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Hold the Champagne on China’s Economy

Thursday, October 22, 2009

Those who witnessed Japan's spectacular rise and fall in the 1980s should get a familiar feeling watching China these days.

This month in Hong Kong, a single bottle of wine sold at auction for $93,000 to a Chinese buyer. No matter how good the vintage, that's not something to pop a cork over and celebrate. Those who witnessed Japan's spectacular rise and fall in the 1980s should be getting a familiar feeling watching China these days. In the eyes of the media and much of the world, China's decades of double-digit growth, military modernization, 2008 Olympics hosting, and picture-perfect celebration of the 60th anniversary of the 1949 Communist victory have raised the People's Republic of China to the top rank of global powers.

Yet unsettling questions about the social effects of this stunning climb are also abundant. Of particular concern is an emerging asset bubble, noted by The Economist and Bloomberg, among others. Fueled by an undervalued yuan and disguised by non-transparent accounting practices, its growth highlights the unequal distribution of economic gains in China and raises doubts about the sustainability of current consumption patterns among the newly wealthy. Many observers have ignored some troubling pieces of evidence, and indeed, most have heralded China for being the first major economy to pull out of the current global economic crisis. Yet looking at the underside of growth leads one to consider that China may be headed for a crash similar to Japan's if certain trends continue. That would be devastating not merely for China, but also for a global economy just beginning recovery.

Observers have long noted with concern the growing income gap in China; disposable income in rural areas lag urban centers by 70 percent, according to some studies.

Questions abound over how efficiently resources are allocated in China, particularly those by wealthy individuals and private companies. Observers have long noted with concern the growing income gap between the affluent coastal belt and the poverty-stricken interior, where disposable incomes in rural areas lag urban centers by 70 percent, according to some studies. Yet the economic haves are not simply outstripping the have-nots; they are increasingly profligate and wasteful. China's new millionaires numbered nearly half a million before the economic crisis last year, putting the country in the number five spot globally. BusinessWeek spotlighted a number of these plutocrats several years ago, some of whom live in 22,000-square-foot mansions and wear $50,000 watches. Rolls Royce and Bentley sell thousands of cars each year in China, as well (the massive carbon footprints of which, along with the giant mansions, Western pundits routinely ignore). Builders have transformed China's urban skylines over the past two decades, yet overbuilding  has led to increased vacancies and heavy debt holdings, and vacancies in major cities have risen by double digits in the past year. While policy makers in Beijing have managed the country's macro-development better and for longer than most observers would have imagined, the structure may be under increasing strain, precisely from its success.

Banks in China undoubtedly have bad loans, shielded by non-transparent accounting practices, and as wealthy individuals and producers over-leverage themselves, the pieces are in place for a very bumpy road ahead.

If a crash comes to China, it may come from the madness of affluent crowds. The danger is primarily social, in the form of unsustainable consumption patterns that will play out in the economy. Conspicuous consumption is spreading through the upper levels of Chinese society. That nearly $100,000 bottle of Chateau Petrus Imperial was sold in the world's largest wine market, Hong Kong. Similarly, Chinese collectors fueled a nearly $24-million sale of "modest pieces" of Chinese art at Christie's in New York in September, according to the New York Times, consistently paying between five and ten times the expected amounts. And Chinese buyers are just getting started, it seems.

A similar tale of excess unfolded in Japan in the 1980s. When land prices skyrocketed, paper profits followed, leading to ever-easier borrowing of money for both individuals and corporations. At the height of the bubble, the land under the Imperial Palace in central Tokyo was worth more than the entire state of California. Japanese investors bought up trophy properties around the globe, such as Rockefeller Center and Pebble Beach, for highly inflated prices, and one investor paid $40 million for Vincent Van Gogh's "Sunflowers." Japanese officials and business leaders believed in their infallibility, publicly deriding American society.

Back in the 1980s, Japanese companies were assumed to have discovered the secret to hyper-efficient production and thus endless profits, while the country's bureaucrats were lauded as perfect macro-planners.

Just like today with China, pundits, investors, and the media largely proclaimed that the Japanese party would go on forever. Today, the sophisticated management of the Chinese government is offered as proof that China will always experience growth (or if contraction, a soft landing). Back in the 1980s, Japanese companies were assumed to have discovered the secret to hyper-efficient production and thus endless profits, while the country's bureaucrats were lauded as perfect macro-planners. Inefficiencies, protected industries, poor management, and a sclerotic bureaucracy were all ignored by those who wanted to believe the hype. Yet such weaknesses were exacerbated by a culture of excess that destroyed consumer reality. Once it took root in Japan, expectations changed permanently and traditional restraint was abandoned. The savings rate dropped, and people paid exorbitant amounts for new houses and cars. I remember watching as whole parties in Tokyo restaurants walked away from tables full of food that was ordered and then left to be thrown away. The economics fed and then followed the social disease. Eventually, the asset bubble burst and the whole edifice came crashing down.

This is the larger danger in China's future, except that it might be even more destabilizing to a country that has such uneven economic growth. To control it, the Chinese Communist Party will have to clamp down on the very economic exuberance that has driven the country forward. Failing to rein it in, however, could prove devastating, especially in a society whose majority remains poor and hostile to the authorities. In flush economic times in 2004 alone, Chinese authorities put down nearly 70,000 riots in the hinterland. But today's spending binge may lead to deeper resentment against the wealthy, while spillover effects from an economic crash could set the countryside on fire. China has seen enough social revolution in its history that no one should rule it out again, especially if fallout from a collapse of the new rich hurts the countryside.

Added to these domestic reverberations would be a dramatic slowing of the global economy, should China's economic growth derail. Beijing would almost certainly limit if not stop its purchase of U.S. debt, driving interest rates in America sky high, while consumers might be hammered by cheap export goods drying up due to the financial distress of Chinese manufacturers; already tens of thousands of factories have closed due to the current economic crisis, disproportionately affecting lower-wage earners in China. Banks in China undoubtedly have bad loans, shielded by non-transparent accounting practices, and as wealthy individuals and producers over-leverage themselves, the pieces are in place for a very bumpy road ahead.

There's no way to predict if or when China's system becomes a house of cards, but if the world's auction houses continue to crow over massive Chinese purchases, then being a contrarian may be the smartest move of all.

Michael Auslin is a resident scholar at the American Enterprise Institute.

FURTHER READING: Auslin also wrote “These Fighter Numbers Don’t Add Up” on congressional funding of America’s most advanced fighter aircraft.

Image by Darren Wamboldt/Bergman Group.

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