independent

Sunday 20 April 2014

David McWilliams: How we'll all get scalded when they break China

THIS week we are going to raise our heads above the lip of the European trench and have a look at the rest of the world. This is critical to an Ireland where the strategy of export-led growth needs the world to grow, to buy the exports that we make.

Regular readers will appreciate that this column is not too persuaded about the ability of exports to do the heavy lifting for the economy.

Without domestic demand, the Irish rate of unemployment -- the only really meaningful economic indicator -- is not likely to fall.

We are going to examine first China and what is going on in the country. Remember that up to now this has been the one constant positive economic story. I have been lucky enough to spend a bit of time over there -- four working trips to the Middle Kingdom in the past two years. Sitting in a cafe just off the impressive Bund in Shanghai, watching the world racing by, it struck me -- as it has many others -- that "growth" has replaced "equality" as the Communist Party's central slogan.

As long as it can deliver growth, the Communist Party can remain in power. Consequently, the Chinese authorities will do anything to keep the growth miracle going. But it's going to get harder and harder for them.

The other thing that strikes you when you look out over the Bund to the teeming new metropolis across the river, is that China's investment boom is now so huge that it might be impossible to protect with traditional economic means alone. Let me explain this. If a country has a boom which is driven by too much investment then increased demand for more investment at a time when there is too much investment will just increase the excess capacity, causing prices to fall further.

Two weeks ago the Chinese central bank cut its lending rate for the first time since December 2008 even though inflation expectations have not fallen. This tells us that the Politburo is seriously worried about China's GDP slowdown as the property boom turns down and exports to Europe plummet.

The Chinese economy is now hostage to a leveraged banking system clogged with dubious real estate loans and provincial government loans. It's not hugely different to the Spanish or Irish banking crisis. Property loans and mortgages in China are 25pc of GDP. Consumer debt has tripled since 2008. As the property boom unravels it will destroy the balance sheet of the Chinese middle class who have bought into it and, of course, the knock-on to GDP will be seen in time.

Much of the commentary on China, written by investment bank analysts who have a vested interest in keeping China going, suggest that China is different. We should be cautious because readers of history might say that China is no different to the USA of the 1920s where the economy boomed, when millions of Americans came off the land into industry (think Steinbeck's 'The Grapes of Wrath') and when America, like China now, turned into the world's lender of last resort, lending gold in particular to Germany.

These analysts claim that China can't have a hard landing. I believe they are talking rubbish, just as similar vested interests writing in Ireland claimed the problems would be limited to development land or claimed that Spain's fundamentals were sound.

High economic growth is the Chinese Communist Party's last pillar of legitimacy, now that Maoist ideology is irrelevant. This sharp slowdown in China comes at a dangerous time for the mandarins of the People's Republic. The Beijing Consensus of a united Party elite and autocratic rule is falling apart. Internally the Party is in disarray as evidenced by the squabbling and public humiliation of some of its key figures in recent weeks.

Against this background, is it clever to expect China to remain politically stable or pull the global economy forward? The Chinese miracle, which produced now close to two generations of 10pc growth, has been financed by exports generating cash which was in turn reinvested into the local economy.

This massive investment has now reached 50pc of GDP -- an unsustainable level -- which, as observed above, can't be improved by lower interest rates alone because lower interest rates incentivize more housing investment, making the overcapacity worse and causing prices to fall more.

Now let's turn to the other giant of the world economy.

Will the Fed cut American interest rates this week in response to evidence that the American recovery is stalling?

The April and May job numbers have made it clear that the labour market is deteriorating. New York Fed President Bill Dudley has stated that a lack of jobs will lead to policy easing. This is now happening. As recently as February, January and December 252,000 jobs a month were being created in the US. In the past three months only an average 100,000 jobs are being created.

Because, unlike the ECB, the American Fed's dual mandate dictates that it act to protect growth in the USA as well as concern itself with inflation, the Fed is likely to cut interest rates.

There is no sign of inflation anywhere. Bond markets are signalling that the world economy will see no inflation in the next year. This is obviously helped by the $30 fall in Brent crude oil, itself an indicator of faltering demand.

IN China, India and Brazil, growth rates have plummeted, which is a major risk for US exports to emerging markets. The world economy and emerging markets, not just US payrolls, are now a source of recession risk for the US. This is an election year and we know that Obama needs the economy to be motoring come October.

Given the crisis in Europe and rolling bank disasters here and in the rest of the periphery, we can probably be forgiven for not seeing or appreciating what is going on in the rest for the world. It's not a pretty sight.

www.davidmcwilliams.ie

Irish Independent

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