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China is not as strong as it looks. America is not as weak as it looks.

May 3, 2014

2008’s financial crash came laden with gloomy predictions for the imminent future of the West. One of the most dominant foresaw the passing of the Anglo-Saxon model of capitalism and with it the rapid demise of the United States, the nation which had surpassed all competitors in the twentieth century. In its place would storm China, the growth miracle of our time and the undisputed owner of the keys to the world’s future. In contrast to the debt-subsumed West, the foundations of the Sino-phenomenon were built on hard work, thrift and enterprise. We were all in thrall, swiftly swivelling our focus to the Masters of the Far East.

‘The erstwhile expectation that by the middle of this century China and India will have attained the standard of living and international power on a par with the US now needs revising,’ I wrote in October 2008. ‘We may be there considerably sooner.’

‘To put it simply’, I went on, ‘money is power. Financial power and global political leadership go hand in hand. The bailout of US and European banks will essentially be underwritten by the flooding in the global capital markets of US and European government bonds which will be mopped up by cash-rich sovereign wealth funds in China, the Gulf and Russia. Their money will buy them power. This power will be used to exert more influence – in the case of China and Russia, backed by military force around its borders. Our entire model of democracy and free markets will be put to the test.’

Nearly six years down the line, and news has this week broken that China will shortly overtake the United States as the world’s largest economy, at least according to new World Bank rankings that compare countries’ purchasing power parity (PPP). In dollar terms, it is China that contributed more than any other country to the growth in global consumption between 2011 and 2013. As US infrastructure deteriorates, China’s high-speed rail network will have expanded by nearly two-thirds by 2020, with almost every city with a population of over 500 000 connected into it. By 2030 China’s cities will house nearly one billion people as urbanisation and modernisation continue apace. China can now boast the world’s largest e-commerce market and some of the most sophisticated consumers on the planet. The Sino-superlatives could go on.

Meanwhile the confidence of the United States remains battered. President Obama’s disengagement from foreign affairs is palpable as President Putin and his supporters induce mayhem on Russia’s western borders, and Syria’s President Assad holds firm in an increasingly chaotic Middle East. Domestic battles on Capitol Hill suck his energy. Gross national debt hurtles towards the $18 trillion mark. Engagement with China revolves around a ‘Pacific pivot’, with alternative Asian alliances nurtured in a bid to contain America’s Far Eastern rival.

Many contend that China’s vast foreign exchange reserves, increasingly educated and technologically savvy population and relative political stability will ensure that it will be able to overcome any future bumps on its own road. Nevertheless, as the memory of the 2008 crash recedes, the scales are beginning to fall off our eyes as we examine China’s remarkable ascent. Amidst the praise and exciting economic figures, uncomfortable realities are creeping to the surface.

As the dangers of the West’s debt bubble became evident six years ago, China set about inflating its own. This was primarily through construction works directed by local governments and aimed at counteracting the effects of the financial crisis on domestic employment and growth. Much of the cheap capital that flowed was invested sensibly on critical infrastructure, some of which I had the chance to admire on a whistle-stop trip to Beijing, Tianjin and Shanghai in March. But with pricing signals dampened, it became harder to ascertain which investments would eventually produce returns, and capital began to be misallocated on a major scale. Even sound projects like metropolitan subway systems now look likely to generate only enough cash to cover operating costs, not repay the original investment.

Since 2008, China’s credit gap – the increase in private sector credit as a proportion of economic output – has risen by 71 percentage points with a lot of new credit now being used to roll over existing loans rather than fuel growth. Total debt stands at 230% of GDP, a figure that last year caused Fitch to downgrade China’s sovereign credit rating for the first time since 1999. Meanwhile, reliance is mounting on the unpoliced and rapidly-expanding shadow banking system and China remains vulnerable to default by Western debtors.

It has been suggested that China’s vast foreign exchange reserves, current account surplus and healthy domestic savings will ward off a credit crisis, and let us hope that is the case. Even so, the figures highlight China’s central dilemma: how to shift the economy away from investment spending (which bestowed China with high growth and low unemployment and now accounts for nearly half the economy) to greater consumption, all the while avoiding economic pain and social disruption. China’s new leadership understands the task it must undertake in restructuring the economy and has asserted its willingness to let the rate of growth slide as the price. But they will need to be resolute if they are to take on the powerful vested interests benefiting from the status quo.

The squeeze on the labour market as a result of the demographic impact of its one-child policy (in contrast to a healthy US fertility rate) is also placing upward pressure on wages, reducing China’s competitiveness and further undermining exports, which had already taken a hit from a taming of Western spending. In short, the two crucial elements of China’s growth miracle – state-driven industrialisation and cheap exports – are now in jeopardy. Part of the answer, as China knows and I have already suggested, is to boost domestic demand. But for all the talk of a Chinese consumer boom, consumption actually trended downward as a percentage of GDP, from 46% in 2000 to 34% in 2010, so there is much work to be done.

Aside from these fundamental challenges, China faces well-documented problems over air pollution and land contamination that are cutting life expectancies and harming quality of life. Rapid urbanisation is exacerbating inequities between existing city dwellers and migrant workers which have the potential to cause considerable social unrest. Endemic cronyism blights the political and economic sphere, and foreign multinationals are finding China an increasingly challenging country in which to do business as sweeping new consumer protection laws, fickle consumers and high profile corruption probes deter further engagement.

I would not wish to overstate China’s problems. It remains a land of staggering potential with a leadership of enormous ambition, open about the challenges it faces as the Chinese economy matures. However, in spite of this week’s news that China looks set shortly to become the world’s largest economy, I believe it remains rash to suggest a swift end to US supremacy. For all its faults, the United States is a place of huge opportunity, able better to innovate across myriad sectors and still the home for dramatic scientific advances. Core US defence spending remains larger than that of the next ten nations (China included) combined. In addition to a nascent revival in manufacturing, the US is in the midst of a breathtaking energy boom that gives it an enormous competitive advantage going forward. With a positive population growth rate, the States also easily has the best demographic outlook of any major power.

As this century progresses, Chinese influence, power and economic clout will undoubtedly grow. But in the foreseeable future the United States can rest easy. Looking over its shoulder, it will still find the challengers to its position as the pre-eminent global superpower some way behind.