The sick man of Asia?

Among observers of international banking and finance, it is an article of faith that the Chinese economy is due for a rough patch in the not-too-distant future. George Friedman, founder of Strategic Forecasting, published this week a tidy summary of the pressures felt in China, stating that “A lot of things have gone into dooming China’s boom, and the money surge is one of the more immediate problems. However, as we have argued (and this article should be read in the context of past analyses), the end of the Chinese boom was inevitable.” The rest of Friedman’s most recent analysis is given over to defining what an economic collapse would mean for China’s Communist Party and the Western businesses that have substantial investments in the People’s Republic; however, there is a potential effect, little discussed, that would be felt most acutely by the American consumer: namely, the effect a sick Chinese economy would have on the supply and price of consumer products in the United States.

The first and most obvious point of concern for Americans is the supply of cheap Chinese imports that have fuelled the ongoing success of retailers like Walmart and Target. For anyone who pays even a modicum of attention, it is clear that the great majority of widgets—from handtools to low-tech electronics—is manufactured in China…and cheaply at that, and in some respects, the retailers’ ability to provide low prices over the past ten years has been directly attributable to China’s policy of propping up failing businesses. Friedman estimates that “the figures for nonperforming and troubled loans…amount to nearly half of China’s gross domestic product.” So in an ironic quirk of the global economy, the American consumer’s purchasing power has been augmented by the Chinese Communist Party!

Clearly, this model of economic growth is not sustainable and begins to resemble the same type of vulnerabilities associated with other export-led economies in Asia. Japan, Korea, Indonesia, the Philippines, and Malaysia all to varying degrees attempted to cut a path to economic prosperity by flooding the West—and particularly the USA—with cheap exports, a flood subsidized by government-sponsored loans to less-than-competitive businesses. In the short term, the strategy works; market share is won as cheap products fly off of the shelves of American retailers, but the dizzying volume of trade masks the fact that many of the manufacturers are not making money. In the long term, this method of economic growth catches up with the banking systems involved. It has hurt Japan and Korea in the last decade, as governments struggled with how to resolve the nonperforming loans and reform the banking system, and it certainly hurt southeast Asia during the so-called Asian Flu of the late nineties, as it played a part in the flight of capital that left many concerns insolvent.

The Chinese economy resembles nothing else on the planet, and one shouldn’t expect a Chinese crisis to play out according to any model we have seen heretofore. That fact makes it exceedingly difficult to project how a crisis would affect American consumers, but higher-priced consumer goods is a very real possibility, and this might help explain why US policymakers have been so insistent upon a hawkish inflation policy, despite the relatively tame statistics. Policymakers are clearly agitated by economic data that continue to defy tidy explanation, such as our outrageous current-account deficit. Historically, such a deficit would have already self-corrected, but the market for dollars is still strong internationally, which is simply one way of saying that the rest of the global economy still supports America’s consumer spending habits. And as suggested above, the relatively strong dollar is made stronger by the cheap exports flooding into American markets. If one scans the recent speeches of American central bankers, you begin to understand that our rate of inflation today is more influenced by factors external to our own national economy than at any point in recent memory, perhaps ever, and this alone makes the fate of the Chinese economy important indeed to the health of our own economy, especially so since we have such a tenuous understanding of how, exactly, the global economy impacts us here at home.

Commentators have also struggled with the economic effects of expensive oil. The thinking was that sustained high prices for oil would have a seriously deleterious effect on our economy, but to date, it’s been only mildly so. We feel it most directly and most painfully in the spike of gasoline prices; the refineries have passed the cost on to consumers, but the price points for gas are as much a product of supply and demand as they are of crude prices. After all, our refining capacity has not kept up with demand, and this alone could cause a rise in gas prices; when you factor in the high price of oil, it should rise that much more, and it has.

While gas prices are a direct effect of expensive oil, we should also feel it indirectly in the consumer goods we purchase, but on this front, we have largely not seen as dramatic a rise. Why has the higher cost of manufacturing not been passed on to the consumer? One could argue that, again, the Chinese are picking up the tab, fearful as they are of losing market share. Instead, they have kept prices low and are sucking up the cost themselves, and of course, this is aided by the fact that large American retailers are extremely powerful and skilled in negotiating cost. In a Chinese economic crisis, it is debatable whether Chinese manufacturers can maintain such a practice, and when those consumer prices reach a more natural level, then you will see extreme inflationary pressure brought to bear upon the American economy, and this forms the basis for my contention that the Federal Reserve is being hawkish on inflation in the expectation of a Chinese crisis.

I grant that this modest proposal of cause and effect is speculative, and I’m no economist; however, to believe that a Chinese economic crisis wouldn’t have knock-on effects on our own economy is foolhardy, especially so since both the Chinese and US are locked into an incredibly symbiotic relationship that goes beyond the set of crescent wrenches in your local Walmart. The Economist published this month a fascinating survey on logistics, the discipline concerned with inventories, supply chains, and the like. One of the featured companies in the survey was Federal Express, whose fortunes have risen in sympathy with the advent of our “next-day” culture. The FedEx model has made possible not only our purchases of cheap books on Amazon.com, but also the ability of a company like Dell to provide quality personal computers at extremely low prices. One might retort that Dell’s computers are “Made in the USA,” which is true for the their desktop models; however, the components inside the machine are made all over the globe, and Dell’s supply chain is a far flung enterprise. Because Dell has perfected the art of supply chain management, the company incurs none of the costs associated with maintaining an inventory; customers place their orders for computers, and Dell in turn gets its components almost instantly from its suppliers to do the job. Using Dell as a model, many companies have adopted the same “low-inventory” approach to manufacturing in order to beat their competitors on price, but what would happen if the global supply chains of these companies were to experience a shock due to a Chinese crisis? After all, many of these supply chains originate in China, as demonstrated by Federal Express’s decision to move its main Asian hub from Subic Bay in the Philippines to mainland China. Again, I unfortunately don’t have a clear answer to this question, but I can’t imagine that we could completely shield our supply chains from a crisis; therefore, it is highly likely that any flu infecting China would have some severe (albeit unprojectable) effects on the US economy—and not just the retailers.

This is especially true should some of the more severe prognostications concerning Chinese civil unrest come to pass. When crisis struck Japan, the country was already well-insulated against civil discord because it was extremely wealthy; when crises struck the rest of Asia, there was a tradition of heavy-handed, even authoritarian, leadership to which people yielded, mitigating some of the nastier aftershocks associated with economic crises. Although China is still governed by a dictatorial one-party state, there are stark divisions within the country that could erupt into open conflict in the face of an economic crisis, so our ability to navigate a Chinese economic crisis might not be simply a question of economics, especially so if instability in China takes hard manufacturing assets off line and endangers supply chains.

In at least one instance, a Chinese crisis would likely be of benefit to us. During times of financial duress, capital tends to find safe havens in which to ride out the storm; therefore, we would likely see an influx of cash enter the US system, either via direct investment or the purchasing of American debt. But when one considers all that could go wrong in a Chinese crisis, this offers small consolation.