This Giant Isn't Sleeping

The most frequent critique of China’s growth is that it’s too dependent on state spending, too reliant on exports to the United States, and not grounded in consumer activity. Or to put it another way, that its growth is fueled by the government and not by the domestic market. A recent McKinsey Report again warned that domestic consumption in China was dangerously low (less than 40 percent of the economy) compared with developed economies in Europe and the United States (where domestic consumption comprises more than 70 percent of the economy). What’s more, financial mavens are almost unified in their belief that Chinese lending this year has been promiscuous and that many of the loans will go bad; that stocks are forming a bubble; and that there still is far too little domestic consumption, especially as the export market once again ticks up as the global economy recovers.

Yet, what if China isn’t headed for a soft landing or a hard landing? What if it’s headed for no landing?

Of course, just because China did not hit any significant speed bumps earlier in the decade is no predictor of whether it will in the future. But the lessons of past underestimation should be taken seriously. The surge in the price of raw materials in 2007-2008 was based almost entirely on unexpected Chinese demand, and the pattern is beginning to repeat itself: Despite widespread pessimism among mining and oil companies after last year’s financial collapse, China’s huge stimulus package kicked off a flurry of industrial activity that led to massive price spikes in things like copper and iron ore: Copper--the leading indicator of global industrial activity--doubled in price between March and August. Other metals have also been rebounding strongly.

The consequence of these miscalculations in the past has been chronic misjudgment about everything from the price of oil and commodities to the strength of corporate earnings and the level of interest rates. For instance, by failing to factor in China’s growth earlier in this decade, oil companies were left with a serious supply shortfall when China consumption surged. That helped propel oil past $145 a barrel in 2008. Gasoline in the United States then surpassed $4 a gallon, with serious economic and political consequences.

True, this year, as global economies contracted, oil fell and fell hard, to $45 a barrel. And with Americans driving less, prices at the pump came down to earth. But it would be a grave mistake to assume that this is the new normal. The rise in oil past $70 a barrel over the summer occurred against a backdrop of China’s rapid rebound, yet the chronic skepticism of China’s path means that we are once again failing to anticipate just what China’s growth might mean for the world.

China now consumes close to 8 million barrels of oil a day. But what if it grows 10 percent a year and if cars sales expand by double-digits in China (as they have been)? What if China doubles its oil consumption in the next few years, just as it has in the past few years? No one believes that the global supply of oil is ready to provide another 8 million barrels a day. And what about the rapid rise in raw materials? Those costs directly affect the economics of global companies. If China is buying up the world’s available iron ore--and it is--that makes the cost of steel everywhere more expensive. If China is buying up the world’s copper--and it is--that puts pressure on everything from air conditioner systems to housing. And if China needs more fertilizer for the increased appetite of its increasingly affluent populace, that makes it more expensive for food companies to operate.

All of those costs erode the profitability of companies. In years past, companies would have simply raised prices. But in the United States and Europe, they haven’t been able, because consumer wages are flat and their access to credit is limited. So what do they do to remain profitable? They try to become more efficient, and they try to cut costs. And one of the best ways to cut costs is to cut people, which is one reason for the 9.7 percent unemployment in the United States. In short, there is a direct link between Chinese growth, higher input costs and higher unemployment in the United States.

But it isn’t so simple to detach from China and erect trade barriers. Last week’s decision of the Obama administration to impose steep tariffs on Chinese tire imports raised the specter of a trade war, but while auto unions in the United States celebrated the decision, such moves do real harm to the domestic U.S. economy. China’s growth benefits America in manifold and unexpected ways, especially in providing a stream of affordable goods that keep our standards of living from falling off a cliff. In addition, China’s demand for Procter & Gamble sundries, General Electric turbines, and Caterpillar earth movers keeps jobs in the United States that might otherwise not exist. In turn, the earnings of those companies can be much more robust than the U.S. economy more broadly--and the recent strength of corporate earnings bears this out. But here too, if investors--and that includes pension plans and even the U.S. Treasury itself--fail to account for the China effect, then their investment decisions will also be flawed: They will assume that U.S. companies can only be as profitable as the U.S. economy and underestimate just how well they can do because of China.

For now, the political class in Washington seems to be preparing for a slow, unspectacular resumption of growth in America, and the financial class is also anticipating that the China story is headed for problems. The first is likely to be correct, but as the above indicates, the China story may play out quite differently. Some of that has positive effects for the United States; some is more challenging for us. Either way, misjudging the viability of China’s economic path has serious negative consequences. In the past, the failure has had only marginal effects. But with China now assuming a joint role with the United States as a cornerstone of the global economy, getting China wrong could be the difference between prosperity and chaos.

Zachary Karabell is the author of the forthcoming Superfusion: How China and American Became One Economy and Why the World’s Prosperity Depends on It. He blogs at www.rivertwice.com.