U.S. Schizophrenia on China   (December 23, 2008)

As the global depression takes its toll on all trading nations, a bizarre schizophrenia has developed in U.S. opinion on China: reports of civil unrest in China are accompanied by opinions that China is poised to reap historic gains from the financial turmoil of the West. Interestingly, the financial turmoil of the East is conveniently ignored or downplayed in these rose-tinted views.

After 8 years of what I have termed "Bogus Prosperity," the underlying structural flaws of both the U.S. and Chinese economies have been laid bare. In the U.S., the decline in real surplus/productivity has been masked by financial legerdemain and a system which favors leverage and asset-stripping over production.

In China, structural corruption/local-official looting, piracy, inconsistent environmental regulations and a focus on exports all are coming home to roost with a vengence. The two global "engines of growth" are dysfunctionally linked and thus falling apart simultaneously.

Yet even as the structural problems within China's political, economic and financial systems are being bared by mainstream media reports like these-- After 30 Years, Economic Perils on China’s Path (New York Times) and China Faces Unrest as Economy Falters (Wall Street Journal), other articles like U.S. Woes Open Door for China (Wall Street Journal) and The Great Crash, 2008: A Geopolitical Setback for the West Foreign Affairs) posit that China is well-protected from Western Depression:

No country will benefit economically from the financial crisis over the coming year, but a few states -- most notably China -- will achieve a stronger relative global position. China is experiencing its own real estate slowdown, its export markets are weak, and its overall growth rate is set to slow. But the country is still relatively insulated from the global crisis. Its foreign exchange reserves are approaching $2 trillion, making it the world's strongest country in terms of liquidity. China's financial system is not exposed, and the country's growth, which is now driven by domestic activity, will continue at solid, if diminished, rates.
Unfortunately, all of the last line is simply incorrect. China's financial system has its own bubbles, malinvestment, legerdemain and hidden bad debt, and it is exposed to the Western malaise, even if indirectly. China's growth is not driven by its domestic demand except in the fantasies of the "China has decoupled from the West" Perma-Bulls; statistically, domestic consumption has actually shrunk as a percentage of Chinese GDP.

As I noted in A 1,000 Foot High Tsunami (October 21, 2008), Henry Paulson's essay in Foreign Affairs, The Right Way to Engage China, states China's domestic demand is only a third of the economy:

One of the most notable indications of China's imbalanced growth is its large current account surplus, which last year amounted to over 11 percent of the country's GDP. This reflects the fact that China spends much less than it produces and earns and that it has a high rate of national saving. Chinese household consumption was only 35 percent of GDP in 2007, down from roughly 50 percent 30 years ago, when Beijing started market reforms. (Household consumption is roughly 70 percent of GDP in the United States and 60 percent in India.)

On the other hand, household savings are high, as individual Chinese try to compensate for the country's thin social safety net, limited options to finance major expenditures such as education, and few investment options other than bank deposits. Demographics will only exacerbate these trends: as China's population ages, the traditional source of support in retirement -- children -- will become increasingly scarce.

(If you'd like some context for China's long-term structural challenges, please read my 2005 report, China: An Interim Report: Its Economy, Ecology and Future .)

The schizophrenia between reports of China's "slowdown" and its supposed readiness to gain from global Depression has its roots in the U.S. mainstream media's basic ignorance of local government actions in China. It's not just the MSM which is clueless; even Chinese citizens without access to higher-ups in local government have no idea what's really going on.

The real action in China is always at the local government level. The structure of the Communist party and the central government lines of authority give the power for everyday management of the economy to local Party and government leaders. Everything from the central government is mostly ignored because there's no real authority to back it up except in cases where the entire nation is mobilized (the SARS scare, etc.)

What most Westerners don't understand is finance, economic development and local government are in constant, permanent collusion. Few Westerners understand that local governments borrow vast sums of money, too, to fund sports pavilions, etc. Few Westerners understand that local officials will essentially steal land from peasants and send locally hired and paid hooligans to beat up protesters while official police look the other way.

Few Westerners understand that loans are approved or arranged by local officials, who also grant the rights to foreign entities to build factories in local business parks. Few Westerners appreciate that the prime directive for local officials--and the source of their own wealth--is economic development, not strict accounting of funds or strict enforcement of nationally-issued environmental regulations.

Those directives are followed when reporters are around, i.e. for show, and then ignored the rest of the time. The Chinese government is essentially schizophrenic itself, with the central government claiming planning and regulatory control even as it cedes actual authority to local Party and government and makes economic growth the priority.

There is literally no advantage for local officials to take a hard line on accountability, anti-corruption and anti-piracy campaigns or strict environmental standards, while there are significant financial and official rewards to driving local growth--even at the expense of peasants, public safety (i.e. shoddy construction) and environmental damage.

Up to 40% of the Chinese GDP is direct foreign investment. As I quoted in Hot Air Dragon: Is China About to Pop? (July 20, 2006):

Construction projects such as the forests of cranes on Changsha's horizon are just the most visible evidence of a nationwide investment binge that raised new spending on construction and factory equipment to $318 billion by the end of May, up 30 percent from the same period of 2005.

Such investments are forecast to exceed $1.3 trillion this year, nearly half of China's GDP.

To finance that spending, China's big commercial banks, their already fat cash balances swollen by government bailouts and recent multibillion-dollar initial public offerings, issued new loans worth $267.5 billion in the first half of this year.

The worry is that too much of the money is going into redundant or ultimately unprofitable investments, risking a rebound in bad loans and possibly a financial crisis. With China now an engine in the global economy and international investors joining in on the Chinese investment binge, a hard landing could jolt world markets.

For more on China's dependence on foreign trade and manufacturing, please read The Myth Behind China's Miracle (Foreign Affairs) and PART 2: The US-China trade imbalance By Henry C K Liu (published in the Asia Times:

These figures show that trade is now a precariously excessive portion of Chinese GDP. And without a trade surplus with the US, China would face a global trade deficit of about 6.25% of GDP, more than the United States' 5.7%.

China's addiction to trade: With any addiction, initial euphoria soon turns to agony. Chinese per capita GDP was $1,231 for 2005, while the country's per capita foreign-trade volume was $1,000. Take away foreign trade, and Chinese per capita GDP would be $231, or 63 cents a day. And that number is per capita GDP, not per capita income, which is usually lower.
None of this is new, but the schizophrenia remains: despite the "decoupling" cheerleaders' hopes, China remains heavily dependent on three pillars which are crumbling: exports, direct foreign investment and borrowed money to fuel China's real estate bubble.

Bottom line: China doesn't need any exposure to the U.S. financial system's collapse: it has its own popping bubbles--in real estate lending, in exports, in direct foreign investment--to deal with.

The schizophrenia in U.S. opinion on China is partly driven by powerful wishful thinking; many here hope that China will somehow dodge all its own problems and "save" the U.S. with its massive reserves of dollars and potentially massive domestic demand for U.S. goods and services. But wishful thinking is no substitute for an understanding of China's homegrown, internal structural flaws and contradictions.

Only those with insider knowledge of local government in China can really know what's going on. Everything else is either rumor or propaganda packaged for domestic and foreign consumption.

Thank you, Cheryl A., for suggesting this topic.

"This guy is THE leading visionary on reality. He routinely discusses things which no one else has talked about, yet, turn out to be quite relevant months later."
--An anonymous comment about CHS posted on another blog.

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