How Long Can the ‘Chinese Miracle’ Last?

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Author Dinny McMahon says China's debt-fueled growth is unsustainable and due for a reckoning.

China book coverWhat goes up must come down, as the saying goes. This could well be true of China, which has seen a massive expansion of its economy in recent years, driven by rampant construction and wild indebtedness. Journalist Dinny McMahon, who covers China’s financial sector for The Wall Street Journal, has written a book that offers a wide perspective on the country’s economy. China’s Great Wall of Debt: Shadow Banks, Ghost Cities, Massive Loans, and the End of the Chinese Miracle explains the danger of the debt-fueled growth bubble and what could happen in the near future. McMahon discussed how China’s actions have ripple effects at home and globally on the Knowledge@Wharton show, which airs on SiriusXM channel 111. (Listen to the full podcast using the player at the top of this page.)

 An edited transcript of the conversation follows.

Knowledge@Wharton: You’ve lived in China and covered the country for quite a while, so did you see this coming?

Dinny McMahon: Yes, absolutely. The first year I lived in China was 1997. From then until now, I’ve seen the country absolutely transform. I’d say that for most of that time, that transformation has been an incredibly positive thing. The quality of people’s lives has improved so much. The infrastructure and the quality of housing have really improved. It’s much better than it was back in the 1990s. But certainly over the last decade, it has been like a freight train — just the pace at which the debt has been piled on to build things like housing, public works and factories.

They all sound like very positive things. But the extent to which they’ve been built, you’ve ended up with a massive amount of excess and waste: factories capable of producing far more steel and aluminum ships than the Chinese economy could ever hope to use; excessive housing in places where it’s just not needed; airports that might only receive one or two flights a week; and new highways that only have a handful of cars on them. The local governments that borrowed to pay for these public works will be paying off the debt indefinitely because they just don’t have the resources.

Knowledge@Wharton: What is driving this rapid economic growth?

McMahon: The big thing was really the global financial crisis. A lot of these tendencies were in place before then, but when the global financial crisis hit, there was a sudden drop in demand for China’s exports. The way that the Chinese government dealt with that was with a massive stimulus.

In other countries that also had a stimulus, the stimulus was usually done by the central government. In China, it wasn’t so much the central government that was spending money. It was the banks. You saw this massive expansion of credit by the banks. When the government tried to shut it down after a year, it said, “That was enough stimulus. The economy is now on a good footing.” The shadow banking system kicked in, and you had this new dynamic where the banks and the shadow banks colluded together to come up with new, creative ways to extend finance.

“China is experiencing one of the fastest-aging populations in the world, and we’re already starting to see the effects of that.”

It explicitly got around the efforts of Beijing to rein in the expansion of credit. It turned into this self-perpetuating machine of credit expansion, which has continued up to this day.

Knowledge@Wharton: As you started to look into this, what surprised you?

McMahon: The thing that really surprises me the most is the ghost cities. There was one particular ghost city that I visited a number of times up in the Liaoning province, which is in China’s northeast. It is one of the most beautiful cities that I have ever visited in China. It has fantastic landscaping with a man-made lake and a man-made rock garden on a man-made hill, with beautiful canals running through the city. But once all the government buildings went up, and block after block of housing, a tennis center and office towers, it only attracted a fraction of the population that it was built for. At the end of the day, it was really just a mechanism for stimulating economic growth when there was no real reason to build it in the first place.

Knowledge@Wharton: You write about how the population in China is aging while the birth rate is declining. How will that affect the future economy?

McMahon: China is experiencing one of the fastest-aging populations in the world, and we’re already starting to see the effects of that. Over the next decade, the working-age population is going to shrink by tens of millions of people. That’s going to have a direct impact on China’s competitiveness.

We’ve traditionally thought of China as a cheap place to manufacture things, but this shift in demographics is really taking a toll on that because as there are fewer people in the workforce, and that’s going to drive up wages without any payoff or comparable rise in productivity. So, making things in China is going to get a lot more expensive. At the same time, because all these people are becoming retirees, the financial burden on the government is going to rise because they’re going to be paying more in health care and pensions.

It was China’s former finance minister who said that this was one his greatest concerns about China’s economic prospects, that the nation will become old before it becomes rich. The sheer fact that it becomes old will make it so much more difficult to become rich.

Knowledge@Wharton: We’ve seen President Xi Jinping really step out and try to sell China to the world. How much of a role has he played in this mounting wall of debt?

“Were it not for the accumulation of debt, China wouldn’t be growing anywhere near as quickly as it is today.”

McMahon: That’s a really good question because, to a certain extent, President Xi inherited the dynamics of the economy. The economy was already rapidly accumulating debt before he took over. The problem he faced is that this is now how China’s economy grows. Were it not for the accumulation of debt, China wouldn’t be growing anywhere near as quickly as it is today. He’s been in this position that he wants fast growth, but he’s certainly aware of the risks in the financial system.

