27 September 2012

China's Great Depression Will Start Post-2014 And Pre-2024

The going rate for iron ore in the international commodities markets is $105 (U.S.) per metric ton. At that price, 40% of China's iron mines can't afford to operate. To put all of those Chinese iron miners back to work, the price would have to go up to about $120 a metric ton. It is unlikely that they will reopen any time soon.

Not surprisingly, China's steel industry is also floundering as a result of the same trend.

The Shortcomings Of An Always Booming Economy

China has been praised as an economic miracle for producing high annual GDP growth rates, year after year, for decades. The growth rates are even more incredible when one realizes that China has basically two economies - one is an Eastern Chinese urban industrial economy that is experiencing economic growth at rates much greater than China as a whole. The other is a profoundly more poor, mostly interior Chinese, rural economy which is experienced slower economic growth - rates in the range of countries in the developed world that drags down the economic growth rate for the nation as a whole.

I'll discuss rural China's situation in a moment, but lets focus for moment on something that China's shuttered iron mines and steel factories, which in absolute magnitude are a blimp in the global economic picture, but are notable because they may be a symptom of a far deeper phenomena that could have global economic implications.

Every country's economic decision makers make mistakes, regardless of the political economy they are acting in, and sooner or later, these mistakes have consequences. A country's recent business cycle history influences the kind of mistakes that economic decision makes will make. China's thriving urban industrial economy is vulnerable to the mistakes usually made by a generation of economic decision makers too inured to booms who haven't come to terms with the notion that sustained, high levels of exponential economic growth are inherently unsustainable.

In a booming housing or investment asset market, of the kind we saw in places like California, Florida and Nevada in the years leading up to the 2007 housing price collapse in those markets, there is a natural tendency to overleverage and to be sloppy in underwriting new loans secured by bubble assets, since foreclosures can promptly forgive ill conceived decisions to lend to uncreditworthy borrowers. Likewise, guarantees of loans are lightly made, since the possibility of a loss seems remote. People who do more deals get rich and the rising tide cures their bad judgment calls painlessly. People who are cautious miss profitable opportunities and few chances to say "I told you so.", to people who ignored the risks that they foresaw.

Of course, this ethos and experience leads to systemic misjudgment by the biggest participants in the marketplace. When a bust arrives, the consequences of excessively optimistic lending practices come to roost, equity positions in the bubble assets are wiped out, declining collateral values turn attention to the creditworthiness of the borrowers and produce huge losses to lenders. In the U.S. subprime market alone, the result was $1 trillion dollars in bad debt and the ripple effects of the write offs produced by these bad lending decisions (mostly in a few select markets where non-recourse lending kept borrowers from injecting an extra layer of caution into their decisions), has brought the U.S. economy, and ultimately the global economy, to its knees.

Risks that are similar in kind loom in China.

In a booming industrial economy, a growing economy quickly soaks up the fruits of a decision that at the time made was an overinvestment in productive capacity. If you build a factory that makes more wigets than anyone needs at the moment, no so many years later, the economy will have grown to the people where those widgets are needs and the only down side was trouble finding buyers for the factory's output for a rough first few years.

A booming industrial economy also generates conventional wisdom organized around periods of seemingly never ending expansion of the demand for industrial goods. So, the economy rewards the decision makers who capture market share early on with razor thin profit margins and then grow their wealth by growing their volume rather than their profit margins.

More generally, economic booms due to literal financial side of the balance sheet overleveraging, and the de facto leveraging associated with very thin profit margins, pose the same basic risk. They organize economic enterprises with little staying power that are not robust enough to weather an economic downturn and decline in demand gracefully.

Bottom Line: Sooner Or Later China Will Have Its Own Great Depression

Sooner or later, unsustainable, relentless exponential economic growth in China will level off and even produce a recession where the size of China's GDP declines for at least six months. When it does, bad decisions rooted in excessive optimism on the part of China's economic decision makers developed through a generation where the next year was always much better than the last, will come to roost. The bigger the boom was without interruption, the bigger the bust will be, and China's boom has been long and large indeed. There may or may not be some "little earthquakes" in China first that put it on guard. But, sooner or later, this much of a bubble is going to produce "the big one."

