Global Narrative About the Chinese Economy Darkens

Last week, the global narrative on China’s economy changed. On Thursday, the New York Times’s Paul Krugman told us China’s economy was hitting “its Great Wall,” and others raced to pen similarly dire forecasts. As Stratfor’s George Friedman writes this week, “We have gone from China the omnipotent, the belief that there was nothing the Chinese couldn’t work out, to the realization that China no longer works.”

China’s economy has shown signs of not working since the fall of 2011, but most economists and analysts chose to ignore them. Now, just about everyone is commenting on Chinese economic weakness. Expert opinion never seemed more synchronized.

Of course, pessimistic observers today could be wrong. Friedman, however, makes one crucial observation as to why the change in global discourse matters: “The admission that a crisis exists is a critical moment, because this is when most others start to change their behavior in reaction to the crisis.”

Precisely. As pessimism grows about Beijing’s ability to create growth, two things will surely happen.

First, outsiders will commit fewer funds to China. Foreign direct investment in the first half of this year increased by only 4.9 percent over the same period in 2012. The number would have been even worse were it not for a simply unbelievable jump in foreign direct investment last month of 20.1 percent. Before the release of the official numbers, observers thought FDI in June would slump. Even if the suspicious June number is accurate, inward investment will tend to fall off in future months when talk about China darkens, as it surely will.

Second, participants in the Chinese economy will take their money out of the country. The process is already underway. Last month, Chinese banks sold a net $6.7 billion of foreign currency, a sign of capital outflow. Undoubtedly, the amount of capital flight is higher if smuggled cash, often stuffed into shipping containers leaving the country, is considered. Beijing has erected sturdy-looking restrictions on currency movements, but the crafty, greedy, and desperate have always been able to move money in and out of the country, almost at will.

Liquidity is already tight in China—Beijing has somehow managed to create the anomalous situation of too much credit and not enough liquidity—so outbound capital flows can aggravate the sense of crisis in the country. Therefore, today’s pessimism could become a self-fulfilling prophesy.

Ultimately, it is confidence that holds economies together. At the moment, most observers still believe that, despite everything, Chinese technocrats will be able to muddle through. China is “too government to fail,” Andrew Wang, a New Jersey financial adviser, said last month.

If everyone thinks this way, then there is some chance Beijing will be able to pull through this rough patch. Yet if the economy continues to underperform expectations—a safe bet in my book because of crushing debt and political paralysis, to name just two factors—then the next break in confidence could herald a historic collapse in China.

In the meantime, follow the money flows in and out of the country. That, rather than expert opinion, will be the best predictor of China’s future.


Photo Credit: Hung Chung Chih / Shutterstock.com


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