The Rise and Fall of the Chinese Economy

So why is the Chinese economy in so much trouble right now? Well, actually, this shouldn't come as a surprise. If you've been watching China over the last several decades, you can understand how the current problems actually fall out of a lot of their earlier successes.

The story starts in 1979. And in 1979, you have Chinese reformers starting to do a good deal to put the Chinese economy on a sounder track. At that time, Chinese per capita income was only a few hundred dollars a year, almost everyone was very poor, people would ride bicycles rather than driving cars, and even starvation was still a possibility. So China introduces more private property, more capitalistic incentives, it privatizes some of its agriculture, it allows more manufacturing, more exporting. Overall, China starts moving toward being a modern economy, a normal economy. And once these reforms are underway, China is growing at really an astonishing pace.

For a lot of the last 35 years, China has been growing at around 10% a year. That's amazing! The American economy typically doesn't grow at much more than 2% a year. At 10% a year growth, that means that living standards double about every 7 years. So if you go back, you keep on visiting China, it's as if every 7 years, every 10 years, you get to see an entirely new country. For me personally, China is the most interesting country in the world to visit as an economist. They have grown at a pace that no other place has matched. Imagine about 10% a year growth for almost 35 years. That has transformed everything. So even year to year, parts of a city or a neighborhood can simply change before your eyes. So you see human progress at work, you see what took some parts of the world centuries to achieve, happening in decades or even years. You see human hope and faith and progress, and a deep underlying optimism about what is possible.

So the Chinese economy during these years of rapid growth -- it had some very notable features. It had high levels of savings, it had super high levels of investment, and they built lots and lots of infrastructure. And those were all very positive. It's wonderful how good the infrastructure is in China. I would much rather ride on a Chinese high-speed rail train than take the Amtrak from Washington, D.C. to New York City. The Chinese train is quicker, nicer,  and it's far more likely to be on time.

But here’s the thing -- for a long time China has been investing almost half of its GDP every year. Half! That's astonishing. When you think about it, it is remarkably hard, every year, to invest half of your GDP and to invest it well. In the early years of China's economic growth, the required investments were pretty simple and straightforward. They needed to build more homes, they needed to put in more train lines, they needed to build more roads, they needed to equip their urban centers with all of the normal features of everyday modern life. And the Chinese government did a really good job at all of those things. It's a big reason why, actually, China's growth has been so strong. But the problem is this -- the way decision-making in China is set up --it's very good for achieving things  with a kind of checklist -- known tasks that require a lot of resources and a lot of effort, and you throw everything you have at getting it done, and you get it done pretty quickly. China has been great at that. But now, a lot of that low-hanging fruit is gone. A lot of the infrastructure which China needs already has been built, but now their economy needs more complex investments. They need a better healthcare system, they need better retail services, they need more startups. And in these areas, there’s not a simple checklist way to get it done. It's not just a question of throwing resources at the problem. You need more trial and error, more experimentation, you need more of a market discovery process to figure out which are the profitable investments and which are the unprofitable ones. And it’s hard to plan and manage those the same ways that the Chinese did that with all of their infrastructure.

Here is another problem with the Chinese economic model. If your economy grows 10% a year or so for so long, businessmen and also your governments -- they start thinking there isn't much risk. At 10% growth, there's so much forward impetus. You can have a business plan with a lot of mistakes, you can have a lot of debt, you can be very poor on execution, but a lot of those investments are still going to make money at about 10% growth. So what happens is, the underlying economy loses some of its discipline. People get sloppy, they overextend, they become too optimistic. They think they can make any investment or any decision and somehow it will pay off or be validated, just because everyone else is pushing on that 10% rate of growth.

A turning point for the Chinese economy comes in 2009 when there’s a significant recession in many other parts of the world. At the time, a lot of observers thought, "Well, there’s going to be a big recession in China too." But there wasn't. The Chinese government undertook some very special steps to avoid or maybe just postpone that recession. So the Chinese government spent a lot more money on infrastructure at a time where maybe less infrastructure investment was called for. The Chinese government, the state-owned banks, the state-owned companies, acted in concert to encourage a lot more borrowing, a lot more debt. And it's true --this did spur spending, it boosted investment, kept the economy running at a higher level, but actually debt rose to the point where it was too high relative to the rates of return available on those projects. So now, we don't have very exact measures, but it seems that total Chinese debt of all kinds is well over 200% of GDP -- possibly as high as 300% of GDP. And maybe that can work when your underlying rate of growth is 10%, but as your underlying rate of economic growth falls, it's harder and harder for that debt to be sustainable. 

