China: A brewing confrontation?

It seems that China is, at last, really being noticed by mainstream analysts. When I see really, I am referring to the key part that China is now playing in the world economy. Of particular note is that the growing share of the world export market held by China and that China is now the world's largest automotive market (mentioned in a recent post).

Perhaps it is these statistics that have served to focus minds.

The actual analyses that are being offered, and the opinions about what might be done about China, are varied. A good contrast can be found between Dylan Grice of Socgen and the Economist magazine. Grice notes that different standards are applied when analysts and investors view the Chinese economy, and provides an example in the comparison of value between Lloyds of the UK and ICBC of China. Both are part government owned, both have potential risks in their loan book, but Lloyds is potentially subject to malign government intervention, whereas ICBC is actually subject to malign government intervention. Despite this, the valuation of ICBC is much higher.

Grice sees this as an example of irrational exuberance on the part of investors towards China. He notes that there is a boom in credit in China, and questions the idea that an infrastructure investment boom will not lead to a bust, citing studies that show that such a bust is possible.

The Economist offers a very different perspective, giving their article the title 'China's Economy: Not Just Antother Fake'. They commence their article with the many aspects of the Chinese economy that might look bubble like, and make comparisons with the conditions in Japan before the Japanese economy popped. However, they go on to say the following:

Scary stuff. However, a close inspection of pessimists’ three main concerns—overvalued asset prices, overinvestment and excessive bank lending—suggests that China’s economy is more robust than they think. Start with asset markets. Chinese share prices are nowhere near as giddy as Japan’s were in the late 1980s. In 1989 Tokyo’s stockmarket had a price-earnings ratio of almost 70; today’s figure for Shanghai A shares is 28, well below its long-run average of 37. Granted, prices jumped by 80% last year, but markets in other large emerging economies went up even more: Brazil, India and Russia rose by an average of 120% in dollar terms. And Chinese profits have rebounded faster than those elsewhere. In the three months to November, industrial profits were 70% higher than a year before.

In a later article (1), the Economist discusses the rise and rise of China's exports, and asks whether the growth might continue. They again compare China with Japan, and note that Japan's exports peaked once Japan had moved up the value chain. However, in the case of China, it is possible to move up the value chain, and keep lower value exports, as China can substitute the low for high value in the coastal cities, and still keep the low value in the inland provinces.

An even more optimistic assessment of China's prospects comes from Foreign Policy magazine (sorry, no link and reliant on memory for the article details). The thesis of the article was one in which China would rapidly develop to become the most dominant economy, and signals the decline of Europe and the US in comparison. Whilst the Western economies might not decline in absolute terms, the article saw them losing economic power and influence.

So where do I stand on the question of the prospects for China? In a series of articles (see links in the notes at the end) I have offered a cautious view of China's prospects. In my first article, at the start of the economic crisis, I suggested that China, on balance, would be likely to come out of the crisis stronger:

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).

You will note that this is a very cautious prediction. I have highlighted some of the potential problems in the Chinese economy, such as the frothiness of the housing market, potential for dud lending by the Chinese banks, and (above all else) the potential for social unrest if Chinese growth ever goes into reverse, and many other concerns.

Within all of the discussions of China, there is often a fundamental problem. This is the idea that China sits as a stand alone entity, in which the policy of China might just be continued. I have frequently highlighted the mercantilism policy of China, and have long been arguing that, unless China acts to trade more fairly, it should be subject to trade sanctions. I have highlighted the manipulation of currency, the theft of intellectual property, and the conditionality of inward investment (with insistence on the transfer of technologies), as well as many other problems.

In August 2008, for example, I argued strongly that it was time to get tough with China, and highlighted a series of unrelated stories, all of which pointed to China using mercanilist methods to enhance their economic position. Whether they are making threats to destroy the $US, using the media to slander overseas businesses, arranging theft of intellectual property, China appears to be set on a course of establishing itself as THE economic power of the world. For example, I have previously mentioned the use of hacking by China to steal commercial secrets from overseas competition, and (again) this is actually starting to be noticed more widely.

