InvestmentsMay 29 2019

China's outlook through prism of two economic theorists

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China's outlook through prism of two economic theorists

Both men took the view that economies develop in a sequence, from hunter gatherer, to agricultural, to industrial, with the progress through each phase driven, in Smith’s mind, by trade, and from Marx’s point of view more by technology.

Smith believed that the benefits of ever freer trade would lead to technological development anyway, and that the benefits were infinite, meaning industrial capitalism would be the final stage of human development. 

Trade would make interactions ever more efficient, and therefore cheaper, and so would constantly increase the affordability of goods, thereby boosting demand in the economy, and spurring economic growth.

Marx believed technological improvement was the driver; that it would be this which would cause the price of goods and services to fall and people to grow wealthier. Smith believed the benefits of trade becoming freer were infinite, meaning a market economy was the final stage.

Both Smith and Marx took the view that governments were the enemy of the system they regarded as optimal, and for the same reason.

Marx believed the existing order was not keen on technological advance, as it would threaten their incumbent position. Smith, on the other hand, took the view that governments would always side with the existing dominant firm in a market, and those firms do not want free trade to happen, as it can reduce their dominant position.

China’s rise

The rise of China over the past 40 years has offered much vindication for both. As the economy moved away from central planning, people became richer, while some Marxists would argue that the speed of progress from an agrarian to an industrial economy was far faster than in the west because of central planning.

The impacts of China’s rapid growth have been felt throughout much of the world.

Advocates of Smith would point to the outcome of the global financial crisis of 2009. Here, in contrast to the events of the Great Depression, there was another buyer prepared to step in: China. For them, this indicated that developed economies could trade their way out of trouble as long as humanity continues to progress to every freer trade.

Fans of Smith would also point to the deflation that the growth of China created around the world. This deflation meant lower interest rates, allowing for an expansion of global bank lending, boosting global demand.

This created a scenario in the years immediately prior to the global financial crisis where inflation remained persistently low but growth continued, and appeared to be a vindication of the ideal of free trade.

Others suggest that China will eventually stop exporting deflationary pressures to other economies. At that point, inflation will rise and growth will fall, leading to the economic condition known as stagflation, and to a reordering of the economic system.

Advocates of Smith contend that there are always more countries to become more economically liberal, and therefore a system in which they believe can perpetuate forever.

The currency issue

A challenge faced by emerging economies trying to profit from trade is that of currency.

Export-led economies face the problem that, as they export more, the value of their currency is liable to increase as those buying the goods have to buy the exporting country’s currency. A rise in the value of the currency makes the goods more expensive, and so reduces demand for those goods, stalling the pace of economic growth.

Policymakers in those countries often try to avoid national exports becoming too expensive by cutting interest rates to weaken the currency. This leads to a scenario where inflation picks up, and wages rise as a result. This in turn increases the cost of producing economic goods, making them less competitive.

Lower interest rates can also lead to banks increasing lending levels, as happened in Ireland prior to the financial crisis. This scenario can create a credit bubble that is destined to eventually burst.

New challenges

The challenge for policymakers in those economies is to become less reliant on exporting low-value goods to developed markets, and instead to increase domestic demand while exporting goods that are less sensitive to economic cycles. China has followed this pattern in recent decades, with its share of global exports rising, and an emerging middle class boosting global demand.

Exporting cheaply has exported deflation around the world, while investment in roads and other infrastructure – known as fixed asset investment – has boosted worldwide demand for commodities and luxury goods. This has helped the global economy to grow, while ensuring inflation stays low.

But with a sense of history not always prevalent among politicians, Chinese leaders are aware of the need to move away from this model. Fixed asset investment is unsustainable because there is a finite amount of this expenditure that can be productive. 

Beijing is also seeking to ease the country’s reliance on low-value exported goods, as the inevitability of wage rises or currency increases will ultimately obliterate the growth that has happened to date.

Fund manager Neil Woodford is among those who believe China’s rise in consumption and fixed asset investment amounted to just a short-term fix for the structural problems in the global economy. He thinks that a more typical cycle of less competitive exports will eventually take hold, leading to a sharp slowdown in the Chinese economy, which will then export slower growth around the world.

The decline in Chinese GDP growth at the end of 2018 was viewed by many as the first sign of this theory coming to fruition, as well as a looming crisis in the country’s economy. 

More positive voices regard the slowdown as being part of a natural progression of China’s move away from the rapid growth of an export-led economy, to the slower, more stable growth of a consumption-based economy. The next generation of export-led economies in Asia and Africa will then emerge in turn.

But an uncomfortable parallel for investors to consider is that while China may avoid the deep cyclicality that affects export-led economies such as Ireland, it could ultimately develop an equally familiar set of problems. Its path could be seen to resemble that of Japan – a country where the export-led growth of the 1980s has long since given way to the sclerotic issues of the present day. 

The threat of this outcome is heightened by the Chinese state’s one-child policy, which ran from 1979 to 2015. It is likely to be a major hurdle as it tries to move to a consumption-based economy, just as stagnant population growth has hindered Tokyo’s attempts to bounce back from lost years and indeed lost decades of economic growth. 

A combination of restrictions on trade within the Chinese economy and a lack of population growth could mean the nation becomes neither a free trader’s dream, nor a reference point for markets, but rather the next Japan.

David Thorpe is investment reporter at FTAdviser.com