As fearmongering election campaign ads go, it’s hard to top the “Chinese Professor,” which flickered across the Internet just before Americans went to the polls last fall. In the spot, set in a sleek Beijing lecture hall 20 years in the future, a sharply dressed Chinese instructor explains to his Asian students why previous empires, from Ancient Greece to the U.S.A., turned to dust. The Americans failed because they lost sight of their principles, he says in Mandarin, with subtitles. They overspent, overtaxed and over-borrowed. “Of course, we owned most of their debt,” he cackles, as the class joins in. “So now they work for us.”
If you missed the ad, put out by the conservative group Citizens Against Government Waste, no matter. The notion that China’s headed for superpower status at the expense of the United States has been repeated so often that many in the West now take it as an undisputable fact. With breathless enthusiasm economists predict China’s red-hot economy will power past America’s to become the world’s largest in just 15 years. Bookstore shelves are filled with titles like China’s Ascent and When China Rules the World: The End of the Western World and the Birth of a New Global Order, in which author Martin Jacques argues America is in denial about the fact China is its “usurper and ultimate replacement.” Hollywood’s even getting in on the act with a remake of the 1980s Cold War paranoia flick Red Dawn, in which Soviet soldiers overran a Midwest American town. Only this time, the marauders are Chinese. Having conquered American capitalism, the People’s Liberation Army is coming for America’s Capitol, too.
It’s easy to find evidence that ostensibly confirms China’s unstoppable ascent. Try this: Go to Google News and type in “China,” along with any laudatory adjective, then add the suffix “-est.” Do so, and you’ll learn that China is building the world’s third-tallest skyscraper (“China usurps U.S. in skyscrapers”); it produces the smartest children (“Chinese students outperform U.S. in recent test”) and now boasts of the world’s fastest trains (“China’s fastest train leaves rest of world behind”). This super-country narrative has become so pervasive that the majority of Americans take it for granted. At the end of last year, pollsters for the Allstate/ National Journal Heartland Monitor asked Americans which country “has the strongest economy in the world today.” Half picked China, and just one in five selected the United States.
Yet for all the talk of China’s economic might, skeptics are gathering force. Over the past year, a growing number of analysts and investors have argued all is not as it appears in the Middle Kingdom. What they see instead is a government desperately priming the pump to maintain an illusion of prosperity. Far from an economic powerhouse, China’s economy remains a middleweight when its vast number of poor people is taken into account — the country’s per capita GDP is only around US$4,500, 1/10th that of the U.S. And as a share of the economy, household incomes have actually declined over the past decade. With the domestic economy too weak to maintain China’s high growth rates, and with exports to the West hurting, the Communist Party in Beijing and its regional offshoots have come to rely heavily on cheap exports and debt-fuelled investment to sustain China’s fragile fortunes. And the problems will only get worse as China’s massive population starts to age rapidly over the next decade. Investors in the West have become too focused on China’s growth and interpret it as a sign of a healthy economy. But the country only maintains that growth rate because it doesn’t worry about being profitable. As Jim Chanos, a U.S. hedge fund manager and China skeptic famously put it early last year, China “is on a treadmill to hell.”
China is trying to transform itself from an agrarian backwater into a modern industrial power in the span of a single generation — a feat that took the West a century of ups and downs, harsh lessons and hard-won victories. Within its borders, China’s dash for modernity has sparked a dangerous property bubble, led to astonishing overcapacity and generated enough toxic debt to put even a U.S. mortgage banker to shame. But the country’s super-charged growth has also profoundly driven world events. Its massive stockpiles of foreign reserves and low-cost factories have suppressed long-term interest rates, kept global inflation in check and driven a boom in commodities that has benefited Canada immensely. In the same way, our interconnected economies mean a slowdown in China is likely to export pain to the rest of the world in ways we’ve never seen before.
So forget the collapse of the Greek or Irish economies, which grab headlines but ultimately matter little to the world economy. Investors are completely unprepared for the shock and upheaval that will come should China fail, and Canada in particular would feel the pain.
In a country that’s often been called the world’s factory floor, China’s Pearl River Delta is the industrial engine that keeps the assembly lines running. So, when America’s economy tanked in 2008, and western consumers stopped buying TVs and sneakers, the region was hit hard. Exports to the U.S. and the rest of the world plunged, and more than 100,000 factories shut their doors, throwing millions of Chinese labourers out of work. As protests broke out, officials worried the backlash could escalate. Their fears were justified. When workers at a steel mill in Dongguan rioted after learning about a new round of job losses, the mob beat a senior manager to death.
