What's going on? Well, China is trying to manage a slowdown that was always going to happen at the same time that it deflates a credit bubble that it wishes hadn't happened. Either one would have been hard enough on its own, but together they might be too much for even the most competent government to deal with. That's because Beijing needs to intervene even more to keep the economy growing today—at least as much as it wants—but loosen its grip on it to keep it growing tomorrow. So there are two dangers. The first is that a tug-of-war within the government leads to half-measures that don't solve either problem. And the second is that fears over a tug-of-war might make these problems harder to solve than they already are. Still, we shouldn't overstate this. It's not like China's economy is about to collapse. Its growth is real, if not as spectacular as it was before. It just might slow down further or faster than we thought, grinding down to 3 or 4 percent growth instead of 6 or 7 percent.
But let's back up a minute. Why was it inevitable that China's economy would shift down to a lower gear? Simple: its old growth model had run out. There are only so many people you can move from the farms to the factories—especially when you only let them have one kid—and so much infrastructure you can build before you run out. Now, China hasn't quite reached that point, but it has gotten to the one where there aren't as many people moving to the cities as before. And that's enough. It not only makes it harder for the economy to grow as much, but also makes it harder for companies to export as much now that, without a steady stream of would-be workers holding down wages, they have to pay people more.
You can probably see where this is going. If workers are making more, they can spend more—and that, rather than selling things to foreigners, can power the economy. But that's a lot harder than it sounds. First, you need a stronger safety net so people feel more comfortable splurging. Then, you need to give them time for their habits to change. But, most importantly, you need to keep adding higher-paying jobs.
It's this last part that would force Beijing to do what it doesn't want to: give up at least some of its control over the economy. Think about it like this. In the short-term, wages are going up because workers have more bargaining power, but, over the longer-term, that will only continue if productivity increases. Workers, in other words, have to make more or better stuff to make more money. How do you do that? Well, the government would have to start deregulating the economy so businesses could expand where they had to and stop supporting zombie companies that were blocking the way. Beijing has actually talked about this quite a bit, even commissioning a rap song about supply-side reforms, but, as we've seen with stocks, this determination to give markets a "decisive" role in the economy has only lasted as long as they give the "right" answer.
That brings us to problem number two. Everything we've been talking about, this shift from a saving to a consuming society, well, takes time. So what is China supposed to do until then? Beijing's answer has been for everyone to run up a lot more debt—and by "a lot," I mean four times as much. Indeed, between 2007 and 2015, China's total debt, including the government, households, and corporations, increased from $7 trillion to $28 trillion. That's 282 percent the size of its economy, which is more than we have relative to ours.
Now, most of this hasn't directly been on Beijing's books, but has rather come at Beijing's direction. The idea, at least, made sense. That was to replace all the foreign customers who disappeared during the financial crisis with even more infrastructure spending until Chinese customers were ready to take their place. In practice, though, it hasn't worked out that well. Developers built cities where nobody lives, companies built factories that nobody needs, and local governments built airports that nobody uses. It hasn't all been wasteful—and who knows, 10 years down the line, what is today might not be—but right now it sure looks like a bubble not all that different from the one we had. Consider this: more than half this debt is tied to a property market that, since 2008, has gone up more than 60 percent in the 40 biggest cities. So far Beijing has been able to keep prices from falling too far, but only by letting people pile new debt on top of the old. That is not a long-term solution.
But it's hard to tell how much this will hurt. It's not just that nobody believes China's official numbers. It's that even if you did, they might not be worth that much anymore. As Larry Summers points out, about 20 percent of China's growth the past year has come from financial services despite the fact that it was already a pretty big share of the economy. That's as close as you'll get to a flashing red warning sign saying "bubble", as we found out with our own.
So what's a better way to tell how China's economy is doing? Well, how about how much people are willing to bet on it—or not. The simple story is that money has been pouring out of China the past year or so, and that actually accelerated in December. Part of this is probably due to wealthy Chinese moving their ill-gotten gains out of the country to stay a step ahead of the government's corruption crackdown. But a bigger part is probably that people who thought they could make a quick buck investing in China are changing their minds now that it's slowing down—which is contagious. Here's why: when people move their money out of China, what they're really doing is selling their yuan to buy, say, dollars. But that's just another of way of saying that there isn't as much demand for yuan—so its price falls. And if that happens, other people who hadn't wanted to get their money out of China might decide that they better do so before it loses any more value.
That's why Beijing has actually been trying to stop its currency from falling too much. It's done that by buying yuan with some of the now-3 trillion in dollars it's stored up. That offsets the selling pressure on the yuan to keep its value stable. The only problem with this strategy is that might be the worst thing it could have done. The best way to think about that is to think about what would have happened if it'd just let the yuan fall as far as markets wanted it to. And the answer, as Paul Krugman explains, there would be a big drop, probably bigger than the fundamentals say it "should," until it got to the point that investors expected it to start rising—which it then would. The idea is that investors would want to buy yuan as soon as they thought it was undervalued. And then it'd be over. The good news would be that Beijing wouldn't have to spend any of its war chest of reserves. But the bad news would be pretty bad. It would probably trigger a trade conflict with the United States and plenty of other countries that would see a much weaker yuan as a bid to subsidize exports.
But that doesn't mean Beijing's current plan is any better. By buying just enough to keep the yuan from falling suddenly, while still allowing it to trend slightly lower, the government is telling people that they're right to move their money out of the country since it will, in fact, be worth a little less if they wait. That puts more pressure on the yuan to fall, and more pressure on the government to keep it from falling by spending its reserves. The end result is that the currency might fall just as much as it would have if you let it fall all at once, but at the cost of a lot of its war chest. And that is a real cost. It sucks even more money out of the economy, which, in turn, forces the government to cut interest rates just to keep growth from slowing down even more. The lesson, then, is that you'd be better off either spending so many reserves that your currency doesn't fall at all, or just letting it go. A controlled fall is the most expensive kind.
China's economy might be a riddle wrapped in a mystery inside an enigma of dodgy data, but its currency is telling a clear story. The people who have the most on the line—that is, ones with money in the country—are worried that the economy is going to slow down a lot more than the government says. The worry is that if, after spending down its reserves, China is forced to let the yuan slide, other countries might follow so their exports don't lose competitiveness—and emerging markets that borrowed in dollars might found their debts too hard to pay back. That wouldn't quite be 2008 all over again, but it'd be close enough for a global economy that is still struggling to recover from the last one.
The rest of the world will be okay if China is just sneezing, but not if it's more than that.