China's first industrial age Great Depression will be epic.

If I were prescient enough to time business cycles accurately, in China or anywhere else, I'd be wealthier than Warren Buffet. No one has a consistent track record of accuracy when it comes to market timing in the long run. Some people make plays, get lucky and win big. And, if you are smart, you can have better odds trying to time China's next recession or the collapse of a real estate bubble than putting money on the tables in Las Vegas, maybe even odds that win more than they lose consistently, albeit with lots of mistakes along the way.

It turns out to be far easier to know that someone is coming sometime, than it is to know when. This can be done with far greater accuracy. The possibility that China will experience its own Great Depression as its economic growth starts to level off as it inevitably will, may not be quite as certain as, for example, the prediction that the world will experience "Peak Oil" with far ranging consequences (although Peak Oil could easily trigger a Chinese Great Depression). But, I would put its likelihood at some point before China is fully economically developed at something on the order of 75%-85%.

The Question of Timing

Also, despite my warnings on timing, some crude methods can bound the timing, and I will be a fool and rush in to calculate them in a place where angels fear to tread.  The easiest way to get a question of timing right is to be sufficiently vague.  The more roughly one predicts when something will happen, the easier it is to be right.  The art is in figuring out just how accurate you can manage to be with a reasonable degree of confidence. 

First, it hasn't happened yet. Indeed, I think that there will probably be a month or three of warning when evidence that a sustained economic growth driven bubble has run its course will reach the grass roots of society and become overwhelming. For example, recall the taxi drivers giving stock picking advice on the eve of the 1929 crash, and the janitors buying $1,000,000 California homes on the eve of the 2007 financial crisis. China doesn't appear to be there yet, so any Great Recession in China will probably start in 2013 or later.

The firmest bound on the latest possible time that a China's Great Depression could happen derives from the widely understood fact in development economics that economic growth slows as per capita GDP approaches the level of affluent, fully developed countries. So, if one calculates a trendline for exponential growth in per capita GDP in China at a conservative growth rate within the range of recent Chinese experience and marks the point in time at which this produces an affluent, first world level of per capita GDP in China (perhaps per capita GDP in France or Italy or Spain might be used as a bench mark), you have the end of the time frame. Using the rule of 72, and doing this calculation from a 6% per capita GDP growth rate, you get a doubling in per capita GDP every twelve years. The World Bank estimated that China had a per capita GDP in 2011 of $8,442. By the same measure, France had a per capita GDP of $35,194, Italy has a per capita GDP of $32,569, and Spain had a per capita GDP of $32,701. In round numbers, this suggests that China's Great Depression ought to happen sometime before 2035.

But, a 6% GDP growth rate for the calculation may be low, given the recent historic data: "Since economic liberalization began in 1978, China's investment- and export-led economy has grown almost a hundredfold and is the fastest-growing major economy in the world. According to the IMF, China's annual average GDP growth between 2001 and 2010 was 10.5%, and the Chinese economy is predicted to grow at an average annual rate of 9.5% between 2011 and 2015." Likewise, per capita GDP growth that could trigger a major Chinese economic downturn that produces a Great Depression as opposed to a merely transient business cycle, may start to lag materially sooner than a cutoff of the per capita GDP of Spain or Italy. The Czech Republic with a per capita GDP of $25,959, Portugal with a per capita GDP of $25,444 and Greece, with a per capita GDP of $26,892 are all still clearly developed industrialized first world countries that are capable of generating the kind of economic growth via imitation that one can achieve during periods of industrialization.

If you are looking at the time it takes an economy's per capita GDP to triple at a conservative something a bit over 8% per annum rate, you are looking at fourteen years. In other words, you would bracket the next Chinese Great Depression to the time frame of late 2013 to 2025.

You could probably trim a couple of years at the front end and back end of that range without undue loss of accuracy, given the conservatism of the assumptions that go into the boundaries on each end of the prediction, and get a time frame for the commencement of the first Chinese originated Great Depression of 2015 to 2023, an eight year spread of plus or minus four years around a midpoint date of 2019, a date well within the economic medium term.

