China’s Madoff economy could come crashing down — with worldwide effect

Not so long ago, China’s economy was known on Wall Street as the Madoff economy.

Like the infamous Bernie Madoff, who fictitiously reported stellar returns each year no matter what really happened to his investments, the Chinese government reported 7% to 8% growth each year no matter what really happened to the economy.

Little wonder then that many Wall Street analysts believed the country’s economy was growing much more slowly than the official numbers purported it to have done.

So how bad must the Chinese economy be that even the “official” numbers have dropped to 4% to 6%?

So bad that the Communist authorities are resorting to new sleight of hand.

They are instructing their local analysts, and they are putting pressure on the foreign investment banks, not to make negative comments on the economy.

It’s a misguided effort to boost domestic and foreign confidence, limit capital flight and prevent the economy from slipping into a deflationary downward spiral.

Staff wearing hazmat suits as a precaution against the COVID-19 coronavirus waiting to check a truck at a customs checkpoint on the border with Russia at Suifenhe
Recently, the Chinese economy has “officially” dropped to 4% to 6% in growth.
AFP via Getty Images

The country’s problems could have a material impact here in America, not least because China is the world’s second-largest economy and until recently was the world economy’s main engine of growth.

On the upside, a Chinese economy on the ropes could provide us with much-needed inflation relief through falling Chinese export prices and lower international oil and food prices.

It does not seem to have occurred to the Communist officials that attempts to muzzle the analysts might have exactly the opposite effect on investor sentiment than intended.

Particularly at a time foreign companies are trying to minimize their supply-chain exposure to China and the government has been intervening in a heavy-handed way in the tech sector, the last thing the Chinese government should be doing is casting doubt on the reliability of experts’ reports.

Chinese President Xi Jinping
The Chinese government is now in defense mode as gross domestic product has not rebounded since President Xi Jinping ended his COVID restrictions this year.

In the absence of reliable analysis, how are investors supposed to make rational investment decisions after all the egregious economic policy mistakes that have been made under President Xi Jinping’s watch?

Among the slew of negative economic data that has put the Chinese government in defensive mode is the fact that gross domestic product has not rebounded after Xi ended his draconian COVID restrictions at the year’s start nearly as much as had been anticipated.

This is raising questions as to whether the Chinese economy will reach even the modest official 5% growth target for the year.

Meanwhile exports are slumping, producer prices have declined in each of the past nine months, consumer prices are flirting with deflation, and youth unemployment has skyrocketed to more than 21%.

If the overall economy is struggling, the data suggest China’s outsized housing and credit market bubble is bursting.

Over the past year, many Chinese property developers, including most notably Evergrande, have defaulted on their loans.

(Just this week, one of the country’s largest private-sector developers, Country Garden, missed interest payments on two dollar-denominated bonds.)

In the same period, house prices have fallen steadily, housing starts are in a deep slump, local governments are experiencing financial difficulties due to slumping land sales, and the housing market continues to be characterized by literally many millions of unoccupied dwellings.  

All this, together with the fact that over the past decade China experienced a larger credit market bubble than did Japan in the run-up to its lost decade in the 1990s, is giving rise to a debate as to whether China might be at the start of a Japanese-style balance-sheet recession.

In such a recession, as prices fall, households tend to cut back on spending in an effort to improve their balance sheets by reducing their debt.

Needless to add, this has an unwelcome cooling effect on the economy by reducing aggregate demand.

The first step toward much-needed economic reform in China would be for the authorities to recognize how excessively reliant the Chinese economy had become on unsustainable credit expansion and housing-market activity.

Instead of suppressing external economic analysis, Chinese policymakers would do well to heed those analysts’ warning about the dangerous path on which the Chinese economy finds itself.

Maybe then they would come up with policies that would allow China to avoid repeating the Japanese experience of a lost economic decade.

If not, the rest of the world economy should brace itself for increased Chinese deflationary pressure.

American Enterprise Institute senior fellow Desmond Lachman was a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging-market economic strategist at Salomon Smith Barney.

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