Now that both major political parties accept that the best days of the commodity boom are over, the question inevitably will turn to whether the Chinese economy will have a soft or hard landing during the next few years.
The reality is that there is no good option available for the Chinese Communist Party. A soft landing will mean that serious structural problems will have been swept under the carpet, delaying the day of reckoning that will be only more painful when it arrives. A hard landing, possibly resulting from the consequences of genuine structural reform, will mean immediate trauma for the economy, which will place the party’s political survival at risk.
Either way, Australia’s China-driven good fortune is on borrowed time.
Those who still believe a rapidly urbanising China will continue to drive record rates of consumption for our iron ore for generations are in for a rude shock. The numbers reveal that China’s voracious consumption of commodities across the past decade has remarkably little to do with the genuine demands of urbanisation, makes little economic or commercial sense, and cannot continue.
Since the mid-1990s, genuine urbanisation has been advancing at the rate of less than 1 per cent each year. Yet fixed investment (which drives commodity consumption) has been growing at 20 per cent to 40 per cent each year for the past decade and is now much more than 50 per cent of gross domestic product. During the periods of rapid industrialisation in Japan, Taiwan and South Korea, fixed investment did not rise above 35 per cent of GDP.
That China is dangerously embarking on a unique and unprecedented economic path is further confirmed by the fact that from 2008 to last year alone, bank assets in the form of outstanding loans have increased by about $US14 trillion ($15.2 trillion), equal to the amount of the entire American commercial banking sector. Debt to GDP now exceeds 200 per cent. The fact the stimulus model is no longer working is confirmed by figures showing that China achieves about 17c of output for every dollar of credit-fuelled stimulus, compared with more than 80c of output when the binge began in 2007.
Presently, debt to GDP exceeds 200 per cent when one includes the so-called shadow banking sector, which involves unregulated and off-book loans by banks and other borrowers. Since so much of the capital has been spent on speculative projects such as empty “ghost cities” and millions of luxury housing units that will never see a single resident in them, China’s state-dominated banking sector is likely to face bad debts of more than $US3 trillion across the next few years as outstanding loans mature.
Unsurprisingly, the reform-minded Premier Li Keqiang now speaks incessantly about structurally reforming the economy through rebalancing. This means dramatically cutting back on building unneeded things and ramping up domestic consumption.
The problem is that genuine structural reform, needed to place the next stage of Chinese economic growth on a sound footing, will necessarily lead to a hard landing – defined as zero growth or economic contraction. Remember that as powerful as they are, Chinese authoritarian leaders cannot force people to consume. Only enormous and rapid increases in across-the-board household income can trigger significant rises in consumption.
For that to occur, economic opportunity and national wealth would have to be distributed more evenly. There are about 144,000 state-owned enterprises that account for almost half of the country’s business and industrial profits and more than 70 per cent of China’s fixed assets – with tens of millions of fledging private firms making up the remainder. Significantly raising across-the-board household incomes would mean radically winding back the economic privilege and protection afforded to SOEs in favour of private firms, as well as ordering an unprecedented transfer of assets belonging to SOEs into private hands.
Given that a dominant SOE sector is critical to the party’s hold on power, such reforms are highly unlikely. Besides, the immediate loss of output that would result from such a reform would be intolerable as far as the party is concerned.
What about the prospect of a softer landing?
This really means preserving the present state-dominated model, with some tactical tinkering designed to insure against the systemic collapse of the financial system and property asset values.
This is what the party has been doing and will continue to do. For example, it is trying to clamp down on the out-of-control shadow banking sector to reduce growing levels of unregulated credit flowing into speculative building assets. Debt issued by the shadow sector has grown from about $US2.9 trillion in 2010 to more than $US6 trillion now. The problem is that attempts to gently deflate asset bubbles by reining in credit rarely ends well for any economy; just ask Japanese and US central bankers. Besides, the fledging private sector, having been starved of formal funds, depends on the shadow banking sector to survive.
Meanwhile, knowing that well-to-do Chinese citizens and cash-rich firms are desperately searching for ways to take their money out of the country, Beijing will continue to place severe restrictions on its capital account to ensure that locals have few options but to deposit savings into Chinese banks. With China’s five largest banks holding more than $US14 trillion in deposits, this will ensure sufficient liquidity to fund a failing growth model for a few years yet.
This may mean more fixed investment growth and some extended joy for our miners. But when the laws of economics eventually catch up in this era of the Chinese economy, then future economic reform and transition to a successful middle-income economy will be that much more difficult.