Faced with crisis, China’s leaders swung into action with a mammoth stimulus plan. In November 2008, Beijing unveiled a US$600-billion rescue effort that, relative to GDP, was several times larger than what America put in place. More important, the government ordered its state-run banks to crank up lending, especially to residential and commercial developers. The banks promptly obliged, shovelling more than US$1.5 trillion of loans out the door last year, an amount equal to 30% of the country’s economy. It worked better than the Chinese could have ever hoped — on paper at least. In the face of a global recession, China’s GDP rocketed 8.9% in 2009. Soon, analysts were crediting Beijing with saving the global economy. The sharp rebound in oil and other commodity prices that came with China’s renewed vigour certainly pulled Canada out of the pit.
To many, the episode was yet another sign of China’s economic prowess. Anthony Bolton, a well-known British fund manager who moved to China to establish a special fund dedicated to the country, hailed “the effectiveness of the centrally run economy.”
Instead, the crisis and the government’s response exposed just how fragile China’s economy has become. The problem is simple — for all the hype around China’s emerging middle class, Chinese shoppers contribute very little to the country’s fortunes. In any economy, domestic consumption typically makes up roughly 55% to 65% of GDP. The remainder is typically split between exports and investment. Not so in China. Over the past decade, domestic consumption’s share of the economy has plunged from around half to a miniscule 35%, the lowest of any significant economy ever, according to Michael Pettis, a finance professor at Peking University whose online writings have become must-reads for those eager to divine what’s really going on in China.
With almost nothing in the way of health insurance, welfare or a social safety net for retirement, Chinese feel pressure to save every penny they earn. At the same time, official policies that favour Chinese banks and exporters — namely artificially low interest rates, an undervalued yuan and cheap labour — come at the expense of household savers. This isn’t to say consumers aren’t spending more than they did a decade ago. A stroll through the busy retail shops along Shanghai’s Nanjing Road, or hours spent in a Beijing traffic jam amid shiny Black Audis, will attest to that. It’s just that the red-hot growth that has earned China its miracle status was overwhelmingly the result of exports and investment.
But the days of China being able to fall back on cheap exports is coming to an end, say experts. It’s not just that consumers in developed countries have retrenched, though that’s an immediate threat. China’s policy of devaluing its currency to grab export market share from the West is now squarely in the crosshairs of politicians in the U.S. and Europe. “Unless Beijing shows real determination to move on the currency front, the likelihood of the U.S. slapping on a surcharge on China’s imports in 2011 is high,” Diana Choyleva, an analyst at Lombard Research in Hong Kong wrote in a report last fall. “The early 2010s could well turn out to mark the end of China’s years of miraculous growth, with trend growth halving during this decade.”
With the writing on the wall for China’s export machine, officials have to scramble for an alternative way to juice the economy. So China has increasingly looked to investments in infrastructure and construction to keep Chinese workers employed. In 2009, the peak of China’s stimulus campaign, fixed investments accounted for a whopping 95% of the country’s GDP growth. Even last year, despite all the efforts by Beijing to rein in its stimulus efforts, investment in fixed assets was the fastest-growing segment of the economy. One report by Thomson Reuters suggested investment in fixed capital projects is “significantly above the levels that prevailed in Japan and the U.S. during their respective real estate bubbles.”
Ironically, it is China’s investment in these hard assets like airports, bridges, mines, railways and office towers that wow so many in the West. We look in awe at China’s cities, with their shimmering skyscrapers, and the claim that another 10 New Yorks must be built over the next two decades to accommodate the country’s surging middle class. With the West’s infrastructure falling apart, we envy their vast network of high-speed railway lines — more extensive than in the rest of the world combined — never mind the 5,000 kilometres to be laid over the next two years alone. And while it can take years for cities in the West to decide whether or not to build a new airport, China is erecting terminals across the country at a rate of nearly 10 a year. Yet the glint from all that shiny metal and glass can easily obscure what’s really going on. Traffic through many of the four-dozen terminals China has built in the past five years is a fraction of what was originally forecasted, according to an Los Angeles Times report. It’s why Yasheng Huang, a professor at MIT and author of the book Capitalism with Chinese Characteristics, uses the term “Airportologists” to describe western pundits who draw sweeping conclusions about China’s economy after passing through its massive terminals.