Over the last five years that he has been in charge, he has certainly made some efforts to rein things in. In particular, he has gone after the local governments that have borrowed so much. He implemented a significant crackdown in 2005, trying to change the way that local governments borrowed money and prevent them from borrowing excessively. At the time, certainly we reporters thought, “OK, this is it. He’s finally managed to fix the problem.”

But what really happened is that the local governments just came up with new, creative ways to borrow that were a lot more difficult to track but allowed them to continue rapidly accumulating debt. Last year, Xi said that he saw local government and debt as being two of the greatest threats to financial stability. I think the single-biggest measure of economic reform isn’t explicitly economic, it has been this sort of political consolidation of power.

Over the last few years, he has shifted a lot of the responsibilities of government into the hands of the Communist Party. He has imposed a greater degree of discipline over the party. And he has consolidated a lot of the power over the party in his own hands.

This could be a positive, at least in the short term, for financial and economic reform because he might now be in a position to (control) the lower levels of government. He might now be in a position to smack heads, so to speak, and get stuff done. It might be good for cleaning up the excess of the system in the short term. But whether it’s good for making a more efficient, more creative economy in the long term, which is really what China needs at the moment, that is not a foregone conclusion by any stretch of the imagination.

Knowledge@Wharton:  How do you think entities outside of China will view what you’re bringing forth in this book? A lot of countries see China as that next great economic leader in the world.

McMahon: China is very much shrouded in this aura of inevitability. If the United States is the indispensable nation, then I think we can say China is seen as the inevitable nation, that it will inevitably become the world’s biggest economy, that it will inevitably become the great power of Asia. And inevitably, it will challenge the United States for the role of the global power.

But it’s facing all these very fundamental economic problems, as well. Its ability to become this great power is very much built on its economic strength. I don’t know exactly what’s going to happen to the Chinese economy — whether it will experience a crisis, a recession, or we’re just going to see growth fall to a significantly slower pace of expansion. But even if China’s growth slows to 2% or 3%, that radically changes the dynamic with which we see China at the moment. If China’s economy grows at 2% a year, then it is effectively growing at the same pace of the United States, which means that it is not catching up with the U.S.

Knowledge@Wharton: How have other countries benefited from China’s growth?

McMahon: Australia has probably benefited from China’s growth more than perhaps any other developed country because all this construction has meant they have been willing to buy anything we dig out of the ground. They’ll pack our iron ore. They’ll pack our coal to fire their coal-fired power plants. But the mining boom in Australia, which was driven by China, peaked in 2012. Now, we talk about a farming boom because you’ve got this very fast-expanding middle class in China and its affluent class, which wants more seafood. They want to eat more beef and honey and wine and chocolate. Australia has benefited hugely from all that.

Knowledge@Wharton:  Do you see a lot of other countries wanting to ride this wave of perceived growth by China?

“In my mind, the miracle’s already over.”

McMahon: What it really comes down to is what drives your economy. Canada is very similar to Australia in that a big part of its economy is natural resources. But then you’ve got places like the United States and Europe and Japan, which are a lot more driven by manufacturing. They have a very different economic relationship with China.

The Chinese love to buy natural resources and have this great demand for services like education and tourism. But China exports three times as much as it imports when it comes to manufactured goods. Most manufactured goods that China consumes are actually made in China. This has made things difficult for Europe, the U.S. and Japan because they rely heavily on manufactured goods to support the economy and for employment.

Knowledge@Wharton: Is the end of the Chinese Miracle in sight?

McMahon: In my mind, the miracle’s already over. The reason I say that is what has been allowing the Chinese economy to grow so quickly over the last six or seven years has been that the accumulation of debt has been faster than the economic growth. That is not sustainable, and that’s not a miracle. That’s just alchemy. The issue is what happens next in the economy. I don’t know exactly what will happen. Firstly, I think the reality is that China will become the global power we assume it will. But it’s certainly not a foregone conclusion.

Knowledge@Wharton: Should we be worrying about a global bubble?

McMahon: That’s a tricky question to answer because, when it comes to financial considerations, China has ring-fenced itself from the rest of the world. When a big economy somewhere in the world has a recession or even a crisis, you get a slowing effect with the financial systems of the United States and Europe and elsewhere. But China doesn’t have those same financial linkages to the rest of the world. The big lesson that it took away from the Asian financial crisis back in the late 1990s is that it wants to keep a control of the capital account, because it doesn’t want foreign money to be able to enter and leave the country quickly, because then it exposes itself to all sorts of risks.

A slowdown in China would affect the rest of the world through the real economy. It’s to the extent that China stops importing commodities or sending its students overseas to study. I think perhaps the greater challenge that the world has to face in the coming years is the approach China takes to warding off these problems. The government knows that this economic model isn’t sustainable, so it already has a vision that it needs to develop new drivers of growth. And that vision is about moving into more technologically advanced industries.

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