The purpose in highlighting these points is that there has been a complacent attitude to the mercantilism of China, but the winds of change are blowing. China has a club to beat the world with, which is the holdings of massive foreign reserves. In an early post I highlighted that it was better to face down China now, rather than later. The ongoing growth of reserves held by China would just make confrontation ever more difficult. The complacency over the method of the ascent of China is now disappearing, but the potential dangers of confronting China have now grown. Nevertheless, there is an increasing recognition that something has to give. This from Roger Bootle in the Telegraph:

The looming threat to the world economy comes from the same source which contributed so much to the financial crisis, namely the draining of demand from the world economy through excessive Chinese saving. But now it will come at a time when most countries of the West are in no position to offset this effect through more stimulus policies and indeed, as in the case of the UK, may actually be about to tighten fiscal policy. We may be not far off the point where, if the Chinese don't take steps to make their trade with the West more balanced, then the West will take steps to do it for them.

Such sentiments can be found elsewhere, and I even find myself in agreement with Krugman, who is arguing against allowing the ongoing manipulation of the value of the RMB. However, what remains missing from these analyses is the complete picture. It is not just the matter of currency manipulation, but the many other policies of the Chinese government in conjunction with the currency manipulation. There is a pattern here, and I long ago discussed this in another post, saying the following:

It is very clear that China intends to rise economically by any means, fair or foul. The crazy part is that the foul is unnecessary, and one then becomes very suspicious of the underlying motives for such methods.

I have not detailed the many individual stories that support the argument of this post, as they can be found in other posts (see list at end). The important point is that, if considering the future of China, it is necessary to consider the actions of China's key trading partners. My best guess is that the situation will not be endured by China's' trading partners much longer - that China will be confronted over the mercantilism. This is, of course, in the hands of politicians, who are by their nature unpredictable. What approach, when, or how they might seek to address the problems, and how China then responds, will play a key part in the determination of whether China continues on the current upward trajectory.

My best guess is that China is heading for very troubled waters. I do not think, as the economic crisis proceeds, that the world will sit by and watch as China continues with the current policies. At the same time, China knows that it must continue to grow if it is to achieve social stability, and that means that it fears make any concessions. In fact, from the point of view of the Chinese government, China MUST continue to grow. That means that they will not back down easily, as the mercantilism is a key element in the level of their growth. In other words, the stage is being set for a confrontation, and the outcome of the confrontation might have profound effects on the ascent of China.

(1) 'Fear of the Dragon', Economist print edition, 9th January 2010

Note: Links to previous posts on China. These posts are the ones that are largely focused on China, but there is discussion of China in other posts. From Trade and Forfaiting Review:

Shanghai Suprise

From the Blog:

1. July 2008, China - What Future?
2. August 2008, China Propping up the $US
3. January 2009, Free Trade 'Yes' - Mercantilism 'No' - Why China Should be Shut Out
4. January 2009, The Myth of the Eternal Status of the $US as 'the' Reserve Currency (post indirectly associated with China)
   
5. February 2009, China's Pivotal Role in the Next Step for the World Economy
6. Fenruary 2009, China and the US - Fighting on the Edge of a Cliff
   
7. March 2009, Economics and Power, the Loss of US Power
8. March 2009, China, Gold and the $US
9. April 2009, China as the World Economic Power?
10. April 2009, The RMB as the Reserve Currency
11. May 2009, China, the RMB and the $US
    
12. July 2009, The RMB as the Reserve Currency - an Update
13. Sep, 2009, The Rise and Rise of China
14. Sep, 2009, China and Treasuries: A Puzzle
15. Oct, 2009, The Great 'Shift' China and the West
16. Jan, 2009, China on Track - The Car Industry
    

And the role of China in the development of the broader economic crisis can be found here (on Huliq).