China too is facing a real estate bubble financed by an unregulated shadow banking system that is just lately starting to get squeezed between tightening government regulation of credit and sharply falling export sales. If real estate prices finally start to tumble, the shock to bullish Chinese investors could collapse the shadow banking system, drive many smaller businesses under, and create severe unemployment problems. Although the U.S. Congress is still fixated on the supposed problem of an undervalued currency, a serious slowdown of the Chinese economy could have worse implications for the world economy than the much touted exchange rate issue.
Americans must start to think more broadly about the role of the Chinese economy in an increasingly troubled world economy and not consider only the bilateral U.S.-China economic relationship in isolation from the rest of the world. Since 2007 the world economy has been rattled by a series of structural failures worse than any since the 1930s. This is a dangerous time. The Great Depression was not a single crisis but a snowballing series of interlinked crises that each pulled the world deeper into depression. The links among various crises in the world today are even tighter than then because of the much greater integration and interdependence of the global financial system and its greater role in real economies everywhere.
The view from Washington is that the main problem is China’s overvalued currency, the RMB or yuan. Congress is urging the Chinese government to let the RMB rise in value against the dollar, which would make everything made in China more expensive to Americans and everything made in United States cheaper in China. This could conceivably stimulate jobs in the U.S. as we sell more to China. China, though, would lose jobs by selling less to the United States.
However, if the RMB rises sharply against the dollar, China’s loss of jobs is more certain than America’s gain. Most Chinese exports to the United States are labor-intensive products such as shoes and clothing that are not likely to be made in America even if Chinese prices for these things rise. Faced with more expensive Chinese products, American consumers will simply shift our purchases to other low-wage countries such as India, Pakistan, Indonesia, and Vietnam. China would lose jobs, but America is unlikely to gain many. We would gain some jobs as our products become cheaper for Chinese consumers, allowing us to sell more, but as I argue below, the structure of Chinese demand favors products from Europe and Japan more than those made in America anyway, so our gain would not be large.
On the other hand, a decline in the value of the dollar (the flip side of the rise in the RMB), such as Congress demands, would make all Americans somewhat poorer and less able to afford foreign-made goods, including oil. American interest rates would also rise, increasing the cost of our public and private debt and slowing our economy, perhaps counteracting any job gains from increased exports. Our current low interest rates depend in part on strong Chinese (and Japanese and Arab) demand for our government debt, demand that is largely driven by the Chinese central bank’s purchase of U.S. government bonds as its main method of preventing the RMB from rising. Selling RMB to buy dollars restrains the dollar value of the RMB. Those dollars are then mostly used to purchase U.S. government bonds, financing our debt. If China stops funding our debt, who will pick up the tab? Interest rates would rise to coax other investors to replace the Chinese. If Congress does manage to provoke the sharp rise in the RMB, we may all regret it.
In any case, the “problem” of an overvalued RMB is gradually being solved even without congressional action. Since 2005 the nominal value of the RMB has risen 30 percent against the dollar. Meanwhile, the real cost of Chinese goods has risen even faster because Chinese inflation has exceeded
U.S. inflation by anywhere between 7 percent and 20 percent during the same period (depending on the measure of inflation), further reducing the competitiveness of Chinese goods in the American market. Rising relative Chinese costs are likely to continue, since the cost of labor in China’s export sector has increased more than 30 percent since the beginning of last year. In fact, precisely because China’s exports compete with those of so many other countries, China is not fully able to pass on its rising costs to foreign consumers through higher prices. Chinese exporters are suffering a profit squeeze instead, which will drive many of them out of business – even more if the RMB value rises sharply.
China and Europe
China’s economic relationship with tottering Europe is even more crucial to the health of the world economy than its relationship with America. China exports to the United States quite a lot more than it imports, not because the Chinese are stubbornly resisting buying American goods, but because the United States does not manufacture so much of what China imports most: factory machinery and railroad equipment. Europe, however, does. Tour any Chinese factory (I have toured scores of them) and you will see plenty of machines made in Germany, Italy, Britain, and Japan. Decades ago, before the rise of China, the United States had already declined as a major world supplier of productive machinery. Yet China, because of its very fast growth rate, high savings rate, and high investment spending, needs factory and transportation equipment more than the farm, consumer and entertainment goods and services that the United States typically exports. Although Boeing does sell lots of airliners to China, it is Europe, not America, that benefits most directly from a healthy Chinese economy.
Yet now, because of the ongoing debt crisis and economic slowdown in Europe, European imports from China have recently fallen rather drastically. This, added to the export-profit squeeze mentioned above, could help trigger an economic crisis in China. Any slowdown in China will, in turn, dramatically reduce Chinese demand for imports from Europe of investment goods such as machinery and transportation equipment (since any slowdown in growth disproportionately decreases demand for investment goods), throwing European economies deeper into crisis in what could become a vicious circle of declining trade demand on both sides.
Europe is a much bigger market for U.S. goods than China could possibly be, regardless of the dollar-RMB exchange rate. A sinking Europe would plunge the U.S. economy back into recession and wreck havoc (again) on the U.S. financial system. The direct effect of a crisis in the Chinese economy looks less severe to the United States than the indirect effect it could have in pushing Europe over the brink.
