Sunday, October 4, 2009

The Next Chinese Revolution

by Daniel Lynch [FEER] - October 1, 2009

Today marks the 60th anniversary of the People's Republic of China. There will be massive military parades and many speeches by the leaders of the Communist Party. But no one will mention the very real possibility of political upheaval in the near future, or the economic inequality, job losses and slowdown in economic growth the country is currently experiencing.

Imagine that U.S. gross domestic product is growing at an annual rate of 4% when suddenly it drops to 2% because important trading partners are hit by a severe recession. An alarmed president pushes through Congress a $2 trillion fiscal stimulus package, while a frantic Federal Reserve dramatically expands credit and increases the money supply by a whopping 25%. Would a decline in the growth rate from 4% to 2% justify such extreme policy measures?

Most economists would say “no way” because heavy stimulation of a generally healthy economy could lead to an inflationary doomsday. Yet the Chinese Communist Party has implemented an equivalent level of stimulation in combating what it insists is a very mild economic downturn. Something isn’t right with this Chinese picture.

Beijing contends that China’s growth rate never fell into negative territory despite the fact that its exports plummeted by 20% to 25% last fall and winter and have not recovered. The only real pain China suffered, government officials maintain, was a mild decline in growth, from an average of 9% to 12% in 2005-2008 to 7.1% in the first half of 2009. Not to worry, the officials say.

Nevertheless, the regime hurriedly implemented a $586 billion fiscal stimulus package, the equivalent of an astonishing 13% of GDP. It also ordered state-owned banks to flood the country with liquidity. If the official data are to be believed, the result has been only a mild uptick in growth back to the country’s 9% to 12% trend line.

But despite the claimed return to growth, an anxious-looking Premier Wen Jiabao warned in early September that “China’s economic rebound is unstable, unbalanced and not yet solid.” He said Beijing must continue its fiscal stimulus measures and “appropriately loose monetary policy” indefinitely — even though growth is now officially back up to around 10%.

China’s foreign boosters — Wall Street analysts, journalists and investors — seem to find nothing strange in all this, which is odd, if not unfathomable. Wen’s call for sustained stimulus would be the equivalent of the president asking for even more stimulus after the measures outlined in our imaginary scenario hiked growth to 3%.

As the Chinese Communist Party celebrates the People’s Republic’s 60th anniversary, China’s economy is in trouble. Yet the leaders can’t afford to tell the truth because for many years they have been blowing a political bubble called “the Rise of China.” This has led some particularly optimistic Chinese to predict that their country will surpass the United States in “comprehensive national power” — military, economic and cultural — by the late 2020s. The bursting of this political bubble would frustrate the expectations of a newly prosperous, well-educated and wired segment of a nationalistic citizenry and potentially create a dangerous political problem for the authoritarian state. Nevertheless, China’s troubled economy may well be on the verge of throwing the country’s “rise” at least temporarily off the rails.

Beijing’s insistence that GDP grew by 7.1 percent in the first half of 2009 is highly doubtful given that coal consumption by Chinese power plants fell 8.9 percent and usage of petroleum products (including gasoline) dropped 2.6 percent. In previous years, energy consumption consistently grew at a 7% to 9% rate.

Equally remarkable, aggregate tax revenues fell 6% in the first half of 2009 after increasing by 17% to 31% in preceding years. The drop in tax receipts occurred at the same time as energy use fell.

Some analysts say there is nothing anomalous about these figures, because Beijing has for years encouraged energy efficiency, and it lowered tax rates at the end of last year to help stave off recession. But the coincidences are far too improbable for these explanations to hold water. Almost certainly, the Chinese economy contracted after the recession began.

The sector hit the hardest would have been China’s privately owned small and medium enterprises. Often producing for export markets, these businesses had, by the mid-2000s, become the most productive and dynamic actors in the Chinese economy. In the years following China’s entry into the World Trade Organization, they absorbed two-thirds of all new entrants into the labor force and contributed nearly as much to the incremental increases in GDP.

The small and medium enterprises logged these accomplishments despite the fact that state-owned banks generally refuse to extend them credit because they regard state-owned enterprises as a surer bet. Today these banks are financing takeovers of troubled privately owned businesses by some state-owned enterprises. All of this spells deep difficulties ahead for China’s economic dynamism.

There are other signs that the Chinese economy is not living up to its testimonials. For example, the explosion of credit and money has not been accompanied by inflation. M2 — currency in circulation plus savings deposits — is reported each month to be, on average, 25% higher than in the comparable month last year. And new bank loans doubled in the first half and continue to increase at high rates. Yet consumer prices are reportedly down 1% to 2% year-to-date, while producer prices are off 7% to 9%.

Economics 101 teaches that if prices fall when the money supply is rising, either production must be increasing at a higher rate than money supply or the velocity of money changing hands must be falling. In China, the only market in which prices are consistently rising is the property market, now that the stock market seems to be “correcting.” Because no Chinese official claims that GDP is increasing by more than 25%, velocity must have plummeted, and a key reason would be socioeconomic inequality. China’s wealthy have easy access to all the new credit, and some of them use the money to speculate on stocks and property. The middle classes and the poor can’t play this game because they cannot get credit. The very poor are barely treading water, given that 20 million to 40 million migrant workers (and surely many others) lost their jobs last winter. These people are unavoidably spending far less this year than last, while the well-off can only consume so much additional food and clothing. Consequently, prices stay steady or decline, and Chinese retailers report consistently disappointing revenues and profits.

The Communist Party hopes to keep the economy afloat by injecting huge amounts of money and credit into the economy while waiting for things to “get back to normal” in the United States and other export markets. One Chinese official recently said that he expects 10% GDP growth next year on the strength of surging exports and real property investment – not, tellingly, on a jump in domestic consumption. But how realistic is the government’s bet on a recovery in exports?

Most U.S. economists expect U.S. unemployment to continue rising into 2010 or 2011 and GDP growth to be tepid even if the economy technically exits recession. While consumer spending edged up slightly during the summer, it’s nowhere near its housing-boom highs, which fueled the growth in Chinese imports. Furthermore, American households are now slowly but steadily reducing their debt and saving more. During the summer, consumer credit outstanding fell at the highest rates in half a century.

China’s other major trading partners aren’t performing much better. Japan is mired in a deep recession and staring into the abyss of structural deflation. Europe is, at best, barely growing, while Taiwan and Southeast Asia are stuck in a deep trough. Only South Korea seems to be recovering modestly but that is chiefly because some Chinese firms are using stimulus money to buy Korean goods. As Beijing weans the Chinese economy off stimulus money, Korea could slide back into recession, particularly given that its major trading partners are the same as China’s.

All of this adds up to a new normal, one that, even in a best-case scenario, would mean slower GDP growth in China for many years to come. China has no choice but to adjust to this new world that will inevitably purchase significantly fewer Chinese goods. The adjustment will likely require wrenching changes in China’s economy and even in its cultural norms. It will be costly.

No matter what, China’s growth rate — and, by extension, its “rise” — must now slow. The only uncertainty is by how much and for how long. The crucial question is how Chinese elites, encouraged in recent years to expect imminent international glory for their country, will react to this new normal. If frustrated expectations cause them to become dissatisfied at the same time as economic malaise grips the general population, Chinese politics could become severely turbulent. China’s leaders might have to make concessions of a kind that they never would have imagined, let alone wished to see. They might have to contemplate liberalization.

Daniel Lynch, a professor of international relations at the University of Southern California and a member of USC’s US-China Institute, is the author of "Rising China and Asian Democratization." He is currently working on a book about elite Chinese expectations of China’s future.