In assessing where China’s economy goes next, at least in the medium term, it is worth drawing comparisons with both East and Southeast Asia in the not-too-distant past.
Closest in time is the Southeast Asian boom of the 1990s, which came to an abrupt halt in 1997 and was followed by two years of contraction. The similarities clearly include excessive credit growth caused by a combination of relaxed monetary policy and euphoria on the part of local and foreign investors alike.
Excessive credit growth is often described as the surest sign of future crisis; asset price bubbles are symptom, not cause, and can happen without being credit driven.
In Southeast Asia, the credit growth came first, sending asset prices skyward and creating a boom in real investment in both buildings and industrial capacity. The latter was responsible for most of the subsequent havoc because it resulted in massive excess capacity and inability to service the debt incurred to finance it.
China could be well down this same path given the apparent over-investment in some heavy industries, in real estate projects beyond the price limits of even the better-off urban households, and waste on grandiose state-funded projects deemed to be "investment," but with scant economic or social return. Even high-profile projects such as high-speed railway lines may fall into the prestige rather than economically viable category, rather like items such as the world’s tallest skyscraper, which Malaysia was still building when the collapse came.
No debt problems
However, there are big differences between China and Southeast Asia, too. Most importantly, Southeast Asian expansion was significantly financed by foreign debt built up over a series of years of large current account deficits. China has its problems with foreign short-term capital flows, which have helped expand domestic credit, but the country’s huge net external balance and years of current account surplus mean the sudden withdrawal of foreign capital wouldn’t have a drastic effect.
Furthermore, China’s banks, being largely government-owned, cannot collapse as so many did in Thailand and Indonesia. The worst scenario is more budget-financed bank bailouts, which will either slow state spending on more productive or socially useful projects, or re-ignite inflation.
The sheer size of China’s domestic economy also protects it against major external shocks, be they caused by trade or financial issues.
That said, this should be no cause for complacency, particularly when taking a slightly longer view. Southeast Asia was able to recover from a deep recession relatively quickly because developed country imports were growing fast and their currencies had devalued to very competitive levels. None of the countries was big enough on its own to incite significant trade friction.
China’s case is different. Its share of global trade is still rising but so are the protectionist forces. Developed nations aren’t the only ones taking action, but also developing countries such as Indonesia, India and Mexico that want to protect their young industries from being wiped out by Chinese competition.
Beijing is also likely to come under greater pressure to allow its currency to appreciate – at least unless the US dollar makes a big rebound, or inflation and domestic demand in China cut the trade surplus considerably.
While China recognizes the need to shift from export and investment-led growth to a domestic demand-driven model, achieving that may be difficult – and not just because of institutional biases against consumption. The negative impact of massive unproductive investment in the recent past will be a drag on new investment in productive enterprises, which will find capital more difficult to come by. State-owned enterprises already benefit from better access to credit and better rates of return in sectors where oligopolies and administered prices prevail.
The future is likely to see a decline in profitability as new investments are not fully utilized. In addition, government money may have to be redirected to the banking sector to service bad debts that arise from lending to inefficient or irresponsible enterprises.
The Japan model
So much for the Southeast Asian comparison. Japan, Korea and Taiwan differ in that they were more vulnerable to international trade fluctuations due either to their size or, as in Japan’s case, overdependence on exports in the 1970s and 1980s.
China is vulnerable in another way. Local value-added in exports appears to be lower than was the case with Japan or Korea during their periods of rapid growth. Also, China’s exports are more reliant on foreign-invested firms, which have a tendency to be footloose. While domestic firms and brand names are gradually making more of an impact, the process is necessarily gradual.
Most significantly, China’s growth is taking place against a less buoyant global background. The effects of the sharp downturn at the end of 2008 might be a one-off affair, but demographics point to slower growth worldwide – which is, again, different from the experiences of earlier Asian growth leaders.
To some extent, rapid income growth in some middle-income countries will offset a weaker performance in the old developed world, where working age populations are barely growing. But China looks likely to face tougher global conditions just as it also must adjust to the consequences of credit excess.