Is China Headed for a Financial Crisis?

In 2001 an American lawyer, Gordon Chang, wrote a book called The Coming Collapse of China.Mr. Chang asserted that the inefficiency of state-run enterprises and the hidden non-performing loans of the largest Chinese banks would bring down China's financial system and its communist government. Critics say Chang has destroyed his own credibility by making repeated wrong predictions over the years since 2001.

But Mr. Chang is not alone. In October 2019, the New York Times Op-Ed Columnist Bret Stephens wrote an article entitled "Is China Heading for Crisis?"  In that article he notes that an estimated $1.2 trillion in capital has left China in the past decade, as foreign investors have soured on China.

I'd like to explore what others are saying about the vast Chinese economy and its prospects for the future, both supporters and critics.

History of China’s Economy

China’s economy was initially very agrarian where the cultivation of land and the development of farming played a key role in the growth of the largest population in the world. Various methods have been implemented to enable more productive and efficient farming techniques to expand and preserve its agricultural sector.

Today, despite maintaining a developing country status, China has become an industrial powerhouse, making itself the world’s second largest economy which composes of 16% of the global GDP. China is home to some of the largest hi-tech companies including Huawei, Alibaba and Tencent. The burgeoning technological advancements and progress in manufacturing have led many to challenge China’s position as a developing country.

70 years ago, in 1949, the People’s Republic of China (PRC) was founded. The progress that China has made from then to now in the pace and quality of industrialization has allowed for higher wages, more favorable living standards and better productivity. Along the way, they overcame many obstacles that have earned them the reputation of having one of the fastest growing economies in the world. In the first two decades following the establishment of the PRC, China’s economy exhibited periods of considerable growth in per capita GDP and output per person, followed by abrupt turnarounds. Under Mao-era socialism, critics posit that the Communist party restricted China’s economy and prevented it from performing to its full potential.

Events like the Great Leap forward and the chaotic Cultural Revolution hurt China, causing economic breakdown and the deaths of tens of millions of citizens. Mao’s rule employed brutal means to impose its power and the traditional rural-urban relationship began to disintegrate which in turn caused the collectivization of agriculture. This relationship broke down because of the high tolerance of labor surplus in rural areas which prevented urban areas from receiving a large population of laborers. Therefore, China’s agricultural production was occupied by the rural population, keeping the concentration of material resources out of cities.

A Defining Moment

1978 was a riveting time for China and its economy. They were finally able to sustain a vigorous industrialization process where their new leader, Deng Xiaoping, was able to put forth the beginnings of what he called “reform and opening” policies. Even though he didn’t entirely reject the Maoist-styled ideology, he wanted to reassure those who feared ideological compromise that he would improve the economy and fix the lingering problems of the previous regime. One of his main goals was to foster a household responsibility system that was aimed to improve the lives of peasants working in the Chinese countryside following a long period of agricultural stagnation.

“It does not matter whether the cat is black or white, as long as it catches mice.” -Deng Xiaoping

With the acceleration of urbanization, higher paying jobs in cities attracted more workers from rural areas searching for higher incomes. This market liberalization was a major catalyst in helping China to become a major global exporter. The implementation of free market reforms and openness to foreign trade and investment has helped China to realize its economic potential. From 1979 to the 2018, their real GDP has averaged 9.5%, a rate that the World Bank describes as “the fastest sustained expansion by a major economy in history.”

Current Problems Facing China’s Economy

Investors are worried about China’s economy and one of the main reasons is that its third quarter economic growth this year sank to 6.5%. Some economists hold that it will soon be difficult for China’s economy to sustain growth rates exceeding 6%. Domestic problems as well as the U.S.-led trade war are making it difficult for China to keep up its rapid expansion. The following graph represents China's real annual GDP growth from 2007-2018 with projections through 2024.

