China—the Other Growth Engine—was supposed to save the world from U.S. financial woes. It won't.
 
By George Wehrfritz
Newsweek International
Updated: 8:00 p.m. ET Sept. 30, 2007

Oct. 1, 2007 issue - You've probably heard of the butterfly effect—inspired by legendary sci-fi writer Ray Bradbury back in 1952—which posits that minute changes in one place can lead to massive impacts elsewhere, as when a fluttering insect triggers atmospheric disturbance that causes a distant tempest. The past few weeks of global market turbulence are a perfect illustration of the effect, as American mortgage troubles have led to Continental bank collapses, emerging-market stock plummets and, most recently, a Great Depression-like run on a British bank. In Hong Kong last week, CLSA's chief economist Jim Walker issued a new warning, predicting that "butterfly wings in America's unfolding subprime-debt debacle ... will blow like a hurricane through China's rust belt." Walker is a well-known China bear, but his thesis is no work of dismal science fiction. Until quite recently, economists worldwide had hoped that America's subprime-induced slowdown would be offset by robust growth elsewhere in the world. After all, Europe had a stellar 2006, and Japan was recovering. Most important, there was China, a new global engine expected to contribute more to world GDP growth this year than any other economy.
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Unfortunately, recent weeks have proved that the global economy hasn't decoupled from the American consumer nearly as much as many theorized it would. Mirroring the U.S. slowdown earlier this year, both Euroland and Japan are seeing their own expansions wind down—suggesting more synchronization, not less. Five months ago, a Merrill Lynch report on Japan was titled "Smiles and Enthusiasm." Earlier this month, the header from the same Merrill economist was "Nightmare," as the country slipped into negative growth. Europe, which was poised to challenge the United States with 3 percent GDP growth, is slipping back to its usual lethargic 2 percent.

Could China be next? Walker predicts that growth may shrink from 12 to 5 percent by the end of next year, as the downturn in developed countries takes its toll on the Chinese rust belt. It wasn't supposed to happen that way. In a newly "rebalanced" global economy, the emergence of a new Chinese consumer class was going to make up for weaker Western spending. But despite Beijing's efforts to boost consumer spending, domestic consumption as a share of GDP is actually decreasing, making the Middle Kingdom more dependent on exports than ever before. In Walker's forecast, demand for all the goods churned out by China will slacken just as thousands of new factories come online next year, collapsing profits inside China Inc. and exposing mountains of problem loans at state banks. The ultimate result will almost surely be a global slowdown. "This is the biggest credit crunch we've ever seen," says Walker.

Already Chinese stocks have rallied into uncharted territory, housing prices in major cities hang in the stratosphere and glittery developments are rising everywhere. If that scenario has a familiar feel, it should. Even as it encapsulates China's ongoing boom, it also aptly describes an earlier pre-bust frenzy some two decades ago in Japan. "It's shockingly similar," says Richard Katz, whose seminal 1998 book "Japan: The System That Soured" dissects the stagnation that crippled the world's second largest economy in the 1990s, following a late-'80s bubble. "Looking at these numbers [from China], I was stunned by how much they resembled some of the imbalances we saw in Japan in the 1980s, except that they're more severe."

The passage of time and globalization's sweeping impact make any comparisons with the Japan of two decades past inexact, to be sure. Yet there's no denying that Beijing is now struggling to engineer the same transition from an export- and investment-led growth model to one in which domestic consumption is the key driver—precisely the shift Tokyo botched so miserably. The difference is that while Japan's adjustment problems were mostly an internal affair, Asia's future prosperity, and possibly even the world's, hangs on China's ability to rejigger its economy.

The quantitative similarities between the two countries are alarming. Fixed- asset investment (construction of ports, factories, condos, etc.) now accounts for about 45 percent of China's GDP. Its trade surplus has grown from almost nothing in the late 1990s to 9 percent of GDP today. Meanwhile, private consumption has shrunk from half of total economic activity in the late 1990s to just 35 percent this year. By comparison, Japan's investment component averaged 30 percent of GDP during its peak growth years, its trade surplus topped out at 4.5 percent of GDP and its consumption levels never dipped below 58 percent of GDP. Conclusion: China's economy is currently more out of kilter than Japan's ever was.

Katz has coined a term for the problem: economic anorexia. He defines it as a nation's chronic inability to consume all that it produces—a malady that leads to bloated trade surpluses, asset bubbles and ultimately collapse. In China today, "you have a pace of investment that is not sustainable and [export growth] that comes at the expense of other countries," he argues. "Really smart people in China know this is a very risky course, but the problem is how to get off the tiger's back." The first casualties of any downturn in China would likely appear at brokerages and on trading floors across the country. Last week David Webb, a shareholder-rights advocate and nonexecutive director of Hong Kong's main stock exchange, called China's stock market "a giant Ponzi scheme" and warned that a correction to reasonable valuations would entail a fall of 78 percent.