China’s potential decline is, in the end, more worrisome than the competitive pressures of China’s dizzying rise. As mentioned above, China’s impending crisis looks superficially like that of the United States a few years ago. It has many of the same ingredients: a housing bubble, a ballooning unregulated and unstable shadow banking system, and a turn toward credit tightening that may be just enough to burst the bubble, collapse the shadow banking system, and throw the economy in reverse. Similar to the U.S. case, the Chinese government would certainly step in to rescue the large, official, too-big-to-fail government-owned banks, but the consequences of collapsing the shadow banking system could be severe.
The most obvious part of this prognosis is the housing bubble. I have lived in China for more than four years now and travelled to many cities here. All of China’s cities are festooned with forests of building cranes, adding huge new blocks of high-rise apartment buildings in every corner of every city. It is the most impressive construction boom the world has ever seen. Tens of millions of workers, most of them migrants from rural China, labor on these projects. This gargantuan effort is less impressive in the evening, when you can see that the vast majority of the newly-constructed apartment blocks are nearly empty. Few lights illuminate these largely uninhabited dwellings. Despite the massive increase in supply, housing prices have continued to soar, so that few working families can afford to buy an apartment. Most of those that are purchased are bought by speculators investing in rising prices rather than families wishing to reside in them. As soon as prices peak and turn down, speculator demand will plummet. Rents are so low in relation to purchase prices that rental income alone is not enough to make these tens of millions of new apartments attractive as investments. Only ever-rising prices have made them attractive. Any reversal of prices could cause speculator-fueled demand to fall precipitously.
The direct consequences of a fall of housing prices may not be as drastic as in the United States, because many of the speculators are small owners who have been allocated at least some of their apartments by the government as part of its redevelopment policies. Not all of the housing speculators are heavily leveraged. But those who have borrowed heavily from the shadow banking sector. Falling real estate prices could cause speculators to sell into a falling market, accelerating its fall. Some will not recover enough from the falling sales prices to repay their loans. As in the United States, those who go bankrupt will surrender their properties to financiers who must also cast them onto the market to remain sufficiently liquid in a declining market. Conceivably the Chinese government could halt the fall by buying apartments itself and through government-owned banks, but this would sustain prices at too high a level. Prices need to fall a lot if sufficient number of non-speculative buyers are to be found.
A fall of housing prices sufficient to make these vast blocks of new housing affordable to Chinese consumers (obviously desirable public policy) is likely to collapse the shadow banking sector, which not only provides credit for much real estate speculation but also funds hundreds of thousands of small and medium-sized businesses unable to obtain credit from the larger government-owned banks. As in the United States in the run-up to the 2007-2008 crisis, the shadow banking system has exploded in size recently. This shadowy system has several components, including off-balance sheet loans from official banks, unofficial loans by large non-financial corporations that can borrow from official banks and then re-lend in the shadow market at higher interest rates, and various unofficial lenders, including rich individuals, pawn brokers, and even gangsters. Because it is so shadowy, the exact size of this sector is difficult to know, but foreign banks estimate it issues at least one-fifth of all Chinese loans and has grown very rapidly recently, especially as the government has tried to rein in lending by its official banks. Despite continuing rapid GDP growth, deposits in official banking accounts are this year more than 20 percent lower than last year as funds from rich and middle class investors are siphoned off into higher-interest “wealth management products” that help fund the unregulated shadow sector.
China’s unemployment is politically sensitive, as about 150 million Chinese urban workers are rural migrants with limited rights in the cities they inhabit. Railroad construction workers alone number about six million, two-thirds of whom have recently been idled because of a slowdown in the previously frenetic pace of construction of new high-speed rail lines. The broader construction industry includes tens of millions who could be thrown out of work if the real estate boom subsides. Tens of millions more could lose their jobs if large numbers of small and medium-sized businesses are bankrupted by falling exports, the export profit squeeze, and high-cost or unavailable credit as the shadow banking system implodes.
The Chinese government responded to the slowdown of 2008 with a massive $600 million infrastructure spending program. Something on this scale might be done again to absorb some of the unemployment likely to occur when the housing bubble bursts. But it may be too little too late to avoid a significant downturn with serious implications for the fragile world economy, starting in Europe and spreading to the United States. Recent hopeful headlines nominate China as part of the bailout of Europe, but severe problems in the world’s most robust economy may overwhelm whatever puny efforts it may be able to make toward a European debt bailout. These are indeed dangerous times.
Americans should be wary of pushing too hard for a free-floating RMB. In this turbulent global economy, anchors of relative stability should not be thrown away lightly. Any rapid appreciation of the RMB will especially devastate the very social forces most congenial to more liberal political reform in China: small and medium-sized export-oriented private businesses. China’s state sector is easily buffered from severe adverse effects by the government’s ample financial resources, but the shadow banking system and large segments of private business stand at the brink. In the longer term, during the next major American business upturn, it might be desirable to allow further depreciation of the dollar against the RMB and let dollar inflation rise, in part to reduce the real cost of servicing our ballooning debt to China. In effect the United States might eventually pay back its large foreign debt with dollars worth much less than those it borrowed. There is little China could do to counter a U.S. policy of inflating away much of the value of its accumulated debt. Now is not yet the time. The tottering global financial system is not in shape to suffer another major unexpected shock.