China’s economic crisis, explained

Editor’s note: China’s “miracle economy” is faltering. In this multi-part series, GlobalPost brings you the latest from the struggling Pearl River Delta, where much of the world’s merchandise is manufactured.

SHENZHEN, China — To understand China’s economy today, a local financial journalist recently told me, you need to picture a stool with three legs. We were having dinner, and he took a toothpick and one of the chopsticks from a serving dish to demonstrate.

One leg is investment, he said, propping up the chopstick. One is exports, he said, standing up the toothpick. And the other is consumption.

But the investment leg is too big, he continued, the export leg is broken, and the consumption leg is just a stump.

“The stool is very imbalanced,” he said.  

Simple as it is, this illustration gets at the heart of what’s worrying many people about the future of the world’s second largest economy.

After 30 years of meteoric, double-digit GDP growth, China’s economy is at a crossroads. The main drivers — exports and infrastructure investment — have lost their punch. Meanwhile, low wages and high housing costs have made it impossible for Chinese consumers to fill the gap.

As a result, China’s growth in 2012 fell to its slowest pace this century, and 2013 looks like it could be even slower. Last month, the International Monetary Fund lowered its projection to 7.75 percent growth from 8 percent, and UBS, Standard Chartered, and Bank of America have likewise lowered their predictions for the year.

Michael Pettis, professor of finance at Peking University, sees an even darker scenario, saying in a recent newsletter that his “expectation for long-term growth is that it shouldn’t average much above 3-4 percent annually.”

“Not only will China’s real GDP growth drop as China shifts towards a different growth engine, but it will drop even more as China is forced to recognize the hidden losses buried in its debt levels,” Pettis said.

China’s leaders are well aware of these challenges, and have sought to manage expectations. In a speech at the end of May, Premier Li Keqiang told senior Communist Party officials that economic “complications are increasing,” and that the government will have to step back and allow the private sector more power in the market.

“Scientific approaches are needed to ensure this year's social and economic goals,” Li said, reiterating the government’s target growth of 7.5 percent this year.

Yet even with these lowered expectations, the latest data have disappointed. In May of this year, China’s exports, industrial production, and lending data all fell below analyst predictions.

In other words, the stool is starting to look shaky, and it’s unclear what Beijing can do to fix it.

Take exports. With labor costs rising nearly 20 percent every year for a decade, China is no longer a low-cost paradise.

Add in an aging workforce and an appreciating yuan, and Chinese factories have become much less competitive. Labor intensive industries have begun to shift to Vietnam, Indonesia, and Thailand.

Then there’s investment. China has long been the land of big government projects, especially after 2008, when Beijing deployed an estimated 4 trillion yuan ($652 billion) in spending to ward off a slump from the financial crisis. The countryside exploded with new train stations, airports, and apartment complexes. Analysts say many of these projects were ill-conceived. And now that they are built, there’s even less the government can do to spur growth without risking additional waste.

"Across the board you’ve got overcapacity. Overinvestment. What that translates into is bad debt," says Patrick Chovanec, a longtime China watcher and chief strategist at Silvercrest Asset Management. "You can pump more money into the economy, but it’s getting less and less of a result."

Or take consumption. China’s middle class will eventually become the engine of its economy — as in America. But that transition is happening slowly, and insanely high housing prices in cities have suppressed people’s ability to spend. At the same time, any fall in the real estate market could be catastrophic.

China’s economic stool looks even shakier when you consider other factors. Debt is ballooning, and banks are being squeezed for cash. Last month, the inter-bank lending rate shot up to a high of 25 percent when the central bank warned that it would not step in to flood the market with liquidity.  

Across China, city governments have issued dubious, high-interest-rate bonds to fund projects. The total amount of credit in China may now be more than twice the size of the economy, according to the China Securities Journal — nearly eight times what it was a decade ago. As a result, credit-rating agencies Fitch and Moody’s both recently downgraded China’s sovereign credit rating.

Remarkably, the mood among many Chinese remains very optimistic. Nearly 90 percent of Chinese people feel that the economy is doing well, according to a new survey of global attitudes by Pew. But Chinese analysts warn against complacency. Hu Shuli, the editor-in-chief of the financial magazine Caixin, recently argued that China should not wait for a crisis to start reform.

“To many Chinese, the fact that China managed to escape the worst impact of the global financial crisis is proof that its economic system is perfect,” she wrote in an op-ed.

“This kind of view is harmful, because it blinds us to the deep-seated structural problems of China's economy, and how truly urgent comprehensive reforms and a transformation of China's economic model are.”