Okay, it’s official, China’s economy is getting weirder and weirder. On the one hand, it is showing all the signs of a Japan style slowdown. It is plagued by deflation. Youth unemployment remains stubbornly high, and the government is introducing more and more stimulus measures to try to get people to spend more.
And, yet at the same time, China’s economy seems to be experiencing a second economic miracle of some sorts. Last year, it was again the second fastest growing major economy. And, in just a few years time, it has come to dominate advanced industries such as petroleum cars, electric vehicles, cleantech, and even A.I.
So, what is really going on with China’s economy. Is it failing? Is it booming? Or is it somewhere in between? In a ‘normal’ economy, these two stories CANNOT be true at the same time.
After all, if consumers are NOT spending, then firms have no revenue, and thus they cannot be investing and producing on such a large scale.
But, if there’s one thing that my years of studying economies around the world has shown me, China is no normal economy.
So, if we cannot use ‘normal’ economics to understand what’s going on with China. Then…
What the heck is going on with China’s economy?
To find out, I started with the most obvious potential explanation, China is lying about their GDP numbers. Yes, it may sound strange that this is the most obvious explanation. But, as I covered 2 years ago, there are serious signs that Chinese provinces overstate their GDP growth every year to hit their growth targets.
However, today, according to recent research by US Federal Reserve Researchers, China appears to be honest about their GDP numbers. These researchers use all sorts of alternative metrics, such as retail sales, and industrial production indices, and conclude that there are really NO red flags,right now, when it comes to China’s impressive GDP growth numbers.
So, that left me no choice. to find out what is actually going on in China, I had to dive into both the crisis and boom stories in MUCH more detail.
My starting point was the crisis story that I talked about a lot on this channel previously, which is about
China’s Japanification
The core of the Japanification story was essentially that China’s economy would surely would follow the path of Japan, which stagnated after a gigantic property bubble burst in the early 1990s.
That is, just like Japan did in the 1960s and 70s, China went through extraordinary economic growth in the 1990s and early 2000s because it used its banks to invest the country on a colossal scale.
This allowed Japan and later China to rapidly catch up to the West by building infrastructure, houses, factories and a world class education system. To obtain foreign knowhow and currency, both Japan and China used various measures to keep both wages and their currencies low. This allowed both countries to quickly become manufacturing powerhouses.
This is often considered a crucial first step in a country’s economic development because manufacturing allows a country to sustainably earn enough foreign currency to pay for crucial imports that keep the economy running, like oil.
However, according to economists, like Peking University professor Michael Pettis, such ‘investment heavy’ economic miracles can only get a country so far. After all, at some point, there are enough bridges, roads, houses and factories. At this point, almost all economists, including those at the Chinese Communist Party, recognize that a developing economy needs to switch to a consumption based model, where wage and currency suppression are abandoned to allow people to have more disposable income. This could lead to a more balanced economy, where all sorts of businesses emerge in response to the needs to Chinese consumers. These types of businesses are often service businesses, such as theme parks and cafés.
Developing a thriving service sector is really important for any modern economy because the service sector can employ way more people than advanced manufacturing does. For example,
So, essentially, the idea is that any economy starts out agrarian, then rapidly industrializes, and then finishes its development by developing a thriving service sector, which employs most people. For example, in the UK a whopping 95% of workers work in the service sector, even though it only accounts for 78% of its economy.
To achieve this transformation rapidly, a government gives certain privileges, like tax exemptions or subsidies to the sector it wants to develop next. However, this also means that for the next stage of the transition, privileges need to be taken away from that sector.
This is why transformations between development stages are easier said then done. Often, the owners of the preferred sector have a lot of political capital, meaning that they resist the transition. For example, Argentinian farmer oligarchs have long resisted the transition to industrialize. Similarly, now China’s powerful industrialists, whom are high ranking members of the Chinese communist party, are resisting the transition to a consumption based economy because it would reduce their power.
But, what if there is a simpler option. One that can just make everyone richer? One that will allow people to spend more, AND to keep the economy growing WITHOUTH taking wealth away from government and manufacturing elites that profited from the investment led growth model?
Belief it or not. But, in macroeconomics that option actually exists and it is called blowing a housing bubble.
Here’s how you can get one started:
First, you get rid of conservative regulation that prevents housing market regulation. Second, you make it easier and easier for banks to supply mortgages to households. And, then its easy, just sit back and relax as the following positive feedback loop start making everybody feel rich.
As more and more households borrow from banks to speculate on the housing market, house prices will be inevitably be pushed up. This will make home owners feel richer, encouraging them to borrow and speculate even more. Of course, banks will be happy to help them out as they have lent against the collateral of these houses. So, if one borrower was not trustworthy, the bank can just take the house, which just keeps going up in value
Crucially for the economy, rising home prices made both the Japanese and Chinese consumers feel richer, allowing them to spend more freely, just as they might have if their countries had chosen to switch to a consumption based model.
