China - What Future?

When you visit a Chinese bank, you will likely be presented with a series of buttons that you can push so that you can rate the service level of the cashier. The buttons, of course, are there to encourage the cashiers towards good service. The reality is that the buttons should be marked from 'surly' to 'downright obnoxious'. The state owned banking systems, despite the best of efforts, remains unreformed.

It is only a few years since the Chinese banking crisis, when the Chinese government bailed out the banks and placed their mountain of bad loans into a special fund. My question is; has anything changed since then?

The answer, in the opaque world of Chinese business, is that no one will know until the government decides it is time to know. In a previous post I pointed out that the Chinese construction boom may be a bubble. In particular, large numbers of apartments are being built, and individuals are investing in them only to leave them empty. One of the curiosities of Chinese property is that, as soon as a person has lived in an apartment, the value of the apartment falls. The result is lots of investors are leaving apartments empty in the hope of the value of the apartment increasing. This looks very much like a bubble.

In addition to apartments there are the endlessly multiplying malls and department stores. In an expanding economy, it may be that there is a real demand for these. The question is whether there is the demand for the numbers that are being built. I can only comment on the city I lived in (Xi'an), but it did appear that the construction was already outstripping demand and that this did not seem to deter new construction starts.

In light of this, I must conclude that there may still be some suspect lending from the Chinese banks. This is pure speculation, but is based on experience 'on the ground'. This raises the possibility that there is also bad lending into business, in particular to the state owned firms. Such lending is not so visible, so it is impossible to say if this is the case. However, if there is bad lending into construction, it is not too great a leap of imagination to think that other lending may also be bad. Having said this, if it does go wrong, if the banks have been lending poorly, then the Chinese government has the finance and will to bail out the banking sector. As such, whilst a risk to the Chinese economy, the danger of bad lending is more that it will hurt the economy, rather than a banking crisis destroying the economy.

On the other side of the equation there is a growing, and aggressive private sector, often managing to grow their businesses without any help from the banking system. Go to a Chinese province such as Guangdong, and you will see the reality of such businesses. For example, I lived for a while in a city called Zhongshan, which is now supplying the majority of the world's lighting. Just outside the main city is a town with literally hundreds of factories all devoted to manufacturing and selling lighting. It presents international buyers with an incredibly competitive one-stop shop. As for lighting in Zhongshan, the same for many other markets. They nearly all have similar clusters.

In effect China is creating clusters of excellence, where whole cities or districts are specialising in particular products and markets, and doing so in a highly competitive way. This allows all of the benefits of network effects, whilst creating an environment of incredible cost efficiency. Each cluster generates its own supporting infrastructure, and economies of scale. Each firm is continually looking at its neighbour, and any new technology, new process, will spread rapidly through the cluster.

This kind of arrangement is very common, and may be part of the reason for the success of Chinese manufacturing. It has certainly turned China into the old cliche of the 'workshop of the world'. We are now all aware of the resulting exports.

The big question for the future of the Chinese economy is how their economy will cope in the coming recession. If we think of the area of Zhongshan that manufactures lights, what will happen when the export orders start to decline? We know that, in a housing market downturn (crash) less people will move house (a time at which people are likely to buy lighting), and that there will be less house building, less office construction and refurbishment and so forth. Export orders will certainly decline.

It is at this point that we come to a big question mark.

The Chinese economy may, or may not be, at a point where internal growth within China has the potential to take up the slack. Has it yet reached that point? It is very difficult to say. It is a finely balanced point, but the economic growth of the coastal areas is now being replicated in the interior. Can the growth in the interior maintain the momentum of the coastal cities? The Chinese government has huge reserves to draw upon should the economy falter, and may seek to use those funds to further develop the interior of the country. There is also an ongoing and dramatic process of infrastructure investment which may help carry China through the bad times.

Furthermore, China has being making ever stronger inroads into markets such as Africa, and South America. Whilst these can not replace the US and European markets, they may serve to ameliorate the effects of a downturn.

As you will note, there are many question marks here. There are many 'experts' in China trying to wade through the piles of figures trying to see what will happen with China. The trouble is that many of the statistics are either opaque or suspect. In this situation, it is just as well to rely on intuition.

In one respect, if China remains stable, we can be sure that China will continue in growing its share of the world export market, even if the size of the market overall declines. China, as has already been mentioned, has benefits of scale. In addition to this, it still has a large untapped pool of labour which will serve to provide labour for growth for many years yet.

In the point above, I have mentioned stability. This is one of the big question marks over China's future. The Chinese government relies upon economic growth and nationalism for its legitimacy. If the economy does falter, and this brings hardship to the rising Chinese middle classes, then there is real potential for instability. With over 100 million often discontented migrant labourers, disenchanted ex-military (traditionally they leave the military and go straight into a comfortable job in a state owned enterprise, but this has stopped), even more disenchanted peasant farmers, all that is needed is a discontented middle class leadership to create an explosive situation. And a spark.

So where does this leave the economic future of China? Where would I place my bet? Would it be on ongoing growth, recession and instability, or what outcome? The honest answer is that I would not place the bet at all but, with a gun to my head forcing me to to make the bet, I would choose continued economic growth, albeit at a slower pace than before. In the meantime the Western world needs to accept that it is no longer in a position to continue with its complacency. China poses a real and ongoing threat to the world economic order, and will continue to grow at the expense of the West, unless the West responds by restructuring of their economies through (real) improvements in education, lowering their cost base, and taking an aggressive approach to intellectual property and fair trade (for why, see here).

Note: I am sure that many readers would want a more firm outlook for China. However, in the case of China, sound information is lacking. As such, it is difficult to see how anyone can really predict what will happen next. The worrying part about this is that China is increasingly important in the world economy, and therefore what happens there is of great importance. Such a large question mark means that policy formulation becomes less certain.