Close attention has been paid to the fragmenting Eurozone, where social benefits funded by debt accumulation are bankrupting the entire aging continent. Less attention has been paid to China, where debt accumulation has financed not social benefits, but massive construction projects.
Financial strength is always ultimately found on the balance sheet of a nation, not the income statement. A nation with high GDP, i.e., strong revenues, may be funding that growth through massive borrowing. As the income statement racks up a string of impressive performances, the balance sheet may be steadily worsening.
Nearly two years ago, in “The China Bubble,” I pointed out numerous examples of asset inflation, primarily in real estate, that had already been going on for over a decade in China. Just like in the United States, these over-valued assets have been used as collateral to fund economic expansion. And just like in the United States, eventually people in China will stop buying over-valued assets and their price plummets. This is happening now in China.
One of the best economics blogs out there is “Global Economic Analysis” by Mike Shedlock. His recent post entitled “Real Estate Crash in China Underway: Foreign Funding Down 80%, Land Sales Down 57%, Starts Down 27%; Expect Chinese GDP to Plunge,” says it all. In his post, Shedlock references a report entitled “China Real Estate Unravels” by Patrick Chovanec, a professor at Tsinghua University’s School of Economics and Management in Beijing, China. Chovanic writes:
“Property investment accounts for roughly a quarter of gross Fixed Asset Investment (FAI), and net FAI accounts for over half of China’s GDP growth. As I noted in January, in a back-of-the-envelope thought exercise, if property investment plateaus (growth falls to zero), it could shave as much as 2.6 percentage points off of real GDP growth. If it fell 10% (in real, not nominal terms) it could bring GDP growth down to 5.3%.”
And Shedlock responds:
“Chovanec notes if real estate investment drops by 10%, GDP will come in at 5.3%. What if real estate investment falls by 20% or 25%? Moreover, why shouldn’t it?”
I agree completely. There is no market left for Chinese real estate. They have entire cities they’ve built that are empty. With no more buyers, there will be no more investment. China’s economy ran on construction and exports. Their export market has not only matured, but declined. Now their construction market is collapsing. They are losing their two primary engines of GDP growth. China now joins Europe, desperately confronting an era of prolonged deflation.
There are several take-aways here:
(1) The US Dollar will remain the global transaction currency and will hold its value in spite of a monetary policy that enables massive deficit spending.
(2) The global prices for conventional energy will drop; the price impact of future middle-eastern turmoil will be mitigated by the reality of depressed energy demand.
(3) China will shift her economic priorities to militarization and become more aggressive in the South China Sea.
(4) The United States, while challenged by the economic disasters unfolding in the Eurozone and China, will not necessarily share their fate. For much more on why the U.S. economy can remain dominant despite mounting levels of debt, read “National Debt and Rates of Return.”
(5) While the relatively better financial condition of the U.S. economy buys time, if the U.S. doesn’t resolve its structural deficits and reform its banking system, it will eventually experience the problems already starting in Europe and China. If this occurs, instead of being the locomotive that pulls the world economy out of a prolonged deflationary depression, the U.S. will be the locomotive that drags the entire global economy into the abyss.
(6) One of the biggest economic challenges facing the United States is providing equitable and sustainable retirement security to an aging population. But America’s population, while aging, is demographically sustainable, unlike that of any other developed nation. Here is one way to restructure America’s retirement entitlements: “Merge Social Security and Public Sector Pensions.”
As I wrote in June 2010 in “The China Bubble,”
“The biggest risk of America reemerging economically amid relatively worse economic problems in the rest of the world is that their good fortune will be squandered, as structural reforms to America’s economy are deferred or abandoned in the face of a deceptively positive economic performance. America will still be able to print currency at will, borrowing additional trillions because even as a nation dealing with unprecedented debt, she still has the most diverse and secure economy on earth. Most crucially, America may delay reforming her public sector, using her ability to persist in massive federal deficit spending only to indulge in overpaying public sector bureaucrats – a hideous waste of deficit spending, which is properly used on infrastructure projects and technology initiatives that yield long-term strategic returns on investment.”