In the Cold War, the foundation of diplomacy was mutual fear and hatred. With that behind us, interdependence has introduced a new system which includes much closer relationships – and something more like angst and loathing. So has our relationship with China evolved.
As China has awakened, the GDP has grown by a factor of ten since 1990. The population went from 22% urban to 52%. All of this came at the expense, and mutual support, of hungry US consumers, corporations, and our nearly limitless need to finance our debt. It was too much, too quickly, and wise investors saw that it was a bubble ready to pop – or at least relax the insane pace.
That day is coming very soon.
There have been signs that China is in trouble before, but this one seems like the real thing. Their manufacturing is in a slowdown which appears to be accelerating. Exports drove their rapid growth, but competition with Japan and South Korea, among other nations, is becoming fierce. But China’s economy can’t have a soft landing for many reasons that are all related to the terrific inefficiency of a system that centrally plans nearly everything.
The problem is credit, or the inability to get it through standard, legal methods. Nevermind that, Chinese people have a history of finding a way to make do. The “shadow banking system” that has grown up has funded nearly all of the entrepreneurial advances away from the government’s eye. It’s a loose system made of up everything from pawn shops to loan sharks to manufacturing companies that loan their suppliers a little bit on the side and make the whole system work.
It has to be this way because ordinary Chinese cannot get loans at state run banks – at least not if they don’t know someone. So they get loans from a very advanced kind of loan shark who often borrows the money from a foreign bank running at much lower interest. Because of all the hands and risks involved, the rates are often very high – 20% or more is not unheard of. But it’s not a problem as long as growth remains high because tomorrow will bring in a lot more money than today.
The demand for money in China has been extreme. Total credit went from 75% of GDP in 2007 to 200% today, and the majority of it is outside their banking system. It’s all tied to foreign loan rates in some way, about 10% of it pure shadow banking and a solid 30% formed by investment pools.
Interest rates in the US have begun climbing. The 10 year T-Bill spiked over 2.4% when Bernanke announced the winding down of mortgage purchases, up from 1.6% just two months ago. When US money is more expensive, the investment pools and loan sharks are squeezed – and will certainly take it out on their clients. Demands to pay outstanding loans are going to increase right when China can afford them the least, given the slowdown and competition.
While not every Chinese entrepreneur can expect a knee-capping in their future, the credit bubble has to burst. That will slow down the growth in their internal markets simultaneous with the external slowdown. The problems with income inequality – where the well connected have become rich and the workers not so much – will become very stark.
Why should we care? The ability to finance our debt is going to become much more difficult. China hasn’t been buying much US Treasury debt lately, but it may feel compelled to sell some off. Interest rates rise by having the underlying debt change in value, and a rising rate means that the US bonds will fall. Plus, higher US rates will translate into more expensive US Dollars and make Chinese exports appear cheaper, something that will have to be tempting. But in the process, China will be killing its own shadow system, which the control freaks will probably find desirable even as it destroys the internal economy.
In short, they can’t win. And as they can’t win, it gets more expensive for us to run a deficit and keep on with our own economic stimulus.
It’s something like a Cold War that is playing out, except it’s likely to be a Currency Cold War. They can threaten us with collapse in our standard of living, and we can threaten them with millions of unemployed people crammed into dirty cities and ripe for serious unrest. The weapons are all pieces of paper. The threat is not one of abject destruction, but instead a much slower decline and even hunger.
That’s the beauty of the new world we live in. The success of our “enemy” is in our best interest, even as we want to beat them. And boy, is our “enemy” in trouble.