China's economic miracle is a fragile one

First published in the Telegraph on 12 November 2009

Every economist has a favourite fact about the Chinese economy. Mine is this: every month, the country generates so much surplus cash from trade that it could afford to go out and buy three of Britain’s biggest companies – say, British Telecom, Rolls Royce and J Sainsbury. Every single month.

The pounds 9.8 billion that Kraft proposed this week to spend on Cadbury’s? China could have generated that much in little over a week – not funny money, but cold, hard cash. Should it decide to go out and spend, it could afford any company it wanted – Google, Goldman Sachs, RBS. Only, it has more sense.

Or does it? The prevailing wisdom in both economic and political circles is twofold: first, that China is fated to become the world’s economic superpower within a generation or two; second, that thanks to the unusual degree of control its leaders exert over the economy, they will skilfully steer the country away from a future bust. Both assumptions are severely flawed. No doubt, China represents a major player of the future. But – not for the first time – we are getting ahead of ourselves.

Twenty years ago, as the fall of the Berlin Wall set in train the events which have led China to its current position, economists and politicians were impressed and scared in equal measure by another Asian giant; one that seemed likely to dominate the global economy. That country was Japan, and we know what happened next: it soon slid into deflation, near-depression and a stagnation that persists to this day.

Japan fell victim to a disastrous asset bubble. There are growing signs that China could be heading for an eerily similar fate. With interest rates at rock bottom, following the financial crisis, and investors desperate to put this cheap money to work, capital has been flooding into China and its fellow emerging economies. This is precisely what happened in the late 1980s, only the crisis then was the Black Monday share collapse and the main recipient was Japan. That influx of cash from rich to emerging nations made the “miracle economy” story all the more compelling – until the asset bubble imploded, sending house and share prices plummeting.

This is not to argue against the importance of the rise of China. The country is overtaking Japan to become the world’s second-largest economy, having left us European slowpokes in its wake some time ago. There is nothing mysterious about this, no economic miracle – it is what happens when the elastic band holding back a country with one fifth of the world’s population suddenly snaps.

But then, all bubbles begin with a compelling prospect: the dotcom boom, for instance, really was a revolution; the problem was that over-excited people invested too much money too soon. China will undoubtedly become an economic superpower, but its path will be strewn with obstacles.

Which brings us back to that pile of cash building up in Chinese coffers. China has grown to its current size, as do most “young” economies, by exporting cheap goods to richer countries. In its case, this has resulted in the biggest trade surplus in history. The proceeds of that surplus have to go somewhere but, rather than buying General Electric, the country’s leaders have splurged it in the currency markets, doing whatever they can to keep their currency, the renminbi, down.

Such a policy made sense when China had an economy that was relatively underdeveloped, and was trying to shield nascent exporters from volatility; but now, by keeping assets artificially cheap, it serves to exacerbate the bubble that is building up as a result of those low US interest rates. And while this approach worked when consumers here and in America would spend on Chinese exports, that is no longer assured. As if this weren’t dangerous enough, the authorities have also taken to trying to pump up the economy further by channelling cheap credit to companies.

There could hardly be a more reliable recipe for an asset bubble, and too many economists assume that the omnipotent Chinese leaders know better. In reality, this bubble is being allowed to grow by a Communist party which is well aware that, if economic growth drops below a certain level, their positions could become less secure; the authorities are also less in control than they would like to be.

China is not alone. Brazil, India, and a host of other countries are following a similar trend. The Buenos Aires stock exchange has more than doubled in the past six months. Brazil recently imposed controls on the amount of foreign cash allowed into the country, in a bid to dampen speculation. But a Chinese collapse would be disastrous for the global economy in a way Japan’s slump never was; China is one of the few countries supporting global growth at the moment.

There is a simple way to stem the expansion of this bubble: China should allow its currency to appreciate, and bear down on its economy by raising borrowing costs. Both tactics would depress economic growth and risk social unrest, which terrifies a Communist party feverishly obsessed with suppressing any whiff of dissent. But, in avoiding difficult decisions now, China’s rulers are setting themselves up for an even more violent reaction if and when this asset bubble eventually implodes.