China can’t lead global recovery

Andrew Michael Teo

Magnus Bocker, CEO of Singapore Exchange, rings the opening bell at NASDAQ

Happier times: Magnus Bocker, CEO of Singapore Exchange, rings the opening bell at NASDAQ

Last year, I mentioned in an article “Green Shoots of Fresh Weeds” that the last recession would lead the global economy into the final phase of the “Inverted Square Root” – shaped recession if policy makers failed to “embrace a brand new economic model and a new way of thinking about how the modern global economy works”. I had also mentioned that should another recession occur, much of those economic tools that were used by global governments in the last recession will no longer be deemed as serious options. In fact, since the last recession, global governments lack the necessary tools to significantly increase businesses and households spending.

The 2008 Financial Crisis

While the last recession in 2008 was ignited by credit crunch resulting in governments around the world easing monetary policies to stimulate their respective economies and ensuring liquidity in the financial markets, this forthcoming recession, if any, and in my opinion, is certainly the aftermath of those monetary and fiscal policies adopted by policy makers – too much debts incurred by the government that needs to be repaid.

Since the last recession, global governments, despite pursuing loose monetary policies, have not only been unable to stimulate their economies but were also gradually losing the confidence of business and financial communities. Consumer confidence has also been negatively affected and is at its lowest. And that, in turn, has caused a sharp reduction in business spending and investing, thus causing a vicious cycle that leads to high unemployment and sluggish growth.

Financial institutions and consumers alike, had feasted on cheap credit in the run-up to the last financial crisis. When the bubble burst, the resulting crash diet of deleveraging caused a massive recessionary shock. However, this time round the problem is exactly the opposite. The economic doldrums are prompting corporate and consumers to hoard their cash and to avoid debt resulting in anemic consumption and investment growth.

The 2008 financial meltdown had a simple solution: Governments had to step in to provide liquidity in droves through lower interest rates, banks bailouts and injection of cash into the economy. Although these policies eventually succeeded in avoiding a Global Depression, it did not come cheap as governments worldwide poured around more than US$ 1 trillion into the system, it was not fair for the tax paying citizens to pick up the bill for other people’s sins.

No confidence in governments

However, digging deeper into the present turmoil, one would realized that the present strains are not caused by a lack of liquidity. The root issue is a chronic lack of confidence in their governments’ ability to kick-start economic activities and growth productively. Pumping more money into an economy that is already flushed with liquidity does not solve the present issues.

As most economies looked to the United States for signs of recovery, in reality and economically speaking, the United States is very much weaker than it was at the outset of the last recession in December 2007 which most governments had thought to have recovered in 2010. However, growth had been very weak that almost no ground has been recouped. Most measures of economic health, including employment, income, industrial production and productivity are worse today than they were before the last recession.

During the last recession, most policy makers had used most of the economic tools at their disposal leaving few options available to combat this forthcoming recession – if any.

To make matter worse, anxieties and uncertainties have increased since the decision by S&P to downgrade the United States’ credit rating and with further warning of another downgrade in the next 3 months pending the proposed long term deficit reduction plan to be undertaken by the Obama Administration for the increment in the United States debt-ceiling. Europe, on the other hand, continues with its desperate attempt to stem its sovereign debt crisis.

In the last 4 years since the recession began, the civilian working population in the United States has grown by almost 3%. If the economy had been healthy, the number of jobs created would have grown by the same amount. However, this has not been the case. Today, the economy has at least 5% lesser jobs than it had before the last recession began. The unemployment rate then was 5%, compared with 9.1% today. And with threats of more jobs cutting across industries, the unemployment rate looks set to climb even higher in the weeks ahead.

With fewer jobs, there is less income for households to spend, creating a huge obstacle for a consumer-driven economy. Consumer spending usually drives an economy to recovery. But with a weak income, spending is only barely where it was when the recession began. If the economy had been healthy, total consumer spending would be higher because of population growth.

Of all major economic indicators that are used by government worldwide to gauge their economic growth, the Index of Industrial Production is by far the worst off. Below are Singapore’s Index of Industrial Production & Labour Productivity tables for illustration.

From the above tables, we can clearly see that our Industrial Production and Labour Productivity have been declining steadily since the 4th quarter of 2010 and moving into negative territory in second quarter of 2011. This is an indication of slow growth and productivity, which if continues, will allow Singapore’s economy to slip into a recession.

China to lead global recovery?

With Europe trying desperately to solve its sovereign debt crisis, and the Americans fighting hard to keep their economy going, all eyes are now turned to China for help. However, little did one realize that though China may seem to be another economic giant, she has a deeper problem than she would like to admit publicly?

In the wake of the last recession, China’s local and regional government had gone on an infrastructure building spree that saw them racking up huge debts, usually channeled through “special-purpose” financing vehicles that allow them to get around the laws that require them to keep balanced budgets.

Various parts of the Chinese government have different estimates of the total size of local government debt, but one of the more authoritative figures puts it at about 37 per cent of GDP at the end of last year, according to the GaveKal-Dragonomics economic research firm. By including a range of other liabilities that Beijing is explicitly or implicitly on the hook for – such as ballooning debt at the railway ministry, bonds issued by so-called policy banks that lend on behalf of the state, and bad debts in the state-owned banking system.