China’s stellar GDP statistics may send western business leaders into raptures, but even the Chinese government doesn’t believe them. In a diplomatic cable released by Wikileaks in December, Li Keqiang, executive vice-premier of China and a leading candidate to replace Premier Wen Jiabao, told a U.S. official China’s GDP statistics are “man-made,” and are “for reference only.”
The fact is, says Vitaliy Katsenelson, director of research at Investment Management Associates in Denver, Colo., and a prominent China skeptic, China’s frantic building boom over the past five years not only boosted GDP on paper and put millions to work but also produced a property bubble where neither investors nor developers are likely to ever recover their costs. “They already had a weak foundation, and on top of that you’ve had a government throwing enormous amounts of money at the economy in a chaotic way,” he says. “This isn’t going to end good.”
When Ma Zhiyuan’s phone rang last year, and a real estate agent told him she had a client ready to pay cash for his Beijing apartment, he was stunned. What surprised him was not that she was offering stacks of Maos. China’s new middle class are as thrifty as their parents and see apartments as the ultimate place to stash their accumulated savings. No, what struck Ma, a marketing manager, was that he hadn’t even listed the place for sale. The realtor had simply hunted him down as the owner of the unit. And now she was offering 1.1 million yuan, or about $170,000 for the pad.
To someone in the West, that may not seem like an exorbitant amount for a highrise apartment in a major capital city. Yet, at that price the unit was 26 times greater than the average Beijinger’s salary. Even so, Ma told her he’d have to think about it. (He’d been renting out the apartment and enjoyed the extra income.) Shortly afterward, the realtor called back to say her client would pay 100,000 yuan more. And when Ma rejected that, she offered another 100,000 yuan, and then another. It went on like this for weeks. Finally Ma agreed to a price: 1.6 million yuan, nearly 50% more than the place had been worth a month earlier. “They hadn’t even seen the apartment,” he says. “At that time, housing prices were going crazy.”
“Crazy” fails to capture the utter insanity of what’s gone on in China’s property markets. In January, home prices in 70 Chinese cities jumped another 6.3% from the year before, and have more than tripled in the past five years. In prime markets like Beijing and Shanghai, prices have risen far faster. It’s no longer surprising to find taxi drivers and teachers who claim to own two or even three apartments each. At one point, Shanghai economist Andy Xie cited local media reports that some 65 million urban homes reported zero electricity consumption over a six-month period, suggesting there are enough vacant homes in China to house 200 million people. While power companies denied that was the case, in the regions around Shanghai, Beijing and other cities, fancy new apartment blocks stretch off into the horizon, their surfaces pocked with black holes where windows would otherwise be. Policy-makers have attempted to deflate prices. They’ve limited the number of homes Chinese can buy, restricted many state-run companies from buying up land, and ordered banks to rein in their lending, yet still prices continue to rise.
It’s not just the residential sector. Commercial developers have engaged in their own orgy of debt-fuelled construction projects, bidding up land values threefold last year and erecting countless office towers, malls and hotels. It’s all adding to a glut of properties that are sitting vacant. In Beijing, where the official commercial vacancy rate is 30% but approaches 50% in many pockets, developers go to great lengths to make empty buildings look occupied, going so far as to paint silhouettes of office workers in stairwells. For instance, in the 29-storey Central Point towers, built three years ago, a handful of tenants finally moved in last fall, according to a property manager. However security guards were surprised to see a visitor come through the door, and appeared to be the only people in the building.
How could there be so many new buildings going up when, at the same time, so many others already sit empty? Simple. China is engaged in an elaborate shell game to hide a mountain of bad debts piling up on the balance sheets of its banks, developers and state-owned enterprises. In the case of real estate, it’s a matter of turning a blind eye to staggering losses, says Patrick Chovanec, a professor at Tsinghua University’s School of Economics and Management in Beijing. In an interview last year, he pointed to situations where buildings sit half empty, yet landlords refuse to lower their rental rates. To do so would sink the value of the underlying land, which was used as collateral for the developer’s loans. “The rational response would be to lower the rental asking price, but that would mean the value of the collateral would be lowered and the bank would be forced to write down the loan,” he says. “So the building stays empty. Economically it makes no sense.”
