PRESIDENT OBAMA’S recent trip to China reflects a symbiotic relationship at the heart of the global economy: China uses American spending power to enlarge its private sector, while America uses Chinese lending power to expand its public sector. Yet this arrangement may unravel in a dangerous way, and if it does, the most likely culprit will be Chinese economic overcapacity.This captures in a neat way the substance of the current relationships and the dangers as well. The US economy is still in a bad way. If you're in any doubt about this have a read of Gretchen Morgenson (Get Ready for Half a Recovery). Once again the issue comes back to the global imbalances (Chinese current account surpluses versus US deficits) and decoupling (or not).
Cowen might be alarmist in his concerns about overcapacity but it seems that there is substantial evidence to back the overcapacity case up. Chinese banks have kept on lending and Chinese companies have kept on producing but who's buying this extended production?
China has been building factories and production capacity in virtually every sector of its economy, but it’s not clear that the latest round of investments will be profitable anytime soon. Automobiles, steel, semiconductors, cement, aluminum and real estate all show signs of too much capacity. In Shanghai, the central business district appears to have high vacancy rates, yet building continues.
Chinese planners now talk of the need to restrict investment in sectors that are overflowing with unsold products. The global market is no longer strong, and domestic demand was never enough in the first place.
Regional officials have an incentive to prop up local enterprises and production statistics, even if that means supporting projects or accounting practices that are not sustainable. For an individual business, the standard way to get more capital resources is to put forward a plan for growth. Because few sectors are mature, and growth has been so widespread, everyone can promise to be profitable in the future.Can China keep on growing without final demand, particularly from the US? There's a lot at stake for Australia as well. China has kept on buying those resources throughout the global recession but eventually it has to sell things to keep buying our resources.
Chinese production is now helping to fund US deficits, which in turn is keeping the US economy afloat. The hope is that the US fiscal stimulus kick starts the US economy, which keeps Chinese factories rolling over, which allows Australian miners to keep selling minerals to China.
It could all work out, but then again it might not.
Cowen outlines perhaps the worst contingency:
China has had a 30-year run of stellar economic growth. But it’s only human nature for such expansion to breed too much optimism, overextending an entire economy. Americans have found this out the hard way in their own financial crisis.
History has shown that no major economy has grown into maturity without bubbles, crises and possibly even civil strife or civil wars along the way. Is China exempt from this broader pattern?
The notions of excess capacity and malinvestment were common in business-cycle theory of the 19th and early 20th centuries, when growing Western economies had frequent crashes of this kind. Numerous writers, from the Rev. Thomas Malthus to the Austrian economist Friedrich A. von Hayek, warned about the overextension of unprofitable capital deployments and the pain from the inevitable crashes. These writers may well end up being a guide for understanding China today.
What will the consequences be for the United States if and when the Chinese economic miracle encounters a major stumble? A lot of Chinese business ventures will stop being profitable, and layoffs and unrest will most likely rise. The Chinese government may crack down further on dissent. The Chinese public may wonder whether its future lies with capitalism after all, and foreign investors in China will become more nervous.
In economic terms, the prices of Chinese exports will probably fall, as overextended businesses compete to justify their capital investments and recoup their losses. American businesses will find it harder to compete with Chinese companies, and there will be deflationary pressures in both countries. And even if the Chinese are selling more at lower prices, they may be taking in less money over all, so they may have less to lend to the United States government.
In any case, China may end up using more of its reserve funds to address domestic problems or placate domestic interest groups. The United States will face higher borrowing costs, and its fiscal position may very quickly become unsustainable.