What if China stumbles?

Economic storm clouds continue to form around the world. The problems in Europe threaten not only Europe, but the global economy too. Even the countries that weathered the 2008 crisis relatively easily, such as Brazil and China, are now developing symptoms of economic distress. After teaching and traveling in some of the major cities in China for several months, I come away with a more pessimistic outlook about this country’s future than most of the Chinese people I have talked to. If my pessimism is borne out, the effects could be very serious for China and the rest of the world. However, there are some things the US could do now to avert a possible catastrophe. 

A quick visit to China’s most vibrant cities like Shanghai, Beijing and Shenzhen suggests a country that is jumping ahead of the rest of the world. Arrive at their newly designed airport terminals, ride their clean and efficient subway systems, gaze up at hundreds of modern skyscrapers, travel on their high-speed trains at over 300km per hour (Beijing to Shanghai -1300km – in just over 4.5 hours), walk through the shopping malls filled with Gucci, Chanel and Louis Vuitton stores, choose from a growing assortment of tony restaurants and stay at one of the hundreds of 5-star hotels, and it is easy to see why so many first-time visitors to China come away with a sense that China is poised to take over the world. 

However, these obvious displays of the progress that China has made over the past 30 years belie a very different experience hidden beneath the shiny surface.  

In the wake of the world financial crisis in 2008, China maintained its high growth largely by expansive government support for infrastructure projects. As a result investment spending in China has recently approached 50% of its GDP (this compares with about 15% on average in the US). Much of that investment has been in the form of apartment buildings sprouting up across cities throughout the country. This has contributed to a real estate bubble that is beginning to burst. Other investment has been channeled through the state-controlled banking system to build capacity within state-owned enterprises. While this investment keeps China’s GDP growing at a heady pace, it is not an approach that can be maintained forever. For government-directed investment to work as a long-term strategy, the investments must yield a return eventually, and this is the rub.

Travelling between cities in China, one will see numerous newly built 20-30 story apartment buildings, many constructed as complexes with several similar buildings side-by side. During the daytime one can marvel at the rapid progress. But at night one will notice something strange – the buildings have very few lights on. Many have none at all as they are completely unoccupied. People in China say it is very common for buildings to have several vacant flats. People buy them hoping to ride their investment to higher future values, but don’t rent them out because current prices fetch no renters. As a result there is enormous excess capacity in the property market at the current price levels. Some experts say that one-quarter of all housing is unoccupied in China. The only way to clear this capacity is either to wait, a very long time, for the economy to catch up, or for prices to plummet. At some point soon, if not already, the realization should set in that it does not make sense to build even more unoccupied apartment buildings.

I suspect a similar excess capacity is developing in the industrial sector as well, especially since the government has been pushing loans out the door to keep GDP growing. Those investments will pay off only if demand for the companies’ final products grows sufficiently fast. However, with stagnating demand for goods and services from Europe and the rest of the world, Chinese businesses are struggling. I spoke with someone who works for a company that supplies intermediate inputs to private businesses in China in a wide range of sectors. This company hasn’t made a profit in over six months. Numerous manufacturing sectors are cutting back as they face the drop in world demand for their products. (Exports in July rose only 1% compared to 11% the month before.) At some point soon, if not already, the realization should set in that it does not make sense to expand factories even more if market demand is not there.  

In the best-case scenario, a significant economic downturn will be averted in China in the next few years. Most people I talked with in China expect that the Chinese government will prevent a serious economic crisis. If China’s downturn is mild, there is little to worry about in the US. Even if China continues to expand at breakneck speed, it cannot and will not become a dominant economic power anytime soon. Many impediments prevail, including China’s inefficient state-owned enterprises, its tightly controlled banking sector, its archaic legal system, its problems with local corruption, and its non-convertible currency. A significant improvement in these conditions is decades away and so there should be few fears that China will soon catch up and dominate the Western countries economically. 

Militarily the story is similar (though I am no expert here). Although the Chinese are eager to improve their military technological capacities, and are taking steps to do so, they are a long way away from duplicating US capabilities. Only note that China launched its first aircraft carrier this year – and that was a refurbished Russian model. Another refurbished aircraft carrier was inaugurated last year – as a hotel. The US by comparison has eleven active carriers with three more under construction. 

Despite these obvious realities, Chinese fear mongering has become a popular activity in the US. What most people don’t realize though is that the threat from China becomes greater when their economy worsens.

Most China observers, and the Chinese themselves, recognize that the first priority of the Communist Party in China is the preservation of the Communist Party. If there were a significant downturn in the Chinese economy however, it may seriously threaten the Chinese peoples’ faith in the Party and this could in turn lead to political instability. Many times in history we have seen regimes, whose existence is threatened by a loss of confidence from their own people, attempt to deflect criticism by creating an external enemy. Nationalism is a powerful political antidote for destabilizing domestic troubles.This tendency is not unique to China or to Communist regimes. US politicians have already begun to do the same thing by blaming China for many of the US economic problems, including the persistently high unemployment rate. China, in turn, responds tit-for-tat to every unfair trade charge the US makes against them.

In times of growing economic prosperity, these kinds of charges and counter-charges are innocuous. However, when economic conditions get tough, these spats can quickly get out of control.

Currently there is growing tension in the South China Sea. This summer, China has taken control of several disputed islands in the region to the dismay of the Philippines and Vietnam. The US calls for a peaceful and negotiated settlement of these disputes, but at the same time is slowly ramping up its military presence in the Asia-Pacific region much to the dismay of China. This kind of situation could easily erupt into unnecessary hostilities, which become more likely if economic troubles at home continue to grow.

As an American, traveling in China is wonderful because the Chinese people love Americans. A person couldn’t ask for more hospitality and kindness. But that goodwill could change on a dime if America is portrayed as contributing to China’s decline. There is a very strong nationalism in China that could also be disrupted if conditions are right. Already, the Chinese press is sharply criticizing America’s growing presence in Asia. 

The safest US response to difficult times ahead is simple: stop portraying China as a villain. Here are a couple suggestions. First, work China into the Trans-Pacific Partnership discussions. A failure to do so either means the US is not fully committed to the principles of rising prosperity through trade, or the US really is working with other countries in the region to put China at a disadvantage. A second simple fix is to stop blaming cheap Chinese products, intellectual property infringements, and China’s undervalued currency for US economic problems. Of course, there are bilateral issues at play, but these should be worked out in a cooperative manner not in a confrontational way. America is not stronger because it talks tough to China, as some US politicians seem to think. America will remain strong only by maintaining its unparalleled military capacities but also by looking internally and focusing attention on its own economic challenges.