This same scenario is playing out across the country on a massive scale, say experts. Beijing and the World Bank officially claim China’s government debt remains very manageable, at less than 20% of GDP — far below levels in the industrial world — but the truth is, local governments are piling on new debt at a staggering pace. In research last year, Victor Shih, a political economist at Northwestern University, examined the borrowing records of 8,000 local-government entities. He found that at the end of 2009 local governments had taken on US$1.7 trillion in debt, with another US$1.9 trillion in lines of credit available. Coupled with other obligations, Beijing is on the hook for nearly US$6 trillion next year, bringing it to par with GDP — making China seem almost as profligate as America. The trillion-dollar question is: How much of that debt is going to go sour? For his part, Shih has warned of a “wave” of non-performing loans hitting the country in 2012, while in August there were reports the China Banking Regulatory Commission conducted a stress test and found 20% of loans to be in “trouble.” By comparison, a stress test on America’s largest banks in 2009 found that in a worst-case scenario, losses at the 19 banks would hit 9.1% of their loan portfolio, although, admittedly, many believe in reality it was far higher.
The final tally of dud loans in China could be far higher, sparking a financial crisis in the country. Consider the case of New Ordos, a city the government of Inner Mongolia built from scratch in just five years to house 100,000 people. There is plenty of public art and innovative architecture on offer in the city, including a reservoir with an artificial waterfall. The only thing missing is people. Most of the apartments are sold out but remain vacant, since speculators snapped them up as investment properties. The most striking building is the eight-storey library, built to resemble books standing side by side. Inside, however, it’s nearly devoid of books and patrons. On a weekday morning last year, the only people using the computer lab, equipped with 100 new PCs, were two teenage boys playing video games.
New Ordos is far from alone. There are at least a dozen other ghost cities scattered across the country. In November, the government of Hebei said it plans to build three new cities in the region around Beijing over the next few years. In Dongguan, the city where rioting workers killed a factory manager, the New South China Mall lays claim to being the largest mall in the world, yet is bereft of tenants. Likewise, in Beijing, Pangu Plaza, a hotel and mall complex shaped like a dragon and which runs the length of seven football fields, is largely vacant of shops and people.
The list goes on and on. But for how much longer, wonder some China watchers. The rush to build over the past five years has left China drowning in overcapacity in many key sectors. In Liaoning province, the government is spending hundreds of millions of dollars to build five mega-ports over the next couple of years, even though China’s ports are already operating far below capacity. Likewise, according to a report by Pivot Capital Management that analyzed China’s manufacturing capabilities, China continues to build new steel mills, cement factories and aluminum smelters even though up to one-third of existing plants sit idle.
As for China’s ever-expanding network of bullet trains, Chinese media report trains on several of the new lines frequently run with more than half their seats empty. Some worry China’s high-speed rail experiment will lead to a debt crisis, since the mammoth project has already saddled China’s railway ministry with US$150 billion in debt. Over just the next few years that figure is expected to rise to half a trillion dollars.
It is at this point analysts and economists invariably argue none of China’s overspending and debt really matters. All of those empty apartments, unused factories and ghost cities will eventually teem with people as rural Chinese move to the cities and grow rich. The theme of China’s urbanization has become deeply entrenched, with the oft-repeated line that over the next 20 years China will add 350 million people to its urban areas — a migration greater than the entire population of the United States. Yet critics point to flaws in this argument that threaten to stunt rather than fuel China’s growth.
For one thing, China under-counts the number of people already living in urban areas, says Katsenelson. China only considers a region to be urban if it has a population density greater than 1,500 people per sq. km, versus around 500 people in the West. By that measure, Edmonton wouldn’t make the cut. Indeed, some so-called rural villages in China boast steel mills and factories, while one, Beishanmen, near the city of Xi’an, recently erected a 23-storey apartment tower. Katsenelson also argues that since local officials are tasked with meeting specified growth targets on a per capita basis, there’s an incentive to downplay the size of the local population. “There are probably a lot more people living in cities already, but they’re just not in the numbers,” he says. Besides, for the hundreds of millions of rural peasants who have already migrated to cities — supplying factories with an endless supply of cheap labour — life in cities like Shanghai, Beijing or Shenzhen means being treated like second-class citizens, since their access to social services and education for their children is tightly limited.
