have managed nevertheless to amass liabilities equivalent to some 30% of GDP. It is not clear that the Chinese government has a full grasp of how big its debt burden actually is. Premier Wen Jiabao says that the country’s national debt is manageable, which could well be the case. But that doesn’t mean it isn’t a problem that could plague the economy.
And, much like the U.S., repairing national finances comes with major political risks. As politicians in Washington haggle over what to do with middle-class entitlement programs like Medicare, the Chinese are in the process of expanding a much-needed social safety net (improving healthcare, for example) that will continue to put pressure on China’s budget.
Third, China’s overall debt level is on the rise. Just as the U.S. built up an excessive mountain of debt before the financial crisis (mainly among consumers), China today seems to be making the same mistake. A recent report by rating agency Fitch outlined that debt continues to rise precipitously in China, despite government efforts to slow credit expansion. Here are the scary figures:
Fitch estimates that total net new financing in China could reach 38% of GDP in 2011, down from an average of 42% of GDP in 2009-2010 but still well above the pre-global crisis average of 22%. Fitch estimates that by end-2011 total financing/GDP could reach 185%, up 61pp from 2007. Increases of similar magnitude have been seen elsewhere in the years leading up to banking stress, underscoring the agency’s cautious outlook on the Chinese banking sector.
It is difficult to determine with any certainty at what point debt levels become dangerous. But economic expansions driven by expanding debt inevitably come to some kind of bad end, especially for the financial system. I don’t see how China can avoid much higher levels of bad loans at its banks. Or the country could run into something even more destabilizing, like a banking crisis. And at some point, China could be looking at a growth-suppressing process of deleveraging, which the U.S. is suffering through now.
Fourth, China is becoming heavily dependent on its property market for growth. Any American can tell you the dangers inherent in that. Though it is difficult to determine if China’s housing market is in a bubble (prices have started to soften in some cities), the construction of houses is the major engine of Chinese growth. Here’s how UBS economist Jonathan Anderson explained it in a very smart recent study:
Real estate and housing construction pervade the entire mainland growth model. They are the most important determinant of commodity demand, a very big marginal driver of China’s external surpluses, and indeed a crucial key to real understanding of household balance sheets, saving and investment behavior and the debate around Chinese rebalancing. In other words (and with only the mildest exaggeration), from a macroeconomic perspective if you don’t understand Chinese property, you probably don’t understand China.
The mainland gross investment share of its own economy has risen dramatically over the past decade, to a stunning 47% or 48% of GDP as of last year on an estimated basis; this is an absolute record for any economy of significant size in the post-war era, and almost single-handedly explains China’s explosive real growth over the same period…The biggest contributor to the trend increase in the investment ratio has been property construction, which rose from 6% of GDP on average during the 1990s to more than 13% of GDP last year when measured on an annual completions basis… And when we talk about property construction what we really mean is residential housing construction;…housing accounted for nearly 75% of total building completions last year. While it’s not a mistake to say that China is an investment-led economy, it is arguably more correct to call it a “housing-led” economy.
And much like the American housing bust sent shockwaves through the global economy, a downturn in China’s property market could do the same. Anderson proclaimed that China’s property industry is “The Most Important Sector in the Universe.” The property sector in China is a primary source of demand for all sorts of things the country buys from the world – like iron ore – as well as a big part of consumer spending. New homeowners loading up their new apartments with furniture and appliances are a key factor behind increases in Chinese consumer spending. So a slowdown of China’s property sector would not only slow down the entire economy – and thus act as a drag on global growth – it would also ripple through global supply chains and suppress business for all kinds of commodities and products.
How Beijing deals with these very American-style challenges in coming years will determine the course of China’s economy. Will China collapse into crisis, as the U.S. has? Who knows. In some ways, China might be better equipped to tackle these problems. For example, its authoritarian government could prove more efficient in controlling its debt level (though there is no guarantee). But China’s corporate sector lags American companies in the kind of skills and expertise necessary to innovate and stay ahead of low-cost competition. And China’s policymakers clearly have some tough decisions to make to decrease the economy’s reliance on the housing market for growth and control rising debt. So far, they don’t seem either able or willing to tackle these issues head on, a problem Washington has had again and again. If China’s leaders don’t learn from the U.S. experience – something they don’t appear to be doing – they could end up facing an American future.