What is the single greatest risk facing the Australian economy over the next 10 to 20 years?
Some might argue its climate change, or population ageing. Some might even say house prices, or household debt – yet again.
But as I contemplate our future, I can’t help coming back to a sobering conclusion: it’s China.
Reserve Bank Governor Phillip Lowe recently outlined many of the immediate financial risks facing China given its continued strong growth in debt.
This debt has largely reflected growth in credit from lesser regulated parts of the financial system, once household savers became freer to chase higher returns outside of the formal banking sector. Much of the money has gone back to the usual suspects – state owned enterprises and local governments desperate for funds to keep their loss-making activities afloat. And some of the money has still come via state owned banks, albeit in more indirect ways.
As has been the case in other countries, the first stages of financial deregulation can often give rise to an explosion in leverage and asset bubbles due to the early inexperience of both borrowers and lenders. China’s challenges are all the greater because of the strong lingering role state owned banks and enterprises and their dulled economic incentives.
Indeed, given this debt has been important in driving China’s economic growth, it’s far from clear China can reign in it in and transition the economy to less debt-intensive economic activity (like private services) all while retaining strong overall political control.
Lowe remains hopeful that China could rise to the challenge, but he nonetheless noted “the experience is that the build-up of financial risks like those seen in China is almost always followed by a marked slowdown in GDP growth or a financial crisis.”
Of course, Lowe offered that China at least had the benefit of being able to “learn from the experiences of other countries” – including Australia, which had its own corporate debt bubble in the late 1980s after the financial system was first deregulated. But he added China task was also “more complicated” due to the structural need to also shift financing from large State owned enterprises and local government to more privately run small and medium enterprises.
More broadly, therefore, the key concern appears to be that state owned enterprises, and Government direction of economic activity still play a major role in China. And in case anyone hasn’t noticed, the Chinese Communists party’s grip on not only political power, but the levers of economic activity has recently been getting tighter, not looser.
And while this continued heavy reliance on top-down direction is probably irresistible in a one-party State, it does seem increasingly at odds with the need for a more flexible, dynamic and entrepreneurial economy. Indeed, the need for greater bottom-up dynamism is becoming increasingly important as living standards rise, and China loses its low cost competitive edge as the “workshop of the world.” It’s a challenge that has often been called the “middle income” trap faced by other developing economies, and many have failed to make this leap forward.
It’s this tension that I fear will gradually build over time and potentially reach breaking point. No country in history has managed to combine dynamic efficient capitalism with one party control. I hope China can become the exception, but history does not given me a lot of confidence.
What’s more, should China ever move toward a more democratic system smoothly or otherwise – and I’m not necessarily advocating it should – it would likely lead to years of wrenching economic and social upheaval not unlike we’ve seen across Eastern Europe, Russia and even the Middle East.
China's leaders are understandably worried about letting the democratic genie escape the bottle!
One risk is that if the economy does gradually falter, China’s political elite will attempt greater nationalist diversions, such as sabre rattling across the Pacific. Another risk is a Trump-like tightening of its already imposing trade barriers.
All up, while Australia is right to engage with and hope for China’s continued economic progress, we should not be blind to the risks and challenges this latest “miracle economy” will increasingly face in the years ahead.
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