But above all, China faces a demographic time bomb that’s as bad, if not worse, as the one plaguing Europe. Largely as a result of the country’s one-child policy, instituted in the 1970s, China’s population is aging fast. The number of workers aged 20 to 29 will peak in about four years, then drop sharply over the next 15. At a point in the not distant future, China’s population will actually begin to shrink. All of those factors will curtail the number of people who are likely to move to cities and take up new jobs. “Their labour force is getting old and shrinking,” says Katsenelson. “I don’t think migration is going to be as big a force as people are expecting it to be.”
We’ve seen all this before. Remember that campaign ad about the Chinese professor? Rather than look 20 years in the future to see what China holds in store, the world would be wise to cast its gaze back a couple of decades instead. In the ’80s and ’90s, U.S. newspaper and magazine headlines trilled the rise of an Asian superpower and the decline of America’s influence abroad. That country was Japan, and business leaders couldn’t contain their enthusiasm for Tokyo’s economic miracle. One-time presidential candidate Walter Mondale warned Americans that unless things changed, there would be no future for their children other than to sweep the factory floors between Japanese-made computers.
That’s not at all how things turned out, of course. Japan’s overreliance on cheap exports and debt-fuelled investment backfired. The refusal to acknowledge the bad debts incurred by banks during its property bubble plunged Japan into its “lost decade” and ended talk about Japanese global domination. (Driving home that point, China recently overtook Japan to become the world’s second-largest economy.)
Two decades of stagnation didn’t tip Japanese society into chaos, but if China’s economy goes bust, don’t expect the fallout to be nearly so smooth. “The problem for China is compounded by the fact that, unlike Japan, the vast majority of Chinese have not participated in this boom,” says George Friedman, CEO of Stratfor, a global intelligence company. In simple terms, the Japanese got rich before they got old, but the Chinese will get old before they get rich. “For them, unemployment, especially for those several hundred million who came to the cities to get jobs, is personally catastrophic, so they have a serious problem.”
Many argue China’s US$2 trillion in foreign reserves would protect it from any crisis, but Chovanec points out there have only been two times in modern history when a country accumulated such large reserves — America in the ’20s and Japan in the ’80s. And if history repeats itself, it’s not just going to be their problem. China is inextricably tied into the global economy. What happens there will have far reaching repercussions, especially in countries like Canada and Australia that have supplied China with the raw material to remake itself.
To grasp what a slowdown in China would do to Canada’s economy, it’s worth stepping back a moment to look at how all those Chinese skyscrapers, railway lines and steel mills have reshaped the economic and political landscape here. Last January, Canfor, Canada’s largest lumber company, mothballed its sawmill in Quesnel, B.C. The move came as a result of the collapse of America’s housing market, which evaporated demand for B.C. lumber. Then, several months later Canfor surprised locals by announcing it would bring everyone back to work. Only now the entire output from the mill is loaded onto freighters and shipped to China. The Asian giant may still accounts for only 15% of the province’s lumber exports, but exports to China are up 71% in just one year, and many believe it’s only a matter of time before China, and not the U.S., becomes B.C.’s largest forestry customer.
What’s happened in tiny Quesnel has played out across the country over the past decade on a massive scale. By some estimates, demand from China is behind half the rise in global commodity prices, such as copper, oil, nickel, iron ore, coal and potash — all resources hauled from the Canadian landscape. China has become Canada’s fastest-growing trading partner, and three-quarters of what we now sell to them comes from the ground. This dynamic shielded us from the brunt of the global recession. In 2009, Canada’s exports fell 28% from the year before because of the crisis in the U.S., yet at the same time our exports to China actually rose 7%.
Some have argued the resource sector isn’t all that crucial to Canada’s well-being, since mining and oil and gas extraction directly account for just 4.5% of the economy. But this figure fails to capture the wider influence the commodity boom has had here. While conventional manufacturers in the automotive, steel and textile sectors have struggled, companies building equipment for the energy and mining sectors barely blinked. Banks and investment firms have reaped windfalls from merger and IPO activity in the resource sector, while the boom is lucrative for investors in the domestic market. Meanwhile, China’s boom has spilled into Canada’s real estate market. In Vancouver, according to condo marketer Bob Rennie, between 60% and 80% of all real estate sales in the city’s West Side are now to mainland Chinese, while markets like Calgary and Saskatoon have soared thanks to all the new oil and potash wealth.