This is the medium to long term future, but hardly impossibly remote either. My estimate is that in terms of probabilities, the certainty of this time frame is probably on the order of a +/- one standard deviation error bar, i.e. about 68%, give or take.

So, there you have it. Based on some admittedly thin information and some very simple economic models, as well as some deeper historical insight and understanding of economic development generally, and in China in particular:

My prediction is that there is a 68% chance that China will experience its own first, post-Cultural Revolution Great Depression (defined by standards similar to those used by first world economy financial journalists to distinguish between a mere recession and a true depression) sometime between 2015 and 2023.

Some of the uncertainty is attributable to my methods.  But, something like the timing of a major economic downturn is also inherently uncertain and relies on a vast number of detailed facts that can never be successfully modeled. 

My intuition, having seen efforts to model events that are similarly complex in their causation over the years, is that it is impossible, with all the brainpower and resources in the world, the kind of resources that might be available to top CIA and Defense Intelligence Agency and Executive Office of the President and State Department policy makers and leading professors at top Western universities, to make an estimate that is accurate to much better than plus or minus 18 months to two years, i.e. to a 3-4 year range.

So, while I'm sure that my eight year range prediction could be improved upon, the room for improvement from this back of napkin estimate to a state of the arts all available resources estimate that would cost millions of dollars to assemble and involve immense intellectual resources to develop, is pretty modest.  Something like a third to half of the eight year range I have proposed arises from inherent unpredictability, with only the balance being due to my rather crude methods.

An Aside On Rural Chinese Economic Development

Rural China is honestly doing so not poorly compared to agricultural economies starting at their level of development. This is mostly because it is not plagued by the problems endemic to most developing agricultural economies.

Rural China not ravaged by wars and succession fights. It has had more than thirty years (figuring from the end of the "Cultural Revolution") of social and military peace. Unlike its neighbor North Korea and despite the immense scale of the Chinese military machine, China has fewer people in military service per capita than almost any other country in the world. Similarly, rural China doesn't have rampant social disorder and massive levels of crime, in the way that much of rural Latin America and Africa do.

Unlike most developing agricultural economies in the world, rural China has strong political and social ties to more developed economies that it can trade with and learn from, has easy access to financing for long term infrastructure projects, has resources to educate its best and brightest who wish to use their skills to return to the places where they grew up, has decent public health systems considering the local per capita GDP, and has no problem finding a market for its products not prone to being hijacked by political dramas of trading partners sublimated to trade policy. While China's anti-natal policies aren't applied as strictly in rural China as in urban China, the rural Chinese are in the unusual position of having progressed well into the demographic transition associated with industrialization and economic development well before it would have been expected to do so were it an independent country.

While rural China has no shortage of corruption, it isn't nearly so corrupt as a typical Third World subsistence farming economy. Indeed, the Chinese national government's experiments with essentially non-partisan democratically elected local government in rural China have been a great success. Rural China's political system is considerably more democratic than urban China's politics and China's national and provincial level politics.

All this allows rural China to have consistent, slow economic growth; rates of economic growth any American President would be happy to take credit for producing. Almost everyone is rural China is much better off than their great-grandparents and grandparents, with the possible exception of the descendants of pre-revolutionary minor landed gentry, many of them have probably found decent Communist party posts by hiding their roots, or have migrated to the cities where they can forget their pasts by now. And, in the Confucian, ancestor oriented milieu of rural China, most people are far more intimately familiar with the lives of their grandparents and great grandparents than Americans.

If you want a best case scenario for economic development in an agricultural economy, look to the example of rural China. This is as good as it gets, and almost any other country with an agricultural economy seeking to encourage economic development while continuing to have an agricultural economic base should have expectations of being less successful at it than the Chinese have been in the last thirty years.

This isn't to say that rural China is viewed as a success story within China. In relative economic success terms, their plight is awful.