So how much is China growing today? Well, it depends who you listen to. The Chinese government, circa 2015, is claiming China is still growing at about 7% a year. But not many external observers believe this, because they’re looking at other pieces of data. No one is sure what the real rate of economic growth is, but what we know is that  it is probably sharply lower and China is now entering a great recession. To track this recession, we can keep in mind five issues or problem areas --the real estate bubble, the stock market bubble, the excess level of municipal debt, excess capacity among Chinese businesses, and finally, the risk of capital flight.

The first of these is the real estate bubble. Chinese property prices became too high in many Chinese cities and China overbuilt. I took a train trip from Beijing through the center of the country -- a six hour train trip. And along the way, I kept on seeing city after city with dozens and dozen of apartment blocks. You would see so many buildings, but so few people, so few retail stores, so few cars. Many of those cities are grossly overbuilt, relative to what can be supported. 

The Chinese stock market bubble is another potential problem. For a while, Chinese stock prices were rising rapidly, but then they fell rapidly too. Too many people were encouraged to buy stocks on margin, the ratio of prices to corporate earnings has been extremely high, and probably those stock price will continue to fall at a pretty rapid pace. That will depress consumer spending, lower confidence and it also will be a problem for some Chinese banks. 

The third problem is municipal debt. No one really knows exactly how big a problem this is. We do know that Chinese municipal governments were not supposed to be able to borrow money -- they were supposed to run balanced budgets. But in fact, a lot of them ended up borrowing money off the books, and in fact they were encouraged by the central government to do this, to keep up that expenditure on all the infrastructure. But what’s happened is, they borrowed a lot more than right now they are able to pay back. And the central government in Beijing is feeling the need to try to bail out these municipal governments.

Another big problem in the Chinese economy is what I would call "excess capacity". That is, in too many sectors you have too many firms, you have too much overconfidence, too much stimulation of investment, and a lot of those companies probably are not profitable -- they're being kept afloat by cheap credit from Chinese state-owned banks, or they may be Chinese state-owned companies themselves, which have political privileges of various kinds. But a lot of those companies right now -- they’re not making really productive investments in the kinds of things that Chinese consumers want. If you look at price indices, if you look at the index for producer prices in China -- that's one measure of this excess capacity. That index actually has been falling now for over three years running, falling every month. That's a sign that too many producer goods have been built for what can be sustained profitably.

So maybe the biggest potential problem is capital flight. There’s a risk that capital within China, foreign capital, but especially domestic capital, seeks to leave the country out of fear of China's economic problems. But if too much of this capital leaves the country, that actually makes the problems much worse, as we saw with the Asian financial crisis in the 1990s for other countries. The big danger in China is simply that capital flight accelerates. But in the meantime, think of the problems the Chinese government has trying to manage all of this. There are a lot of firms which are no longer profitable, but the government’s reluctant to let them go bankrupt because of fear of unemployment and also alienating special interest groups. There’s too much credit and too much borrowing in the economy, but if that bubble is burst, well, then economic activity will fall all the more. There's been too much investment in real estate, there’s too much continuing reliance on infrastructure, and somehow the government is supposed to juggle all of these balls at once and stop the recession from getting worse. When you put all of those issues together, it is indeed a very complex picture, very difficult to understand. But what we see is that the world's number two economy really is running a very serious risk of a recession which will be deep, and also may last really quite some number of years. My personal view is that, at this point, these problems are so deeply baked into the Chinese economy, there is no way to set this all right. But still there are some major reasons to be optimistic looking forward. First, the most important source of wealth in any economy is human capital. The Chinese have done a fantastic job investing in their own human capital. So from the economist’s point of view, which values human capital above all else as the most fundamental source of national wealth, when we look at the future of China in the medium-term prospects, we really should be optimistic or even cheery, because China has invested very well in human capital. Those investments will survive the current recession intact, and we have every reason to believe that China will be extending the talents, energies, drives, and ambitions of its people, and we can look forward, I think, to still a bright Chinese economic future.

To see more videos like this, check out our "Everyday Economics" video series. To dig deeper into China, go to mruniversity.com/china for a variety of resources and additional videos.