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Get Four
|  | OCTOBER 25, 2004
By Michael Mandel China's Coming Financial Crisis And thanks to its quasi-socialist goverment, the budding superpower is ill-equipped to handle this almost inevitable bust Economists and economic journalists do a lot of hand-wringing about America's budget and trade deficits. They worry that the dollar will plunge and that foreign investors will flee U.S. financial markets. The country is committing the sin of profligacy, it's said, and will suffer for it. But let me make a fearless prediction: The next big financial crisis won't happen in the U.S. Nor will it occur in Europe. No, China is in the biggest danger of a meltdown over the next five years. Within this decade, its financial system will hit a big bump, and the response of China's political leaders will determine whether the country recovers quickly or slips into depression. Moreover, if a real financial crisis happens in China, the economic and political implications for the rest of the world will be tremendous. POOR INVESTMENTS. On the surface, this forecast may seem absolutely ludicrous. After all, China has averaged annual growth of almost 10% for the past 20 years -- a faster pace than almost any other country. It's on the verge of making the big jump to being an industrial superpower. And it has run a $100 billion trade surplus with the U.S. in the first eight months of this year alone. Yet if you look back over the last 15 years, it's apparent that financial crises are more likely to hit booming economies than weak ones. The Japanese financial breakdown of the early 1990s came after several years of very strong growth, when it looked like Japan was on top of the world. Similarly, the Asian crisis of 1997 was preceded by several years of huge growth in countries such as Indonesia, Korea, Taiwan, and Thailand. And the bursting of the U.S. tech bubble came after a boom period. Right now, the Chinese financial system seems to be funding a lot of investment that will never pay off. As BusinessWeek wrote in May, "China is still burdened with a backward financial system that can't tell a good risk from a bad one -- and often doesn't seem to care" (see BW, 5/3/04, "Headed For A Crisis?"). DOWNWARD SPIRAL. State-run banks and local lenders have poured money into businesses and construction projects, regardless of whether they're profitable. And even though the national government recently has taken steps to rein in the financial system, it hasn't done enough. "Overinvestment in everything from office towers to TV factories roars on, thanks in part to speculative funds from abroad," reported a recent BusinessWeek story (see BW, 10/18/04, "Untying The Yuan Would Get China Out Of A Bind"). As a result, a bubble of unprofitable investments and excess capacity is building up in China. By itself, that's not such a big deal, since capitalist economies regularly overshoot and then retrench. The real issue, though, is that China has built a modern economy on top of a quasi-socialist political system, and it's that hybrid system that could be the key deficiency. In a capitalist economy, when financial markets go into crisis, they rarely are able to heal themselves without government intervention. The reason is simple: The natural reactions of most investors tend to make the crisis worse. If they see a stock market plunging or a currency tanking, investors want to get out the door before they lose all their money. This triggers a downward spiral that can rapidly get out of control. TWO CRUCIAL MOVES. In the 75 years since America's Great Depression, one of the major achievements of economics has been figuring out how to stop this downward spiral before it's too late. When faced with a financial crisis, central bankers and government policymakers must do two things. First, they have to cut interest rates sharply -- in effect, throwing money at the financial system. By doing that, they make money cheap enough to calm down panicked investors and stop them from rushing out of the market. In the aftermath of the stock market crash of 1987, Federal Reserve Board Chairman Alan Greenspan quickly cut interest rates. He did the same starting in 2001, after the tech bubble burst. If things start to go bad in China, the goverment would be able to pump money into the economy. But that wouldn't be enough. Economists have learned that when faced with a financial crisis, it's also essential for regulators to close down the parts of the financial system that are hemorrhaging money. That means shutting down the worst of the money-losing banks or merging them into other banks. And it means cutting off the flow of new loans to highly unprofitable companies, forcing them to close or be acquired. And that's precisely where Beijing is going to have a real problem. The right response when the financial crisis comes will be to shutter the money-losing state banks and the worst of the state-run enterprises. However, that would require throwing millions of people out of work, which politically may be a very hard thing for the government to do. DEMOCRACY OR FASCISM? Lack of appropriate action in the face of a financial crisis could lead to several equally distressing outcomes. If the money-losing enterprises are kept open, the crisis could linger and bring forth economic stagnation, as it did in Japan in the 1990s. China assuredly could limp along with a distressed financial system, but it would grow much more slowly and be much less of a dynamic competitor and a magnet for outsourcing. Moreover, the U.S. would become a safe haven for the investment dollars that are now going to China, and the dollar would strengthen, not weaken. The other possible outcome would be political upheaval -- and the ultimate consequences of that are unpredictable. Can the current socialist government make the necessary leap to deal with a capitalist crisis? Will it have to move to more of a Western-style or Korean-style democracy, or will it revert to a kind of industrial fascism? In the 1950s, vicious political arguments raged in the U.S. about who was responsible for allowing China to go Communist. "Who lost China?" was how it was put in the shorthand of the time. In 2010, will politicians be asking that question again?  Mandel is chief economist for BusinessWeek Edited by Patricia O'Connell
BW MALL
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