The World is not Enough is the name of a James Bond thriller and is an apt description of the multiple challenges facing global growth. Globalization, which has enhanced living standards in the developing world, has also been referred to as Americanization. While we do not want to discuss the cultural aspects of that reference, it does highlight the central role the American consumer has played as a key market for the world’s goods. Export driven emerging economies, whether they are selling directly to the US consumer or indirectly by selling commodities to China, all look to the health of the US recovery.
In previous commentaries, we have agreed with the hypothesis that recoveries following credit crises are slower than those following recessions characterized by inventory imbalances. And, slow growth means that an economy is vulnerable to shocks. In addition to the uncertainties of the rapid developments in the Middle East, high energy prices, ongoing and unresolved debt problems in the eurozone, and now the traumatic news coming out of Japan, we should include, as if all of that were not enough, the potential surprise of a faltering Chinese economy.
To date, there is no substitute for the purchasing power of the US consumer. China, in particular, imports large quantities of raw materials and semi-processed goods to be ultimately exported to the United States. China’s economy is a third the size of the economy of the United States. The Chinese middle class, less than 10% of the population, drives about 35% of GDP. The American middle class is about 80% of the population and accounts for 70% of GDP. Chinese middle and upper classes have less than 7% of the purchasing power of their American counterparts. For the time being, the Chinese consumer will not be a substitute market for their goods.
The fact that the US consumer will not be able to finance a continuation of the 21% a year export growth that China has experienced over the last decade has not been lost on the Chinese leadership. China has made a transition from a small pre-industrialized economy in the 1970s to becoming the world’s largest energy user and exceeds the US in carbon dioxide emissions. In their new Five Year Plan, they seek to reduce export growth to 10% a year and to increase energy use per unit of GDP by 17%. They have espoused a desire to improve the quality and efficiency of growth and to improve living standards. They will face many challenges finessing this next transition.
During the height of the Great Recession, China responded with a very large stimulus program enabling the country to continue importing huge amounts of raw materials, such as iron ore and copper, used for further infrastructure investments. Stimulus funds and high domestic savings (around 30%) worked their way into the state banks which, in turn, lent to inefficient state owned enterprises. Restrictions on lending to local governments were circumvented in 2009 by using off-balance sheet vehicles to finance infrastructure projects. We have seen estimates that these activities total $1.5 trillion. The Chinese authorities, recognizing the potential risk of these practices, have ordered the banks to stop lending to off-balance sheet vehicles. And, much like the incentives in the US after the 2001 recession led to a boom in housing prices, the recent Chinese stimulus program found its way into the domestic housing market. Housing and construction account for about 60% of China’s economic growth. Residential property increased in price by 20% in 2009. The authorities have taken a number of measures to curtail speculation. Down payments have been increased for primary and secondary homes. These measures have stemmed demand, but not housing starts – which continued rising about 40% in 2010. In a command economy, it is difficult to balance the relationship between supply and demand. In fact, imbalances can be extended well beyond normal, with unfortunate consequences.
The challenges were best summed up by the Chinese Banking Regulatory Commission itself, which wrote in June 2010: “Domestically, the soundness of the banking sector is being tested by the increasing pressure of a nonperforming loan rebound, by the potential credit risks associated with lending to local government financing platforms, and by the real estate sector and industries with excess capacity.”