Mon, Jul 23, 2012 - Page 8 News List

How bad is China’s downturn?

By Henrique Schneider

Every now and then, an army of experts goes around proclaiming the end of China’s economy. Since the middle of this month, the new song is about China being a bubble and the bubble bursting. Giving the answers right away: Yes, China’s economy is weakening; Yes, there are troubling signals; No, China is not a bubble; No, the bubble is not bursting.

What is wrong with China?

Chinese economic authorities have revised their growth-forecast from 8 percent to 7.5 percent for this year. This rate, taken at face-value, does not mean anything. It is important to compare it with inflation, which has been estimated at between 4 and 5 percent. This leaves room for a yearly real growth rate of about 3 percent. Not bad? Not good.

China needs more than 4 percent-growth to pull its citizens out of poverty and to accumulate capital to invest in all those new branches of innovation and technology in which it aspires to compete. Most importantly, China needs more than a 4 percent real growth-rate to fulfil the Chinese Communist Party’s promise to its people and therefore for the party to stay in power.

So, it is true that China will be facing downturn risks this year. The weakening of its spectacular growth may entail the country getting stuck in the middle income trap. Even a mild recession is possible. However, it does not mean that it will decline or fail.

A bubble? Bursting?

The best definition of a bubble was given by former US Federal Reserve Bank chairman Alan Greenspan when he described it as speculative “irrational exuberance.” This means that a bubble is fundamentally speculative and driven by mostly (macroeconomic) irrational actions. However, China’s economy is the contrary of speculation. Its profit rates — if anything — are lower than the high yields of exuberance. Its economic planning is too rational not to scare notorious risk-takers. The very fact that the whole country is constantly analyzing data and looking for flaws to remedy them tells us that it is not a bubble.

There is value in China. Over the past decades, the country has come a long way. Today, Chinese companies are world-players, universities innovate, the labor-market has know-how, banking and finance thrives and there is a relatively high rate of new investment. China still has strong fundamentals that allow a rational pricing of its assets. Therefore, it is not a bubble and it is not going to burst.

Is anything wrong at all?

Yes, and it is important. China’s remarkable resilience to crisis (so far) and the value it is building up come at high cost. The more the government intervenes to create value and to avert downturns, the bigger the economic imbalance it creates.

First, it is diverting almost all investment into infrastructure, telecommunications and construction. This crowds out more interesting options like technology or pharmaceuticals. The logic is simple: If the government gives me a safeguard to build a road at a return rate of 5 percent, I will not be investing in technology at a rate of 8 percent, but without a safeguard.

This massive accumulation of investment in some sectors not only diminishes capital gains, but also influences the allocation of labor to lesser-paid jobs, therefore keeping the value of labor below the market threshold. These two market distortions ultimately lead to less growth.

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