Therefore, the housing bubble years helped sustain high economic growth well after most productive investments were done, both in Japan in the 1980s and China in the 2010s.
Sadly, while these mortgages helped push GDP up, they made debt go up way faster, causing debt to GDP to rise rapidly, almost doubling from about 130% of GDP in 2008 to roughly 260% in 2019.
A huge sign that this growth was not sustainable.
Then, when house price inevitably started dropping, the virtuous cycle that we saw before became a doom loop. Banks started demanding their money back. Consumers could not fully repay their loans, and therefore, they stopped spending their money in the economy.
In Japan, reduced spending meant that its industries started getting fewer and fewer orders. On top of that, reduced home values and more and more bad borrowers meant that the banks stopped lending to anyone, including firms. Therefore, firms stopped investing, and lost their edge. To keep the doors open, they had to lower their prices, making it harder for them to repay their debts as well. Therefore, the Bank of Japan eventually stepped in to support banks, consumers, and firms with lower interest rates, in the hope to get Japanese consumers to start spending again and banks to start lending again.
This is the story that many economists, is including me, said we’d likely see in China as well. But, now, just a couple of years later, I can say that it was only half true.
Yes, we have seen the property slump stick around. Yes, Chinese consumers don’t spend as much anymore, causing deflation and youth unemployment. And yes, just like in Japan, we are seeing the central bank stepping in with stimulus.
However, we are not seeing this translate to a recession in Chinese manufacturing. Despite Chinese consumers suffering, are seeing Chinese factories produce more and more and more and more. Even expanding into risky new sectors such as green technologies and EVs.
In all my years of studying economies around the world, I can truly say, I’ve seen nothing like it before. This is why I think it is fair to call this
China’s second economic miracle.
So, how did China do it?
I think this graph from National University of Singapore professor Bert Hofman shows it best.
As you can see here, as Chinese banks stepped back from the real estate market, they started absolutely pumping money into industry.
This is the key difference with Japan. In Japan, private banks did NOT do this because it was much too risky. Similarly, in Western economies banks absolutely DID NOT go on a lending spree to industry after the housing crash of 2007.
But, China is no ‘normal economy’ because its state is much more powerful than in Japan or in the West. So, after the housing bubble burst, the government essentially stepped in and ordered its state owned banks to pivot hard and turn on the lending taps to industries that it considered essential for its further economic development.
Of course, Chinese consumers are still in trouble, so factories couldn’t all of this new stuff to Chinese consumers, meaning that we are seeing deflation in China. However, with so much state support Chinese manufacturers now had a significant edge over foreign firms, meaning that China’s export growth exploded.
So, why is China’s economy still growing so fast? Why is its industry taking over the world, even though Chinese consumers are suffering? Simple, its an unprecedented lending boom from Chinese banks, following the orders of the government.
So, in
Conclusion
both stories are correct. China is not faking its economic numbers. It’s consumers and property market are actually struggling, similarly to how it happened in Japan in the 1990s. However, unlike Japan, China’s industries are thriving, thanks to massive support by the state.
One the one hand, this is truly impressive. On the other hand, it is a really risky bet for two reasons.
The first is that Chinese economic growth is now even more dependent on foreigners wanting more and more Chinese products. The US is already closing off its markets. Yes, so far, China has managed to actually reroute its exports to other markets. But, it is increasingly facing a backlash all over the world, as countries like Brazil, Indonesia, and India are fearing the demise of their home grown industries, who cannot compete with heavily subsidized Chinese firms.
The second reason China’s new economic model is not sustainable is that China’s debt to GDP ratio is once again rapidly rising.
This cannot continue indefinitely. When taking into account household, corporate and government debt, China is now even more indebted than the United States. That being said, though, China’s total private sector and government debt is still quite a bit lower than that of Japan. So, me saying this is not sustainable does NOT mean that China’s economy will crash in 5 years. How far they can take this, I do not know.
But, I do think that this was the wrong choice. As I argued in my previous video, for more stable economic growth, China should switch to a consumption based economic model. And, that’s not just me saying that. The Chinese communist party essentially agrees with me, saying that it now prioritizes ‘high quality’ growth. That is growth that does not increase debt to GDP. Whether or not it can actually do that though… remains to be seen, especially now that it’s working age population is projected to start declining rapidly in the coming decades.
So, yeah, what do you think, let me know in the comments below, and if you want to know more about China’s second economic miracle, I highly recommend you check out the following three super interesting in-depth articles by our advertising sponsor, the Economist.
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