The China Syndrome
In 1971, Ralph Lapp, a nuclear physicist, used the term “China syndrome” to describe a hypothetical nuclear reactor meltdown where the molten core breaches containment barriers and melts through the crust of the Earth reaching China. The economic equivalent of the China Syndrome describes a process where China’s strong growth, abundant savings and foreign exchange reserves assists a rapid restoration of global growth.
The nuclear metaphor ignores the geographical fact that the opposite side of the globe from the USA is actually the Indian Ocean and that the entire idea is physically impossible. The economic metaphor conveniently discards some significant doubts about the ability of China to act as a catalyst for global recovery.
The Unbalanced Bicycle
China’s economic growth model was a contributing factor in the current Global Financial Crisis (“GFC”).
Under Deng Xiaoping, leader of the Communist Party from 1978, China undertook Gaige Kaifang (Reforms and Openness) – reform of domestic, social, political and economic policy. Economic stagnation and serious social and institutional woes that could be traced to Mao’s Cultural Revolution forced the change.
The centrepiece was economic reforms that combined socialism with elements of the market economy. It entailed engagement with the global economy reversing the traditional policy of economic self-reliance and a lack of interest in trade. As Robert Hart, 19th Century British trade commissioner for China, wrote: “[The] Chinese have the best food in the world, rice; the best drink, tea; and the best clothing, cotton, silk, fur. Possessing these staples and their innumerable native adjuncts, they do not need to buy a penny’s worth elsewhere.“
In embracing markets, Deng famously observed that: “It doesn’t matter if a cat is black or white, so long as it catches mice.” Deng also embraced a change in philosophy: “Poverty is not socialism. To be rich is glorious.“
China’s economic reforms coincided with the ‘Great Moderation’ – a period of strong growth in the global economy based on low interest rates, low oil prices and deregulation of key industries such as banking and telecommunications. The boom was also based on increases in global trade and investment driven, in part, by the fall of the Berlin Wall, the collapse of the Soviet Union and integration of socialist economies into the world economy.
China’s growth model, inspired by the post-War recovery of Japan, used trade to accelerate the growth and modernisation of its economy. The economic engine was export driven growth. Special Economic Zones (“SEZ”), for example in Shenzen located strategically close to Hong Kong, were established to encourage investment and industry.
The model took advantage of China’s large, cheap labour force. The strategy benefited from rising costs in neighbouring Asian countries such as Japan, South Korea, Taiwan, Hong Kong and Singapore. China was able to attract significant foreign investment, technology and management and trading skills from countries keen to outsource manufacturing to lower cost locations to improve declining competitiveness.
China converted itself, at least parts of the country, into the world’s factory of choice. It imported resources and parts that were then assembled or processed and then shipped out again. The Great Moderation ensured a growing market for exports.
Innate conservatism, the desire to maintain Communist Party control of the domestic economy and avoid social disruption favoured partial market liberalisation. China’s need to provide employment for its underemployed population and improve its technology also favoured this strategy. China currently needs to grow at around 7-8% pa. to absorb workers entering the formal workforce each year.
The strategy was decidedly ‘trickle down economics’ as Deng himself acknowledged: “Let some people get rich first.” Later, Deng would grouse: “Young leading cadres have risen up by helicopter. They should really rise step by step.“
As economic momentum increased, foreign businesses invested in China to take advantage of the growth and rising living standards. Opportunities encouraged Chinese nationals living, studying and working overseas to return. As Deng astutely noted: “When our thousands of Chinese students abroad return home, you will see how China will transform itself.”
Over time, a novel liquidity system also accelerated growth to staggering levels.
Export success created large foreign reserves that now total over $2 trillion. These reserves became the centre of a gigantic lending scheme where China would finance and thereby boost global trade flows.
Dollars received from exports and foreign investment have to be exchanged into Renminbi.
In order to maintain the competitiveness of its exporters, China invests the foreign currency overseas to mitigate upward pressure on the Renmimbi.
As reserves grew paralleling its growing trade surplus, China invested heavily in dollars helping to finance America’s large trade and budget deficits. It is estimated that China has invested around 60-70% of its $2 trillion reserves in dollar denominated investments, primarily U.S. Treasury bonds and other high quality securities.
Chinese funds helped keep American interest rates low encouraging increasing levels of borrowing, especially among consumers. The increased debt fuelled further consumption and housing and stock market bubbles that enabled consumers to decrease savings as the ‘paper’ value of investments rose sharply. The consumption fed increased imports from China creating further outflows of dollars via the growing trade deficit. The overvalued dollar and an undervalued Renminbi exacerbated excess U.S. demand for imported goods.
In effect, China was lending the funds used to purchase its goods. China never got paid, at least until the loan to America was paid off.
The Asian crisis of 1997-98 encouraged China to build even larger surpluses. Reserves were seen as protection against the destabilising volatility of short-term foreign capital flows that had almost destroyed many Asian countries during the crisis.
The substantial build-up of foreign reserves in China and the central banks of other emerging countries was a liquidity creation scheme. The arrangements boosted growth and prosperity in China, other emerging markets and the developed world. Commodity exporters, such as Australia, benefited significantly from the increased demand for commodity and the higher prices for resources.
© 2009 Satyajit Das
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).