What is the problem with Chinese Economy?

An economist is an expert who will know tomorrow why the things he predicted yesterday didn't happen today. I don’t remember who said this but the more I remember what our economists are saying every time there is some change in Economic data…I find the above sadly true. They are the most confusing people.

Just see when Oil was high, they were saying india was in trouble as it would lead to costly imports due to rupee fall, high inflation then low growth, low growth to low employment and so more rupee devaluation. And now when oil is down to the brink, they are saying it is indicative of low global growth, low Chinese demand, low growth in oil producers which will lead to low demand for products by them so it may lead to global de growth including india due to low exports as low exports means low consumption by exporters in india so again degrowth.

When China was devaluating its Yuan for competing in exports to USA, USA was crying that it was making its people unemployed. Now when China has devalued it more after a prolonged period of stable Yuan, they are fearing that it is a sign of problems with Chinese growth and so it may hamper USA exports to china…and so USA and global stocks are falling.

Come on guys…please hang on…I mean please let people take breath.

Let’s see like a common man what is happening behind this complex game. Let us take China for making it real. China exports 1000 bucks goods and imports for 1500 bucks. So in order to pay for extra import of 500/- china needs to have currency acceptable to the other country which is Dollar. So china can borrow that 500 dollar for paying hoping that in the future it will pay with more exports. Or China can attract Foreign investors to invest money in China and by doing so it can use dollars brought in by FDI people to pay its net imports. Here the game is opposite, China is an export surplus economy, means it is having 500/- excess dollars with it after paying for imports. Now add to these 500/- the other 1000 dollars brought in by FDI people for making factories mainly for global exports as China makes goods cheap. All this is resulting china with huge dollar reserves (around $ 3 trillion now).

But there is one problem with this model. You are becoming reliant on others for your earnings and competing against fierce competitors. Any change in demand could be drastic for your economy where only exporters are becoming rich; labor is getting very low wage the only factor making your product cheap. So China forayed into other destination, Investments. It invested huge amounts in building infrastructure, real estate, bridges, Trains….all this at a gigantic scale. This provided employment to the people, more money as rising demand for labor raised the labor rates.

There is nothing wrong with it. It is the best policy for promoting innovation and growth.  Although Classical economists like Keynes were not in favor of investments or savings; they were the supporters of consumption. Do not save but consume as more consumption means more employment and more growth. I will come to this consumption theory later on as I am a firm non believer of this.

First let me explain some myths about china. First myth which is making us nervous all this time is that China is an export oriented economy so any global slowdown will kill Chinese economy with non availability of financial resources. Net exports are just around 5% of total Chinese GDP. Finding hard to believe. But this is true. Actually there are terms which confuse us to believe otherwise like Gross exports are around 30% of Chinese GDP. Ok this is also true…but we are comparing an Apple with a Mango. GDP is a value added thing, but gross exports mean total value of exports…so we are comparing gross with net. China exports mostly those goods which are manufactured with imported goods. Like China imports raw Granite from india and after cutting it, processing and polishing it exports it globally. So gross value of this may be 150 but after deducting raw granite imports of 100, net exports are just 50/- . 

So Chinese growth story is surprisingly internal. Also if we take into account the fact that some of the goods imported by china are not used for exporting but for domestic consumption/production, then the net share of exports will rise from 5% to 7-8%. I am just using this to show that we can use these figures anyway we want. But having knowledge of their working will help us in making decisions.

Some economists are of the view to reduce those domestic inputs also from exports which are used for manufacturing products for exports along with imported raw or intermediate products. Like for exporting shoes, china may be importing leather from india but they are using locally produced rubber soles. If export value of shoe is 150, cost of leather is 100 and sole is 20. They say that value added by export is 30, so net export is 30. But this is where I differ from them and this is the area which may be causing problems to Chinese now.

I feel that this extra sole is produced only for Export purpose. Had it not been used for export shoe, it would not have been produced at all. So this rubber sole also represents the export economy sector. It should not be counted as internal.  I am having no statistics with me for this but we can safely assume that this can take the net exports to 12-15% which is now taking the shape of something material.

Chinese exports are very different as they mostly use intermediate imports. This value addition thing is a great source of income for china. It is quite safer than countries like Brazil, Australia or Canada which are based on export of natural resources or commodities and any fall in the prices of these can create havoc in their economies. China is a value added exporter with so many other intermediary goods supplier countries as partners. Although it is also prone to competition but the sheer scale of its production capabilities make it a potent force.

But if there is a global slowdown and demand falls then there is a danger to it. But this danger is lesser than what we thought initially and this danger has nothing to do with any mistake by china. However it can make itself safer by building capacities for virtually recession free goods than discretionary goods.