GaveKal-Dragonomics estimates that China’s real debt-to-GDP ratio could be as high as 90 per cent. Other analysts believe the total debt-to-GDP ratio is more like 70-80 per cent, and Fitch Ratings makes a conservative estimate of about 48 per cent gross general government debt by the end of last year, based on the opaque and incomplete information available. The main point is that China’s debt burden is much higher than she would like to admit, and much of that debt has piled up in the past few years, which was a result of Beijing’s response to the global financial crisis.

“Even though headline sovereign debt levels are low in China, so much quasi-sovereign activity happens through the banking system that if you include some of those contingent liabilities, the number can get very big,” says Charlene Chu, head of Fitch’s China Bank Ratings. “People forget that China undertook its fiscal stimulus package through the banking system rather than by issuing public debt in the same way other countries did.”

While government debt in China is definitely much larger than it appears at first glance, nobody is predicting an imminent debt crisis. On the contrary, it does not mean that a debt crisis will not occur.

“With an economy growing at a nominal rate of 15 per cent, and tax revenues of around 26 per cent of GDP, China clearly has more firepower than, say, Greece,” says Stephen Green, head of China research at Standard Chartered bank.

Another key point is that China, like Japan, does not have large external debts that could spark a crisis if they were called in. In addition, China’s borrowing has mainly been used to fund infrastructure projects that will have future economic benefits for the country, whereas the US, for example, is borrowing huge amounts to pay for defence and social welfare programmes that do not provide the same economic boost.

China’s fiscal picture is not quite as pristine as Beijing would have the world believe, but surging growth rates tentatively cover up a lot of sins and the situation remains much worse in the west. China’s inflation hit another 3-year high at 6.5% in July. By itself, that rate is not especially high, and Beijing has succeeded in checking inflation in the past. Even as the economy grew quickly over the last decade, overheating was not a problem—GDP grew at an average annual rate of 10.5% from 2001-10, but consumer prices rose an average of only 2.2% per year during the same period.

However, the difference now is that inflation is rising even as growth slows. This is known as stagflation. This is a sign that Beijing’s monetary policy, which kept both the exchange rate and prices stable for a decade even as productivity grew dramatically, has reached its limit. Unwinding that policy may be painful both for China and the world.

During China’s Goldilocks decades, foreigners bought her goods and invested in building factories. That inflow of dollars would normally have led the RenMinBi to appreciate, but the government intervened to buy dollars and sell RenMinBi. That in turn should have led to a blow-out of the money supply and inflation. The People’s Bank of China stopped this by “sterilizing,” selling government bonds to withdraw RenMinBi from circulation. Increased productivity with stable prices and a stable exchange rate favors exporters, and so China’s trade surplus continued and its foreign exchange reserves grew to $3.2 trillion.

Hitherto, the high savings rate meant Chinese banks were highly liquid. This would allowed the central bank to issue bonds and raise required reserve ratios to sterilize without crimping lending to companies. But as sterilization has accelerated over the past couple of years, the banks have run low on liquidity, meaning that Beijing has to choose between starving companies of credit or allowing inflation to accelerate—or, as seems to be the case now, a bit of both.

Asia’s Financial History

This is in line with the experience of other rising Asian economic powers that played out the Chinese growth model in the past. Japan ran a monetary policy similar to China’s current one from 1966-71. The resulting outflow of dollars to Japan was one factor that helped drive the U.S. off the gold standard in 1971 and caused a crisis in the global monetary system. In the 1980s, the problem re-emerged, leading to the 1985 Plaza Accord. After the yen was allowed to appreciate, the Bank of Japan feared the impact on exports and allowed the money supply to expand dramatically, creating a bubble. The collapse of that bubble left Japan in a malaise from which it has never fully recovered.

Another example is Malaysia in the mid-1990s. When the central bank stopped accumulating reserves, inflation re-emerged and credit growth went to a 30% annual rate from 10% in the space of a few months. That overheating led to wasteful investment and a crisis in 1997.

Taiwan in the late 1980s was a particularly extreme case. The government ended up borrowing 40% of the deposits in the banking system to buy foreign exchange reserves, which exceeded Japan’s on a per capita basis. A stock market bubble was building at the same time, which went into overdrive when the government couldn’t borrow any more to buy dollars and began printing money to do so. The stock index went from 1000 in 1986 to 12000 in January 1990, before collapsing.

These examples show that China is no “miracle.” Running a trade surplus while accumulating and sterilizing foreign reserves succeeds only for a time. While inflation can be deferred, the more that is stored up, the worse will be the hangover afterward. Investments that were predicated on the good times lasting forever must then be written off. Subsidized exports must shrink to a more appropriate share of the economy.

There is some irony here in that one of the reasons Beijing has refused to change its monetary arrangements is that she does not want to repeat the experience of Japan. That was understandable during the Asian monetary turmoil of the late 1997, and again during the panic of 2008-2009. But in economics what cannot continue will not be continued. Tokyo pursued a policy of reserve accumulation for too long, making a difficult transition inevitable.


Stagflation is indeed a warning to Beijing that she is running out of time to avoid that fate. Will China be able to step in once again this time round to ward off another looming Global Depression given her own domestic economic and political issues?

Since most policy makers are already lack of significant economic tools and their failure learn from the last recession to adopt a new economic model to prevent their respective economy from slipping into the worse Global Depression since 1929, it is time for us, to borrow a line from Kenneth Jeyaratnam, “Buckle Up for a Double-Dip Recession”.

Photo courtesy of Reuters