The Great Chinese Bubble

China overtakes Japan as the worlds second largest economy; China becomes the largest automobile market in the world overtaking the US; China will account for a fifth of global economic growth this year; China accounts for 40% of worlds coal consumption; China overtakes US in supercomputing power; China bails out Greece and promises more to other ailing debt ridden countries and the list of these superlatives go on to prove the force that China has become. This when combined with the Military might of China makes it possibly the second hyperpower in the world after the US. History is filled with examples of how economic or military power in isolation doesn't confer the superpower status on one country. Collapse of Soviet Union and what happens in Iraq are examples of that. State planners in China are acutely aware of this and they have therefore built a military that's second to none in the world. China is therefore, like it or not, a superpower today and the worrying aspect of that superpower status is that Chinese are not afraid to use that power.

Recent actions of the Chinese against Japan for release of one of their fisherman alleged to be a state spy by Japan, halting of rare earth mineral supplies to the world and refusal to grant normal and not stapled visas to J&K address passport holders speak volumes on how Chinese are drunk on power and are not willing to play by the rules. US having overstretched itself militarily in Iraq and Afghanistan and having extreme economic and political problems in home is not able to exert any influence on the Chinese. Chinese are well aware of this and that's what has prompted them to react in such blatant manner to a long standing ally of the US, Japan.

There are two crucial things the Chinese are neglecting in all this jingoism. Firstly, it accounts for only 8.6% of world GDP, well below the USA or the EU, which stand at 24.4% and 28.4% respectively. They are therefore far from dominating the world. Secondly, they need to be aware of the reality that their entire economic fortune is dependent on the continued prosperity (read consumption) of the West.

China is a huge importer of raw materiels and intermediate goods and in turn a huge exporter of the final goods. It runs a trade deficit with countries exporting raw materiels and oil and runs surplus with importers of finished goods. Having built a large export base, a natural step would have been to boost domestic consumption. This sadly has still not got the attention it deserves. Chinese seem to discount the fact that in the long term, other large underdeveloped economies s like India, Vietnam, Indonesia etc may catch up with the cost benefits and for sure West cant keep on consuming like there is no tomorrow. Deleveraging in most of the developed world is already pointing to years of no or muted economic growth, Bangladesh and Vietnam are already exerting themselves in labor intensive sectors like Apparel exports and India is catching up in the automotive export sector.

Chinese are smart people and one would expect them to take notice of this trend ahead of the curve but unfortunately this one has stumped them. They are behaving like an addict who doesn't want to let go of the drugs. They already have huge overcapacity across most of the capital goods (power equipment, telecom and network equipment, steel, aluminium etc), real estate and infrastructure industries. This overcapacity is a direct consequence of years of mostly investment led growth rather than a consumption led or balanced growth. China’s real fixed investment has increased at a faster rate than GDP in nine of the past 10 years. Investment is at 70% of GDP and the return on every marginal dollar invested in China is decreasing. In 2000, it took $1.50 of credit to generate $1 of GDP. But by 2008, it took $7 of new credit to generate a $1 increase in GDP. Sad reality despite these startling facts their economic stimulus combined with cheap state financing is leading to creation of more and more capital intensive production capacity. This neither creates employment nor boosts domestic consumption in the long run. It only creates further oversupply and thus deflationary trends across the world.

State directed bank lending has led to credit-to-GDP rising to 140% – levels equal to America in 2008 and Japan in 1991 just before their market meltdowns and credit quality has deteriorated. The truth today is no one knows the real story behind the quantum of bad loans Chinese banks may be sitting on. Chinese government recently took $ 200 billion in bad loans off the balance sheet of its top 4 banks and transferred them to state owned AMCs. How many more of such recapitalization is needed in future is as good as foretelling from a crystal ball.

What further compound the problems is the ongoing suppression of opposing voices and independent institutions. There has been no or little reform of the political system and economic activity continues to be dominated by the state. China’s 10 largest companies, are all state-owned or controlled and as many as 34 of the top 35 companies on the Shanghai exchange are state owned or controlled. While living standard of those living in the cities have drastically improved, those living in the countryside remain sidelined with restrictions on free movement and no outlet for protest.

Every central banker and every reasonably intelligent government is aware of these facts but they have chosen to keep mum on this. The hard reality for them is that China is today the lender of last resort and already owns significant amount of their bonds. Given that many painful years of fiscal correction lie ahead of the developed world and they need the Chinese to finance the deficit and keep interest rate low, they would rather manage the bursting of the Chinese bubble later than now. Key question is, whether the world be a better place with or without the Chinese bubble. Economic pain notwithstanding, this bubble needs to deflate so that the global economy is more balanced and predictable. Plus, a deflating bubble may well open the eyes of the state planners in China to be more respectful of human rights, independent institutions and make them behave more responsibly in world affairs as against their current high on dope I dont give a damn attitude.