Pudong: How long can this go on?

Pudong: How long can this go on? Photo: AFP

In the last of a three-part series, Satyajit Das asks, where to now for China.

CHINA'S economic model is reminiscent of 17th century mercantilist policies.

Thomas Mun, a director of the East India Company wrote in 1664 that the purpose of trade was to export more than you imported. At the same time, a country should amass foreign ''treasure'' that would be the basis of acquiring foreign colonies, thus gaining control of essential natural resources. The strategy required reducing domestic consumption and imports, while also reducing the export of goods manufactured with imported foreign raw materials. China's strategy coincides almost entirely with Mun's views.

Part 1: The China Syndrome and the crisis
Part 2: Dragon's easy credit inflates bubble

And yet, the Chinese economic model may be unsustainable. It relies on global trade and investment (much of it export related), which together contribute a high proportion of China's gross domestic product (GDP). This trade entails importing foreign components that are then assembled and exported. Domestic consumption has been kept low. Treasure has been built up in the form of domestic savings and trade surpluses.

Recently, China announced that its $2 trillion treasure would be used to make foreign acquisitions to secure exclusive access to raw materials. The problem is that China's treasure is already invested in assets of dubious value and limited liquidity to finance global consumption.

Chinese Premier Wen Jiabao warned that Chinese growth was becoming ''unstable, unbalanced, unco-ordinated and ultimately unsustainable''. That was two years ago! Currently, China may be aggravating the problems by a huge liquidity-driven stimulus to perpetuate a failed strategy.

There is broad agreement that a key component of the global financial crisis (GFC) was the problem of global capital imbalances. A central feature was debt-funded consumption by the US that allowed 5 per cent of the global population to constitute 25 per cent of its GDP, 15 per cent of consumption and 48 per cent of the global current account deficit.

Any lasting solution to the GFC requires that this imbalance be rectified. The glib solution would ask the US to save more and consume less and the savers to save less and consume more. The problems in implementing the solution are considerable.

On the one hand, America needs the Chinese to continue to buy US Government debt to finance its fiscal stimulus and bail-outs. On the other hand, America needs China to cut its current account surplus, boost government spending, encourage personal consumption and reduce savings. All this should also occur, ideally, without any major decline in the value of the dollar or US Treasury bonds or the need for China to liberalise its currency and allow internationalisation of the yuan.

A cursory look at the respective economies shows the magnitude of the task. Consumption's contribution to GDP in the US is 71 per cent; in China it is 37 per cent. Given that the GDP of China is about $4-5 trillion - versus $15 trillion for the US - and average income in China is about 10-15 per cent of US earnings, the difficulty of using Chinese consumption to drive the global economy becomes apparent.

Over the past 25 years, Chinese savings have risen and exports have driven growth. Given that a large portion of exports is sold ultimately to American and European buyers, lower global growth and declining consumption creates big challenges for China. However, dealing with the global imbalance has not been a high priority at the various summits global leaders have shuttled to and from lately.

In March 2009, in advance of a schedule G20 meeting, the Chinese central bank proposed replacing the US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund. In an essay posted on the People's Bank of China's website, Zhou Xiaochuan, the central bank's governor, argued in favour of creating a reserve currency ''disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies''.

Zhou wrote: ''The outbreak of the [current] crisis and its slipover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system.''

The US predictably dismissed the proposal. The Wall Street Journal argued: ''For all its faults, the dollar is attractive as a reserve currency because it is the common language of global finance and trade. In other words, its appeal is proportionate to how many other market players use it. For decades, the dollar has been a convenient medium of exchange for everyone from a central bank seeking to buy US Treasury bonds to a business exporting commodities from Latin America to Asia.'' The difficulties the US would face if it were forced to finance itself in a currency it could not control hardly seemed worth mentioning.

China's problems, to a degree, mirror earlier problems of Japan, its neighbour and competitor for global influence.

Japan's export-driven model generated average growth of 10 per cent in the 1960s, 5 per cent in the 1970s and 4 per cent in the 1980s. This growth was driven by several factors, including an artificially low yen exchange rate.

In 1985, Japan, the US, Britain, Germany and France signed the Plaza Accord, in which they agreed to depreciate the dollar in relation to the yen and the mark by intervention in currency markets. The accord had limited success in reducing the US trade deficit or helping the American economy out of recession.

The Plaza Accord signalled Japan's emergence as an important participant in the international monetary system and global economy. But the effects on the Japanese economy were disastrous.

The stronger yen triggered a recession in Japan's export-dependent economy. In an effort to restart the economy, Japan pursued expansionary monetary policies that led to the Japanese asset price bubble that then collapsed in 1989. Economic growth fell sharply and Japan entered an extended period of lower growth and recession, generally referred to as ''The Lost Decade''.

In the 1990s, Japan ran huge budget deficits to finance large public works programs in a largely unsuccessful attempt to stimulate growth. Only structural reforms in the late 1990s and early 2000s restored modest rates of growth. Japan's public debt is approaching 200 per cent of GDP.

China can try to continue its existing economic strategy, but this looks increasingly difficult. However, changing its economic model may mean a slower rate of growth. China's challenge will be to learn from the problems and avoid the fate of Japan.

The trade-off between economic and political liberalisation may also prove problematic. As Fang Li, a renowned astro-physicist often called China's Andrei Sakharov, remarks in dissident author Ma Jian's novel about China, Beijing Coma: ''Without a democratic political system in place, [China's] economy will eventually flounder. The people's wealth will be eaten up by the corrupt institutions of this one-party state.''

There is an apocryphal story about John Howard, then prime minister, drawing back the curtain of his hotel room to be stunned by the futuristic skyline of Shanghai's Pudong financial district. ''How long has this being going on?'' he asked. Today, the question might be: ''How long can this go on?''

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.