Now to the investment part. Investment is always good but if it is deployed in productive resources. Like Chinese Govt can make an investment for making a temple in a poor unconnected village thinking that it will provide employment to the villagers. But is this investment fruitful? No. Now compare this to a situation if they build a road from village to city and a small warehouse for storing agriculture produce. It will result in lower wastages of products and quick supply of those to cities at high rates. It will make village grow.

Also there is always a marginal productivity limit to an investment. More investments after a certain level result in lower incremental production. And even more investments after that limit make that particular investment as wasted. Like making two parallel roads from village to city; one road is wastage of resources. China has really wasted enormous resources on building excessive infrastructure in chasing growth. But this is not the fallacy of Investment model but wrong or wasted investments.

By providing cheaper finances to real estate builders, it is sitting on a huge unsold inventory of real estate. So now as china has realized its mistakes, so it is not expanding that much on building excess roads, train tracks, houses, bridges etc. So demand for steel, cement, paint and oil has come down big time; making the supplier of these quiver. So prices of these commodities will come down more; but more demand by countries like India and Africa will give these some supports.

Although countries which have built substantial capacities for steel, cement etc on the basis of Chinese demand are themselves to blame. But again we are finding ourselves at the doors of economists of these countries who failed to understand the fallacy of wasted investment Chinese model. Here I remember india Power sector giant, Tata power who placed the lower bids for its 4000 MW mega power plant at Mundra, Gujarat on the basis of cheap Indonesian coal thinking prices would remain lower. But Indonesian Govt raised the prices of coal meant for export and it made Mundra plant Powerless. Kudos to these planners.  World over global Shipping lines went mad for acquiring more ships for fulfilling demand for huge Chinese  imports of raw material and they are crying for last 5-6 years.

So after starting correcting this investment cycle, China focused on another growth vertical, Consumption. Chinese people were saving in excess; around 25% of their earning, to meet their future plans for house, education etc as financing for these were very less. Bank rates were low due to Govt focus on promoting investment cycle. So that money was just getting wasted; plus consumption of goods by people were very low. Chinese consumption share in total GDP is just 35%, USA is at 71%. China is lower but USA is excess. Anything near 50% is good. Because unless people consume more, investments made will not bear fruit. But this is where there is huge confusion; what is the right consumption, there is a huge debate on this.

To best understand this debate of Investment or consumption for development, let’s take the case of an isolated individual on a deserted island just like Robinson Crusoe. So Crusoe on his deserted island can produce fish and fruits for his consumption. If production is easy then he can arrange for fish and fruits for 2-3 days on a single day. Since he can’t turn his excess produce into savings in the from of money by selling these to others. So his savings will be in the form of surplus time left with him of two days. Then he’ll have two options to use his savings (time), first he can indulge in consuming his surplus produce alongwith enjoying sightseeing of the island (Leisure) or can use spare time to harness his production skills by weaving baskets or nets for catching fish or trying to learn agriculture (Research) to produce fruits on his own or he can make clothes/shelter for himself or can produce (Fish and fruits) further more.

As we can see, consuming his excess produce will lead him to nowhere near to growth infact it will diminish his wealth. The time he spends on producing (accumulating more fruits and fishing) increases his wealth but the time he spends on improving his skills or tools (Like an Axe for cutting wood for shelter and fire) increases his wealth even more.

And if one more person joins him, then he can lend his saving (excess fruits and Fish) to him who in return will indulge in making tools for better and more production or for easy and safe life. So return for Crusoe for his saving that he lends to him will be in the form of tools for extra and easy production.

So as we can see that it is investment of savings not consumption into production and research that leads to increased productivity and development. When people save more, it leads to fall in the interest rate which motivates entrepreneurs to borrow to invest into productive resources.

Excess consumption only leads to inflation with high interest rates which further aggravate the situation because due to high consumption and less savings little money is left for investing into increasing production and recession bites.

Conclusion

So I feel this Chinese fall story is over reacted by market forces. In fact china is trying to achieve much comprehensive growth which is inclusive of Exports, Investments and consumption; and so it is doing what is good for it. This may cause some short term problems to commodities suppliers like Brazil, Australia but even they can adjust as mining does not require huge capital. For others there may be a short term war like we are seeing in Oil where nobody is retreating. This will eventually lead to the oust of the weaker.

But global economy is much more complex now as all the countries are interdependent, so complete fall of the other will also leave me alone in the game. USA, the global anchor, is in much better shape. India is also growing strong. One cannot ignore the power of demand of goods from people from china and India; they are a strong force of 2.6-2.7 billions.

This post is an attempt to understand the brief working of Chinese economy and the ways Chinese are trying to have inclusive all round growth. But there is another part of this story…the currency war…more on this later.