China's economy has been growing at a phenomenal pace in recent decades,
averaging around 10% a year. Few people seemed to worry, therefore, when the
Chinese government announced recently that gross domestic product (GDP) growth
in the third quarter of 2011 slowed to "only" 9.1% . Almost any country would
envy such growth. Yet beneath the continued robust appearances, there are signs
that China is heading toward a crash reminiscent of the one that brought down
the United States economy during 2007-2008.
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
Although the US 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
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 US-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 yuan. Congress is urging the Chinese government to let the yuan
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 US as we sell more to
China. China, though, would lose jobs by selling less to the United States.
However, if the yuan 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 yuan), 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
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 US government bonds as its main method of
preventing the yuan from rising. Selling yuan to buy dollars restrains the
dollar value of the yuan.
Those dollars are then mostly used to purchase US 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 yuan, we may all regret it.
In any case, the "problem" of an overvalued yuan is gradually being solved even
without congressional action. Since 2005 the nominal value of the yuan has
risen 30% against the dollar. Meanwhile, the real cost of Chinese goods has
risen even faster because Chinese inflation has exceeded US inflation by
anywhere between 7% and 20% during the same period (depending on the measure of
inflation), further reducing the competitiveness of Chinese goods in the
Rising relative Chinese costs are likely to continue, since the cost of labor
in China's export sector has increased more than 30% 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 yuan 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
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 cycle of declining trade demand on both sides.
Europe is a much bigger market for US goods than China could possibly be,
regardless of the dollar-yuan exchange rate. A sinking Europe would plunge the
US economy back into recession and wreck havoc (again) on the US 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 US 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 did so by borrowing heavily from the shadow
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
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
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% 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
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 $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
Americans should be wary of pushing too hard for a free-floating yuan. In this
turbulent global economy, anchors of relative stability should not be thrown
away lightly. Any rapid appreciation of the yuan 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 yuan 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 US 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.
James Nolt is a senior fellow at the World Policy Institute, an assistant
Dean at the NYIT School of Management in Nanjing, China, and a contributor to
Foreign Policy In Focus.