Events now playing out in Europe and the United States may soon force a resolution. Since early August, banking woes have prompted central banks to inject in the neighborhood of $400 billion into the financial system to prevent a total freeze-up. U.S. Federal Reserve chairman Ben Bernanke lowered interest rates by 0.5 percent, sparking a stock rally but raising questions as to whether more liquidity is a cure or merely a painkiller. The core problem is no longer subprime, but rather the resultant crimping of the credit pipeline that now undermines the increasingly complex "structured finance" on which much of the modern economy runs. According to Fed data, the current credit downturn has been the sharpest since the Great Depression.

One disturbing result has been a massive falloff in interbank lending. Case in point: Northern Rock, the U.K.'s fifth largest mortgage lender, found itself unable to finance mortgages by borrowing from other banks last week, which led to whispers of impending insolvency, then a 1930s-style bank run that prompted the British government to guarantee the savings at not only Northern Rock but all other banks.

Why has interbank lending fallen? The generic answer—heightened risk aversion—is correct but incomplete. The specific terror that grips bankers in New York, London and Tokyo today is based on what they know but outsiders as of yet merely suspect: that billions in subprime debt remain still untallied, parked off the balance sheets in collateralized debt obligations (CDOs) and structured investment vehicles (SIVs). "There's very little difference between what these banks have been doing and Enron," says CLSA equity strategist Christopher Wood, referring to the American energy giant that collapsed under the weight of its hidden debt. Given this, it's no surprise that banks aren't keen to lend to their peers that might be holding equally explosive bags of highly complex debt products.

The sanguine view maintains that today's financial woes can be overcome by deft central-bank interventions. Others say the real limits are on what the Fed and its counterparts can do. Indeed, last week's rate cut further widened the already large spread between what the government charges banks for money and the interbank rate, at which they lend to each other. To be effective, liquidity injections must reach the real economy. But they won't so long as "banks don't want to lend to anyone," says Wood, adding that the result of the drama now playing out in Europe could be "an unwinding of [risk] securitization" globally.

And that brings us back to Asia, and China's case of anorexia.

In today's China, the government's weak yuan policy and myriad subsidies make its export sector hypercompetitive, yet government efforts to awaken a domestic consumption habit have yet to take hold. As in Japan two decades ago, China's export bias has led to overinvestment, asset bubbles in stocks and real estate, and a politically explosive trade imbalance. The key actors are the same, too, including out-of-their-depths government planners, wobbly state banks, myopic business groups and political leaders who have come to believe their own good press. Dong Tao, chief regional economist for Credit Suisse in Hong Kong, warns that all this "could intensify resource misallocation and cause long-term damage to China's competitiveness."

Just like Japan in the 1970s, China is overbuilding heavy industry with export subsidies, cheap energy and easy credit. The result in steel, for example, is that smelting capacity tripled between 2001 and 2005, making China the world's leading producer, but also driving down domestic steel prices to 30 percent below the international average. The same is true of many Chinese industries, making the country ever more dependent on exports for growth, and therefore vulnerable to an export shock of the sort that could now be coming.

The problems, of course, are compounded by China's size. A slowdown in Chinese exports would have a huge impact on players ranging from resource providers in Africa, to East Asian components makers, to German heavy-machinery manufacturers. Meanwhile, the country's shaky banking system is likely the next global financial bubble to burst. China's banks—all of them state-owned behemoths—are products of a command economy. The yuan is undervalued and not convertible. The mountains of savings amassed over a 27-year economic boom remain locked inside the country, where negative real interest rates push ever larger portions into speculative asset markets.

Policymakers in Beijing have been cautious in their efforts to cool Shanghai's sizzling bourse, stabilize real-estate prices (up thirteen-fold in some cities since 2000) or change the growth equation to de-emphasize exports. With an eye on next year's Olympics, Beijing's top priority has been to keep the party going.

That slow and steady approach is good—to a point. But Beijing should avoid "the false impression that China has time on its side," argue Jahangir Aziz and Steven Dunaway in a study published by the International Monetary Fund this month. "Unchecked, the imbalances [in China] will continue to grow and, with them, the rising probability of a large correction." CLSA's Walker says leaders in Beijing are now powerless to avert a major shock. "What you do to avoid a Japan situation is take actions before things get to this stage," he says. "They've already failed."

Does that mean China is in for a bigger version of Japan's "lost decade"? Not necessarily, says Katz. Even at half of today's growth rate, China would have more forward momentum than Japan did in the 1990s. The Chinese are also far less likely to experience a long denial phase prior to enacting reforms. That said, change won't be easy. Millions could lose manufacturing jobs, and curing the bad-loan problem will cost taxpayers dearly. Such fixes are always best made before—not during—a crisis. Says Katz, "The longer they wait, the harder it gets."

Until that waiting game ends, however, China will remain geared to ship ever more product to increasingly beleaguered Western markets, but unable to consume what the rest of the world makes with the appetite its economic girth would suggest. Whether China's rust-belt crisis will trigger a full-blown global recession remains to be seen, of course. What's clear is that butterflies in the United States still have the power to stir up global tempests from which no country is sheltered.

With Sonia Kolesnikov-Jessop in Singapore and Emily Flynn Vencat in London