China Transformation or Bust

By: John_Mauldin

China continues to be front and center on my list of concerns, even moreso than the latest Federal Reserve press release or fluctuation in the Dow (although you should pay attention). I believe China is the single biggest risk to world economic equilibrium, even larger than Japan or Europe. This week my young associate Worth Wray provides us with a keenly insightful essay on what is currently happening in China. I will admit to not having written about China very much in the past five years, primarily because, prior to Worth’s coming to work with me I really had no secure understanding of what was happening there. I know some readers may be surprised, but I really don’t like to write about things I have no understanding of. Worth has helped me focus. (It helps that he studied Mandarin and lived in China for a while, and is obsessed with China.)

Worth has been working directly with me for over one year now. I have had the privilege of working with a number of impressive (lately mostly younger) people over the years, but Worth brings something extra to the table. He is one of the best young macroeconomic minds I have been with in years. He constantly challenges me to step up my game. And so without further ado, let me give you Worth’s thinking regarding our latest discussions on China.

Transformation or Bust, China Version

The People’s Republic of China is running up against its debt capacity; and its consumption-repressing, credit-fueled, investment-heavy growth model is nearly exhausted. History suggests that China’s “miracle” could dissipate into a long period of painfully slow growth or terminate abruptly with a banking crisis and sudden collapse. That said, China’s modern economic transformation has defied historical precedents for decades. However unlikely, China could surprise us again. Miracles will happen in the Age of Transformation.

What happens next depends largely on the economic wisdom and political resolve of China’s reformers, who must find a way to gradually deleverage overextended regional governments and investment-intensive sectors while simultaneously rebalancing the national economy toward a more sustainable consumption-driven, service-intensive model. The trouble is, their efforts may prove too little too late to slowly let the air out of a massive debt bubble. Even rapid productivity growth from “new economy” sectors may not be enough to overcome the debt equation.

At first blush, China’s ruling elite do not appear to be in denial about the severity of the debt problem, the urgent need for structural reforms, or the opposition from vested interests within the Communist Party; but the jury is still out on whether President Xi Jinping and his allies will maintain the political capital necessary to complete, or even continue, the task. With little margin for error, he will either lead the Middle Kingdom through the greatest transformation in world history... or he will preside over one of the most spectacular busts on record.

Before we dive into recent data and explore the transformation taking place across the People’s Republic, let’s step back and think intentionally about the conditions that often set “rich” developed economies apart from their “poor” developing peers.

I am going to quote extensively in the next two sections from a recent blog post by Peking University Professor Michael Pettis. Pettis provides a CRITICAL foundation for understanding the transformation taking place and the reforms required to keep it going, so please bear with me. We will have plenty of time to delve into the recent data in the second half of the letter. Unless otherwise noted, all quotes are excerpted from his brilliant post, "The Four Stages of Chinese Growth."

Becoming a Developed Economy

Becoming a truly developed country depends on far more than just accumulating an abundant capital stock or a highly capable workforce. Durable growth and sustainable development depend on “social capital” – or institutional structures including property rights, the legal code and the justice system, the financial system, corporate governance, political culture and practice, tax structures, etc. – which establish and/or maintain the right incentives for economic resources to be used efficiently, creatively, and ultimately, productively.

Pettis explains: “In a country with highly developed social capital, incentive structures are aligned and frictional costs reduced in such a way that agents are rewarded for innovation and productive activity. The higher the level of social capital, the more likely they are to act individually and creatively to exploit current economic conditions and infrastructure to generate productive growth.” Extending his argument, John and I would contend that high levels of social capital effectively incubate innovation and entrepreneurship so that, with disciplined savings and investment over time, the right incentives produce lasting wealth and ever-higher levels of development.

I think MIT Professor Robert Solow would agree with us on this front. Solow’s work on the US economy – which has become a textbook economics lesson – explains that innovation has accounted for more than 80% of the long-term growth in US per capita income, with capital investments accounting for only 20% of per capita income growth. In other words, the United States and the rest of the post-industrial, developed world owe their epic rise in living standards to the underlying “social capital” that properly incentivized innovation, entrepreneurship, and thus technological transformation over the last two centuries.

The lesson here is powerful. It is not enough just to mobilize resources and direct investments to the “right” sectors as China’s central planners have been doing for the last few decades. Once the basic building blocks of economic development are at hand, they still need to be used creatively, effectively, and productively.

Pettis elaborates, “In developed countries … abundant social capital encourages residents and businesses to use available conditions and infrastructure in the most productive ways possible. Undeveloped countries, on the other hand, are poor because they do not have the often-intangible qualities that allow citizens spontaneously, and without planning, to exploit their economic and infrastructure resources most efficiently and productively.”

Emphasizing the importance of incentive-aligning institutions, developing economies must not only strive to create (1) policies aimed at providing and improving the basic building blocks of production like adequate infrastructure, abundant capital stocks, and healthy, educated workforces but also (2) policies and institutions capable of streamlining the commercial incentives for using those resources as productively as possible with as little waste as possible.

Like the USSR in the Cold War era, the People’s Republic has been wildly successful in mobilizing resources; but failing to use those resources efficiently may be its downfall.

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