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The China Bubble
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The China Bubble

Walter Russell Mead

As China’s stock markets sagged through the early days of 2016, there has been no shortage of follow-up stories in the MSM that try to paint the bigger picture—about how China’s slowdown is having knock-on effects around the world. Here at TAI, we have been following the commodity crash story for some time—and not just as a piece of economic news mostly interesting to financial market speculators. This is a political and a geopolitical story as well. Falling commodity prices matter to everything from the security of Putin’s power base to the ability of the oil-dependent Nigerian state to wage an effective war against Boko Haram; the fate of democracy in countries like Brazil and South Africa is complicated by the prospective fallout from the commodity crash; Venezuela may implode into chaos as a result of the oil crash, and fears for Venezuela’s future were a major consideration in Cuba’s decision to respond to the Obama Administration’s normalization overtures. In other words, significant shifts in world commodity prices can tilt the balance of power, undermine the stability of some governments, and boost the prospects of others.

But the story may be getting still bigger. We may be looking at something more serious than the unwinding of a commodity boom; we may be looking at the bursting of a bubble that could dwarf what happened in 2008. The China Bubble is bigger than the real estate bubble, and its liquidation could pose bigger risks for world politics than the subprime implosion.

There’s a difference between China and the China Bubble. China is a middle-income developing country bumping up against the limits of a growth model built on massive exports of manufactured goods. There are lots of bubbles inside China, largely because both national and local governments have pursued a mix of stimulative policies even as the health of the underlying growth model deteriorated. Massive over-investment in real estate, infrastructure and manufacturing capacity, overvalued stock prices and poorly priced financial assets have created an increasingly toxic and dangerous economic situation inside China, and a rattled government is doing its best to keep the system from imploding. The government is hoping to achieve a ‘soft landing’ as China switches away from growth led by manufacturing for export to growth led by services and internal consumption. We shall see; China’s regulators and managers are skilled and have a lot of ammunition. But this is a difficult maneuver to execute and as Chinese society and the Chinese economy both become more complex, the task of running the country keeps getting harder.

The China Bubble on the other hand is an international phenomenon. All over the world, the producers of commodities and manufactured goods have bought into the idea that Chinese demand is a perpetual growth machine. Producers of everything from cotton to copper to soybeans to silicon chips have assumed that double digit growth in China’s appetite for the components of its industrial machine will continue indefinitely—and they have invested to create the capacity to match this inexorably growing demand. From the jungles of Africa and the backwoods of Brazil to the rice paddies of Thailand and the Australian Outback there have been massive investments in mining, agriculture, energy production and infrastructure that assume continuing and even accelerating growth in Chinese demand.

These investments, the excess capacity they represent and the stocks and bonds dependent on these investments (both inside and outside China) are what the China Bubble is about.

The Chinese government may or may not succeed in stabilizing the economic situation there, at least for now, and Beijing may or may not succeed at avoiding the dreaded ‘middle income trap’ in which formerly rapidly growing developing economies hit a wall after reaching a certain level of per capita prosperity. And the inevitable deceleration of Chinese growth that comes with the transition to a less export-dependent economy may or may not result in a financial crash inside China. But whether or not China’s economic planners execute their new strategy effectively, the China Bubble is going to burst.

That is to say, if China’s economic managers fail, the financial system implodes and China faces a wrenching transition and a hard landing, the massive global investments built to sustain China’s manufacturing growth will fail—dramatically, suddenly and expensively. But even if China’s economic managers succeed, and the country moves to a soft landing with growth still strong but increasingly based outside manufacturing and the export economy, the global investments predicated on China’s continuing hunger for the commodities and components it needs for a manufacturing export boom will also fail.

We do not yet know whether China’s economy will fall into recession, or how exactly China will manage its mix of overbuilt manufacturing capacity, land speculation, empty apartments, local government debt and over-built infrastructure even as it attempts to move to a more market based economy. We do not and cannot know when all of China’s chickens will come home to roost—and how fast they will be running to get there.

But we do know that the vast global network of mines, roads, agricultural development and financial speculation built on the assumption that the old Chinese economy would grow at eight percent forever is running on empty. The commodity price crash, a direct consequence of massive over investment in production facilities whose output cannot be sold at a price that justifies the original investment, is already here. The consequences of the crash on financial markets, tax revenues and trade flows are already being felt. From the South African rand (which plunged over the weekend by ten percent to unheard of levels) to the Brazilian real and the Australian dollar, the currencies most closely linked to the old China paradigm have already crashed.

The earthquake has happened; we are now watching the tsunami surge around the world. From Germany’s high tech capital goods export sector to the copper pits of Zimbabwe, those who have invested on the basis of indefinite high growth of the old Post-Mao China economy are now waking up to the new post-post-Mao reality of sharply lower growth in demand for the key inputs of an export based manufacturing system.

But we have not yet hit bottom. The new reality of a much slower growth in China’s demand for basic manufacturing inputs is still young and its impact is only now beginning to be felt. There is more to come, and the consequences have yet to manifest themselves fully. Over the next few weeks and months, the realization that the China Party has ended will spread through more industries and more markets.

This is going to present a challenge for central bankers above all others; the consequences of the old bubble, in the form of ultra-low interest rates, are still with us as the world economy has looked in vain for a return to robust, unassisted growth since the 2008 crisis. The Fed had just started to raise interest rates when the latest bout of China-related instability knocked global financial markets for a loop and raised anxieties about 2016. Interesting times.

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