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Whither China?   (May 31, 2006)

Will China be hurt as the U.S. housing bubble bursts, triggering a recession? And why should we care?

We should care for a number of reasons, chiefly those of blatant self-interest. We depend on China (among others) to use their surplus dollars to buy our Treasury bonds (regardless of low yield and high risk of a decline) to keep our interest rates low. If the Chinese have fewer surplus dollars--i.e., our recession causes their exports to us to plummet-- then that also means they'll be buying fewer Treasuries. Once the willing buyers vanish, then interest rates will have to rise to entice less-willing buyers.

And as everyone knows, higher interest rates mean higher mortgage rates, which will only speed up the global real estate bubble's collapse.

There seems little doubt that China will be hurt by a U.S. recession. While some have argued that China's domestic market is large enough that they don't need exports, this view ignores two important factors of macro-economic growth: as Braudel documented in his massive three-volume history of capitalism, The Structures of Everyday Life (Volume 1 of Civilization & Capitalism) outsized profits flow from trade, not domestic markets. Karl Marx explained why: domestic markets readily attract competitors, leading to over-capacity and a reduction of profits. The end result, Marx projected, was monopoly capital--one or two companies would buy up or crush their smaller competitors, and get rid of excess capacity so they could return to profitability.

On my first visit to China in 2000, the official English-language paper carried numerous stories describing a massive over-capacity glut in domestic television production; tremendous overproduction of TV sets had led to lower consumer prices and huge losses for the producers. So yes, the Chinese can make goods for their domestic market, but they can't sell them at a profit, for the reasons (ironically, perhaps) Marx outlined. As this chart reveals, the Chinese are busily creating massive over-capacity in steel, automobiles and many other key industries, aided by gigantic inflows of foreign capital.

For more, please read China Irony: Steel, Marx and Monopoly Capital.

The other reason China needs Western partners is for capital. Up to 40% of their entire GDP is foreign investment--factories, high-rises, you name it. As the bursting housing bubble reduces American consumer's profligate borrowing and spending, then why would anyone pour additional billions into making new factories in China? Once foreign investment dries up, so will the Chinese sectors which depend on huge inflows of foreign capital.

As for the Chinese real estate market: sadly, the rest of the world exported their bubble to China. Experienced analyst Andy Xie expects a hard landing in China properties values, and there is little evidence that the government is successfully reining in the vast speculative building of luxury properties. The problem is structural; while the central government is theoretically in charge of everything, the actual administration is left in the hands of local authorities-- the same authorities who are beholden to growth at any price and who are famously corrupt.

The consequence is that central government policies are rarely enforced, in either economic or environmental policies. So the government announces yet another Yangtze River clean-up campaign but few expect any real action to result because the clean-up depends on local authorities with other things on their minds--such as getting rich and enabling their region to get rich.

The structural flaw in the Chinese financial system relates not to local authority but the peculiar way the government has funded employment. Rather than tax productive assets and people, China has funded its notoriously money-losing government factories by taking the savings of its citizenry and lending that money to the factories through its four State-owned banks. As the factories continue to lose money, new loans are made; the alternative is to close the factories and suffer mass unemployment, which has occurred in the industrial north. Despite such large-scale lay-offs, about 40% of the workforce still labors for a government-owned enterprise.

Factories that remain open are still drawing new loans which will never be paid back; and what's left of the closed factories is hundreds of billions in bad debt. The government throws $50 billion or so to reduce the debt every now and again, but this doesn't reform the system; it just keeps the still-growing bad debt down to managable levels. As China shifts to a system of tax collection, they might be able to wean themselves off this bizarre system of loaning savings out, never to be repaid, in lieu of public spending; but the tax collection system is young and already corrupted; some pay, most don't.

A recent estimate of China's bad debt at $919 billion drew a chilly official response and was promptly withdrawn-- excellent evidence that it was accurate or perhaps even low: China's bad debts. The reason is, of course, that the Chinese government is very much into managing perceptions; this plays out in myriad ways, such as ignoring the cultural revolution as an embarrassment (like bad debt) better left obscured from public scrutiny.

If everything which doesn't fit into the official propaganda is suppressed, then how can anyone be confident that bad debt, or indeed, any data, is even close to reality? And if you don't have any real data, how can you make good decisions? That doesn't bode well for either the Chinese government or the foreign investors gambling on its officially burnished future.

For more on these topics, please read China and the U.S.: Curing a Dysfunctional Fiscal Relationship and China: An Interim Report: Its Economy, Ecology and Future.

For more on this subject and a wide array of other topics, please visit my weblog.


copyright © 2006 Charles Hugh Smith. All rights reserved in all media.

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