Can China really ‘de-couple’ from a US recession?

January 25th, 2008

Share |

Now that it is a widespread view that the US will fall into recession, the frame of debate has been shifted to whether China (and other emerging economies) will be affected as well. Back in November last year, as we said in Is Chinese growth ?de-coupled? from the US economy?,

On the other hand, another theory has been gaining in popularity: China?s growth is ?de-coupled? from the ailing US economy. According to this new theory, China should continue to grow and power the global economy regardless of what happens to the US economy. This is the ?de-coupling? theory. Proponents of this theory sees that so far, China had ?de-coupled? (both in real and financial terms) the most from the US. As we can all see, so far, despite the slowdown in the US (due to the credit crunch and housing slowdown), China?s growth had so far been unaffected. Proponents of the ?de-coupling? theory sees that if Chinese growth is dependent on the health of the US economy, we should see signs of the Chinese economy slowing as well. Since there are no signs of this happening, then the conclusion is that the Chinese economy is independent from the health of the US economy.

In that article, we explained Nouriel Roubini’s argument that such ‘de-coupling’ theory will not hold.

Today, we will give a more qualitative argument against the ‘de-coupling’ theory, based on the Austrian School of economic thought. For this, we will again refer to one of the most deeply buried Austrian School 1936 classic (originally written in German), Crises & Cycles by Wilhelm R?pk. But before you can understand what is to follow, you will have to understand the Austrian School‘s concept of capital structure mentioned at two of our earlier articles: The first step in an economic slowdown?mal-investment in capital followed by Overproduction or mis-configuration of production?. Specifically, understand the difference between consumer goods and higher-order of capital goods.

Now, let’s take a look at Chapter 4 of Wilhelm R?pk’s Crises & Cycles

… it will be easily grasped that any increase in general economic activity will have the tendency to produce a disproportionate expansion in the higher stages of production, the rate of expansion being the greater the higher is the stage of production, i.e., the further it is removed from the sphere of consumption. The opposite is true for any decrease of general economic activity.

At this point, we will look at this idea in the context of China. First, look at this simplified picture of the current state of affairs in the global economy: Australia (and other nations as well) produces the highest order of capital goods (e.g. base metal resources like copper, iron, oil, etc). China (and Asia) specialises in the intermediate order of production, turning the raw resources into final consumer goods. Finally, the US (and Australia and UK as well) specialises in consuming those consumer goods (final products).

Much of the economic activities in China revolve around spending on investments. As this article in the Sydney Morning Herald says, “A sharp slowdown in export growth to the US was more than offset by extraordinary investment in new housing, commercial property and infrastructure.” In other words, the Chinese economy is geared more towards producing higher order of capital goods (the higher stages of production), which will take years to bear fruit into higher productive capacity.

A severe recession in the US economy will crimp US consumption significantly. This will translate into a disproportionate contraction in the higher stages of production, which is China’s job. This in turn will result in yet another disproportionate contraction in yet another higher stage of production- for example, Australian resource production. To understand why, consider the example of a factory working flat out to produce 100 widgets a year for consumers. Let’s say that it is anticipated that demand will increase 10% in a year. In the absence of spare capacity, the only way to increase production is to build a new factory. You cannot build one-tenth of a factory to increase production by 10% for that 10% increase in demand. You either build an entire factory or you do not build it at all. As Wilhelm R?pk explains,

The reasons for this intensified impact on the higher stages of production are twofold : (1) In the absence of excess capacity any increase of the productive equipment of the country necessitates a further increase of the productive equipment in order to produce the initial increase (as in the example of the poultry and silver-fox farms). In order to produce more machinery the machine industry itself has to produce more machines for producing more machines; an enlargement of the cement factories calls forth not only an increased demand for building the additional cement plants, but also an increased demand for enlarging other factories delivering the equipment of the additional cement plants and so forth. (2) Assuming that in all stages of production and distribution a certain fixed percentage of sales is held as stocks, any increase of general economic activity (as measured by the volume of sales or goods produced) will bring forth an increase of orders greater than the initial increase of sales. If the demand for shoes increases, dealers will place orders equivalent to the aggregate of additional sales and additional stocks, and the same thing will be repeated in the higher stages on a progressively rising scale. But this whole machinery of increasing intensification will stop the moment the increase comes to an end. In substance, this process of intensification by the enlargement of stocks of working capital amounts to the same thing as the process of intensification by the enlargement of the productive equipment (fixed capital). In both cases the increased volume of production in the upper stages can be maintained only if the increase of demand in the lower stages goes on at the same rate. It is, therefore, not sufficient that the demand does not decrease absolutely, nor even that it continues to increase if only at a lower rate; for the maintenance of the top-heavy superstructure of production, it is necessary that the ultimate demand should rise at the same rate or, in other words, in geometrical progression.

But look at what China is doing right now. In the face of a major slowdown in US consumption, it is still building yet even more productive capacity. Worse still, such investments are very resource intensive at this stage, which consumes a lot of resources in countries like Australia that provide the higher order of capital goods in the form of raw materials. There are signs that the Australian economy has reached full productive capacity (see Interest rate rise in Australia- be prepared for more to come), which means it will be hard pressed to provide the Chinese economy with sufficient raw materials for fuelling further growth in its capital goods investments (see Can Australia?s mining boom turn into bust?). There are also signs that China itself is approaching its limits (see China at turning point?).

So, do you see China being caught in between? On one hand, a slowdown in US consumption will ultimately result in far greater proportion of contraction in investment spending in China, which accounts for the majority of Chinese economic activity. On the other hand, it is running out of resources (including Australia raw material resources) to ensure the successful completion of its capital investments in the current pipeline.

Some may argue that the Chinese consumers will rise up to to keep the ball rolling. We have our doubts against this view:

  1. Does China have enough capital goods, labour (yes, there are reports of labour shortages in China) and raw materials to continue the current trajectory of capital investment growth in China?
  2. The needs of the Chinese consumption economy is different from the US consumption economy. Some Chinese are rich. But some other parts of China are unbelievably poor. Wealth distribution in China is rather uneven and there are still many pressing social and environmental issues to be solved. Currently, the Chinese export economy is tooled towards US consumption. To re-tool and re-configure the Chinese economy towards its domestic needs requires a period of adjustment in which capitals are destroyed and built. As we said before in Overproduction or mis-configuration of production?, the issue is not a simple case of overproduction. Rather, it is the mis-configuration of production that is the issue.

We may be wrong, but our theory is that this may be an epic boom waiting to be a bust. Note: we are not making a prediction here- we are merely expressing our scepticism on the de-coupling theory.