A colleague recently forwarded me an amusing puff piece from a few months ago on the prospects for China drawn up by Arthur Kroeber at GK Dragonomics, in which he argues that there is nothing to fear from a slowdown as all of the elements of the Chinese growth story remain intact. While I'm not without my own vested interest here I'd like to address his analysis and in doing so further illuminate my own perspective. His argument is inconsistent and contradictory, frequently lapsing into broad generalizations extrapolated from top-down aggregates, and evades the fundamental problem at the core of the Chinese economic machine. In this respect its fairly representative of most of the bull-case arguments floating around as of late, so I figured I'd take a crack at it.
My issues center around a critical distinction, the importance of which I think is pretty hard to overstate- while China is undoubtedly in need of hard infrastructure in some areas, the real problems that will continue to hinder Chinese development are in the country’s ‘soft’ infrastructure – its political and legal system in general and its capital allocation infrastructure specifically. This is attributable to the limited liberalization of interest rates, the dominance of finance by state-controlled banks, and the attendant politicization and corruption of capital allocation. This is a government that has its hands on everything. Even with efficient capital allocation rapid growth, such as that enjoyed by China in the past decade, is often accompanied by accumulated imbalances and when you wed the captive below-market financing offered through financial repression to China's banking system the results are unlikely to be positive. Indeed, the past three decades of Chinese banking suggest that when the bill inevitably comes due, the costs will be enormous.
About a year ago I began compiling a slide deck on the short case against China in an effort to formalize my thought and form an actionable thesis. This proved to be fairly all-consuming endeavor and led to a substantial amount of highly enjoyable work that I summarized in a rather long-winded, sometimes polemical (and now slightly out of date) PowerPoint presentation. My focus is towards the most misunderstood elements of the modern Chinese economy and reflects a perspective sharply at odds with the Western consensus. Of the ‘soft landing’ camp I am not.
In my first of what will hopefully be many, if irregularly published, pieces I’d like to briefly touch on my perspective of the Chinese slowdown and its prospects for 2012.
To bring readers up to speed, the situation has recently taken a turn for the worse. The Chinese debt cancer has continued to metastasize. Loathe to loosen in the face of vast demand from local government clients for stimulus, the center has been forced into action by the potential of a looming global slowdown; the Chinese economy, and especially the property markets, however, had already been showing signs of strain. The domestic outlook has been increasingly poor with even the heavily massaged official domestic data looking worse and worse. However, the Chinese policy elite remain trapped between a very real economic (and increasingly pressing social) need to cool inflation driven by unchecked credit growth and the demands of Ponzi growth targets (to be achieved by the aforementioned credit growth). Absent genuine reform and liberalization, the inherently inflationary tilt of China's managed economy will continue to plague policymakers even as economic activity slows; it is endemic to the model. Unfortunately, such a fundamental change requires an autocratic oligopoly of the ruling elite to voluntarily relinquish their total control of a massive wealth-generating machine.
Increasing cognizance of the fact that the $3+ trn of dollars of spoils from mass economic manipulation and top-to-bottom accounting fraud may already be largely spoken for has begun to percolate in the western media. The scale, opacity, and complexity of China's closely held financial system will limit comprehension of the full extent of the problems for most Western observers before it is already well underway.