In plain terms, should China’s economic miracle turn out to be a mirage, all of that would be at risk. “If China fails, or even if this fixed investment model fails, countries like Australia and Canada are in deep trouble,” says John Lee, a foreign-policy expert at the Hudson Institute who is also a research fellow at the Centre for Independent Studies in Sydney, Australia. For one thing, commodity prices are likely to plunge. That could throw a wrench in plans for the oilsands, which require high oil prices to remain profitable, and crimp much of the manic exploration activity in mining. Canada’s resource sector was one of the primary drivers for employment over the past decade, according to Statistics Canada, so a correction in China would also rob this country of a key engine for job growth. It would also sap provincial and federal governments of needed tax and royalty revenue, hurting their balance sheets.
A slowdown in China would have repercussions far beyond commodity prices. If China’s growth slumps, experts see civil unrest as the likely outcome. China already faces dozens of large-scale “mass incidents” — the government’s term for riots — each year, but they’re largely contained to rural areas. That could change with a prolonged downturn. “At the moment, they have unrest, but it’s in rural areas, not the cities,” says Lee. “The whole strategy of [the Chinese Communist Party] to stay in power is to keep the urban people happy. If growth slows down, they won’t have the means to keep those people happy.” For instance if China’s housing bubble were to collapse, urban property owners would be hard hit. In a recent report the Chinese Academy of Social Sciences argued house prices in 11 cities, including Beijing, Shanghai and Shenzhen are overvalued by between 30% and 50%. The obvious fear within the Chinese government is a repeat of the Tiananmen Square protest and crackdown in 1989. After the incident, it took three years for the economy to fully recover.
But the world is a much more interconnected place than it was even 20 years ago, and China’s role is vastly greater. The International Monetary Fund recently stressed China’s importance to global growth when it updated its growth forecast for the country — at 10.5% in 2010 and 9.6% in 2011. “China’s strong and sustained growth over the past several years has served as a linchpin for global trade, benefiting exporters of commodities and capital goods,” the fund said in a report. Anything hinting of a revolution would undoubtedly shock investors and spark a crisis of confidence among economists who have come to view China as the cornerstone of the economy decades into the future. There’s a reason paranoid officials tried to block Chinese netizens from reading about populist uprisings in Egypt and elsewhere.
Some observers are hopeful the aftershocks of a Chinese economic collapse would be muted. Pettis at Peking University has argued on his blog that a slowdown in Chinese growth “might not be the disaster for the world that many believe.” If China’s massive trade surplus with the rest of the world contracts, that could act as a boost to its trading partners. He argues everything depends on whether China rebalances its economy amid a sharp slowdown by raising interest rates and wages. If that happened, a recession would be borne by state-owned enterprises, and not consumers, he says.
There are also those who insist China’s blistering growth rate is sustainable, saying predictions about the demise of China’s economy are nothing new. And they’re right. It’s been nine years since the book The Coming Collapse of China first hit bookshelves.
But simply because China has twisted and contorted its economy to generate empty growth doesn’t mean its future success is guaranteed. Quite the opposite. China has failed to learn the most important lesson of being a modern, thriving economy, says Chovanec at Tingshua University. “Failure is very important for any economy. To have businesses fail, to have people lose money, to have the stock market and real estate go down, is all really critical, because it teaches people what is a good investment, and what is a waste of resources,” he says. “Unless you have that, then people will think they can put their money into whatever they want, and they’ll always make more money, until the costs get socialized and everybody wonders why everyone in China is so poor.”
Not that you’ll hear frank talk like that from most investment bankers, business consultants or in corner offices in the West. Otherwise ardent free market capitalists, they remain strangely convinced that China’s socialist brain trust is capable of correctly pulling all the levers of its massive economy to keep it on a path to prosperity. Perhaps this isn’t so strange, though. After all, China offers all the elements of Wall Street’s most cherished commodity — the investment story. Such a narrative must be easily packaged, sold and resold — think dot-coms, U.S. real estate or green energy — and China offers angles. As with all investment stories, critics pointing out the risks are easily dismissed, until it’s too late.
With files from April Rabkin