The rural Chinese have gone from being economic peers of, or just a bit worse off than, the urban working class to having incomes that are a sixth or eighth or tenth of their urban peers. A fair share of those urban peers are the prize of the village children of neighbors who moved to the big city, who write home with stories of their hard struggled but new found wealth, and who visit now and then in economic displays that prove that their stories are real. The relative privation of the rural Chinese is not just immense, it is also immensely personal and concrete.

In a country whose officially proclaimed central political principle is economic equality, in the same sort of sense that "freedom" is the central political ideal of American politics, this is an acid bath of class tension ready to explode in a sudden, catastrophic revolutionary earthquake, perhaps akin to the one that ended Soviet communism and lead to the break up of the Soviet Union, at any time. The lid that an authoritarian one party national and provincial level political system with massive resources that can be mobilized from a nation of far more than a billion people, prevent any more gradual process from letting off steam from rural Chinese discontent in any other way.

One of the few factors that argue against such political collapse, at least in Han Chinese areas (the submerged nationalist movements in Chinese deep interior highlands and parts of South China are another, more complicated story), is that unlike restive rural communities experiencing economic development in other parts of Asia, in Africa, and in Latin America, rural Han Chinese peasants do not have a bulging generation of underemployed youths ready to cause trouble. Restrictions on family size, and migration from rural areas to more quickly developing cities had left the youths who remain with no shortage of economic tasks to occupy themselves with and little time for revolutionary organizing.

Rather than having an excess of young women causing distress to their families, rural China has a shortage of young women and is turning to questionable means to bring them to reasonably prosperous rural young men as wives. The nasty social consequences of an excess of young men in the current generation in China seems to be more visible in the chaos of China's big cities that are growing so quickly that no one fully understands what is going on in the big picture.

Political And Military Implications

Serious economic downturns produce a predictable grass roots political response that is indifferent to the policy preferences of the people currently in power: Throw the bums out.  Likewise, regime change is quite heavily balanced towards moments when a nation is at the economic bottom.  China may not be a free and open democracy, but it isn't a hereditary monarchy either and requires a considerable base of supporters to stay in power.  Also, China's political elite is much more tightly linked to its economic elite than political figures in most Western developed countries.  So, pointing the blame for an economic collapse elsewhere might be harder for China's political elites than it would be in the West.

The obvious moment for China's fragile but intense pent up political frustrations, including those that fall on its intense urban-rural divide would be in the wake of China's first modern Great Depression, which I have predicted will most likely begin sometime in the time frame from 2015 to 2023.  So, look to that time frame, not just for Chinese domestic economic malaise, but also for major Chinese political upheaval of some sort and for Chinese aggression in foreign policy and military affairs in a probably vain attempt to divert public attention from the domestic crisis.

U.S. foreign policy makers and defense planners should be prepared for this kind of critical moment in U.S.-Chinese diplomatic and military relations by the early end of this time frame.  The preparations they engage in, moreover, should be devoted to considering what possiblities are plausible when it does happen, how to respond to each, and what resources need to be marshalled and developed in that time frame, rather than to pinpointing more precisely exactly when this will happen.

Given the relatively modest and medium term nature of this diplomatic and military challenge that we can expect to fact, major new research and development programs are not a wise investment.  Instead, planners should focus on the resources that can be bring fruit that would be useful in foreseeable scenarios in the next two to six years, since this planning and development of resources should reflect the reality that any development of resources not accomplished before a crisis breaks out is useless.


andrew said...

BBC news reports today for the first time that I have heard it in the popular press that international economic bodies are sounding the alarm (in very non-alarmist technical language) on unsustainable growth and an unbalanced economy in China. If the bottom holds off from dropping out for a year and a half, my prediction will be correct.

andrew said...

More signs of a bubble in China.

I am worried that my "after 2014" prediction may have been too optimistic about how distant the risk is right now.

andrew said...

Again, more signs of imminent economic bust in China:

"Average capacity utilization is now below 60 percent."

A collapse needs to hold off for another six and a half months for my prediction to be correct, but again, sooner rather than later seems to be favored by the economic indicators.

Anonymous said...

Looks like you were right. Summer of 2015 has certainly been interesting so far for China.