Source: IMF, World Economic Outlook Database, April 2019

Senior Asia Economist at Oxford Economics, Tommy Wu, says “Both the weakening in the domestic economy and deteriorating external environment, including both a global slowdown, and the US-China trade tensions, have a role to play in China’s slowdown.” Due to China’s prominent role in the global economy and their high demand for commodities and machinery, an economic downturn can be a hard blow with extensive consequences.

China is now seeing industrial output at its weakest pace since 2002, accompanied by slowed retail sales from products like cars and Iphones.

Some of China’s goals to stimulate the economy include tax cuts and boosting liquidity in the financial system. In the past, they have relied mainly on infrastructure spending to boost the economy, but analysts are saying that there is very limited room for that.

Julian Evans-Pritchard, an economist at Capital Economics, says that the effects from U.S. tariffs have been somewhat offset by a weaker yuan, the Chinese currency. To avoid taxes, China has sought to export through other Asian countries. Evans-Pritchard asserts that China’s share of global exports has gone up in the past year, indicating that the decline in Chinese exports has been less conspicuous than those from other countries. Meanwhile, businesses in the west are finding it difficult to deal with this uncertainty.

The longer we see these tariffs continue, the more likely it is that firms will take their business elsewhere, ultimately making the country a less attractive place to invest. Some firms plan to keep some of their production in China to satisfy their domestic markets, but others are already planning their departure.

In a 2019 survey by the American Chamber of Commerce in China, roughly 65% of members said that trade tensions have a large effect on their long-term business strategies and nearly a quarter of all respondents are holding off on their China investments.

Another point of view comes from author Ann Lee who is a professor of economics at New York University. Lee is a global economics pundit who frequently comments on financial issues surrounding countries such as China. In her recent book, Will China’s Economy Collapse?, Lee assesses the various challenges facing China, questioning how the country can be so at risk when its economy is much better shape than the U.S. economy. She highlights China’s sustained annual growth rate of 10% over the last 20 plus years as a remarkable accomplishment. Lee attributes China’s economic turnaround to their adoption of a state-centered, export-focused economic model.

Calling China the world’s growth engine and a better investment than the U.S., Lee argues that Chinese banks are healthier and more transparent than banks here in the U.S. She points out how China’s public debt, which is less than half of the United States, is on a downward trend while the personal savings rate remains at a high 50%. Lee makes the assertion that China’s fiscal policies are growth-oriented and says there is no need for China to make financial reforms in regulating its currency valuations or interest rates. Overall, Lee believes that the chances of an economic crash in China are very remote due to the diversity and complexity of their economic system.

Prospects for the Future

Economists from the National Bureau of Economic Research say that China’s economy will likely continue to see relatively strong levels of growth, although much lower than we have seen over previous decades.

I mentioned earlier in this article, from 1979-2018, the average growth rate of China’s real GDP maintained an impressive 9.5%, but that some analysts project a rate of below 6% come 2024. It’s important to remember that these are long-term projections and that they are subject to change, but the overall trajectory seems to indicate slowing growth.

With an economy China’s size, delivering a consistent growth rate can be challenging with such a high level of GDP. It’s important to consider factors that have helped expand their economy in past decades and see how they are relative today. The number of workers shifting from agricultural jobs to higher-paying city jobs is on track to decline and the process of urbanization will, consequentially, not be able to bring in as much output per person as it has in years past.

While the “catch-up” process has provided significant growth in productivity, it is likely to slow as China makes big leaps in technological advancements in relation to its Western competitors.

Some analysts say that it’s crucial for China to rely on broadening its own domestic demands to meet growth targets rather than low-cost exports. To achieve this, subsequent reforms will be required to release Chinese consumers’ spending power and build a more balanced and growth-driven economy.

Sources Used:

Forget the Trade War. China is Already in a Financial Crisis

How Close is China to a Financial Crisis?

Is China About to Cause the Next Asian Economic Crisis?

A Little History of Chinese Economy

China's Economic Rise: History, Trends, Challenges, and Implications for the United States