Sean O'Grady: China's growth has shaky foundations

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Imagine you own a thriving shop. You offer the best prices. People travel miles to buy your wares, and you've been making substantial profits. You have one customer in particular who is extremely reliable. Problem is, for some years you have had to lend him the money to buy stuff from the shop, usually out of the profits you make from him. He's happy to borrow, and you're content to hold on to his IOUs because he's never reneged on a debt. But lately your best punter has been getting some gip at home. Some family members are worried that they owe too much to the shopkeeper, and wonder whether he is being manipulative. Deep down, you, the shopkeeper, begin to doubt the wisdom of holding all those IOU's.

That, in case, you haven't guessed it, is a small-town version of the economic relationship between China and the US. The "G2" have been conspiring in this lop-sided defiance of economic gravity for a decade, and you do wonder how long this, the greatest of the "global imbalances", can persist. And if you wonder about that then you're half way to becoming a "sino-sceptic".

Sino-scepticism is something of a minority interest, less fashionable than Euro-scepticism, but the case for it is strong. This week's hype about the Chinese economy overtaking Japan now, and America by 2020, is just that. It is based on the extrapolation of trends that are unsustainable. China's growth has been based on an export boom; a real-estate bubble; low costs and the driving will of the Beijing government. All are shaky.

How, and when, China's exports to the West will stutter is unpredictable. If we are lucky it will come from a market correction: pressure, political and financial, that will push the renminbi higher; a reduced US capacity and willingness to borrow and consume; rising Chinese costs. If we are unlucky the adjustment will arrive via trade barriers erected by nervous US politicians. If we are still less fortunate, the Chinese will dump their US Treasury paper and trigger an unprecedented dollar crisis.

The more immediate danger for China is its tottering property market, with house prices up by 50 per cent plus a year in the big cities, maybe more. We know that when bubbles burst they have a habit of doing so in spectacular style. The Chinese one promises to be quite a fireworks show, with unknowable – but probably massive – damage being inflicted on her financial sector, household wealth and public finances, in classic post-bubble style. We have seen the damage the bursting of the American real estate bubble inflicted; the Chinese version may be no less momentous. Panic beckons.

Third, China has so many distortions and eccentricities built into its system that any kind of adjustment to external or internal shocks is tricky, because market mechanisms and price signals are not allowed to operate smoothly. There is vast over-investment, often on state-sponsored "prestige" infrastructure and property projects, often accompanied by cronyism in typical East Asian fashion. This was the very combination that plunged the smaller tigers such as Thailand and South Korea into a slump in 1998. The Chinese have better foreign exchange reserves, but foreign investment will flow out just as rapidly as it gushed in if there's an upset. Say an Israeli bombing raid on Iran pushed the price of a barrel of oil to $250. China's notoriously energy-inefficient industries would be even less able to deal with that than their American, European or Japanese counterparts. The current commodity spikes – caused in part by Chinese demand for everything from copper to pork bellies – are looking ominous. At best they are an in-built stabiliser to prevent China overheating; at worst they will push China into stagnation. Even now China's low cost advantage is being eaten away by the likes of Vietnam, Bangladesh and Indonesia.

In all events Beijing seems unwilling to deal decisively with her imbalances and other challenges. Nowhere is that more true than in the Chinese leadership's indulgence of Kim Jong-Il, a one-man threat to everything. At home, workers rights', as we saw in the recent wave of strikes, are somewhat underdeveloped, while free debate and even web access is constrained. The fact is, and clichéd as it is, free markets rarely co-exist alongside political repression.

Twenty years ago Japan's phenomenal export-driven economy seemed set to overtake the US, and the land in the emperor's' garden in Tokyo was worth more than the state of California. Breathless films and books predicted Americans would become little more than Japanese serfs. Well, that bubble burst and no one talks now about the 21st century belonging to Japan as the 20th did to America or the 19th to Britain. I'm sceptical about it belonging to China.

Persistently failing investments (PFI)

We're all in this together, they say. That must mean the private companies that have made such handsome profits from the private finance initiative as well. The precise extent to which they have benefited from PFI is yet to be estimated properly, but a BBC investigation has revealed that in the NHS PFI schemes worth £11bn in the way of new investment will in due course drain £65bn from the NHS, swallowing a tenth of the turnover of many trusts.

Energetic new Tory MP Jesse Norman is campaigning for a "PFI Rebate". After all, the PFI firms receive typically 8 to 10 per cent in taxpayer-guaranteed annual returns. But a tiny reduction in interest charges paid to contractors by NHS hospitals of just 0.02 or 0.03 per cent could save £200m. Taken across all existing PFI contracts even this modest rebate could save £500m to £1bn. It could easily be much more.

Of course we cannot just rip up PFI contracts, much as we might like to; but the sheer scale of the business the state puts the companies' way should be incentive enough for them to come up with a voluntary rebate. Mr Norman's imaginative financial initiative deserves to be taken seriously by the Treasury.

For further reading

'Signed Projects List' – HM Treasury: