April 30, 2004

Is the PRC Crashing?

Stratfor's sample analysis this week (after this week, the same URL will point to a different article) points to what might be the beginning of the end for that country's economic miracle. The key graphs are below:

To understand China's problems, it is necessary to look at the structure -- and failures -- of other Asian economies. We have already seen two major systemic crackups in Asia during this generation. Japan went from being an economic superpower that was predicted to dominate the global economy in the 21st century to an economic cripple during the early 1990s. East and Southeast Asia, excluding China, similarly passed from economic miracles to economic catastrophes in 1997. In both cases, the striking characteristic was the speed at which overblown Western expectations turned into disappointment. It is our view that China, which got started later than other Asian economies, is on course to be the third Asian meltdown in this generation. The euphoria about China until very recently -- and China's assiduous attempts to stoke expectations -- tracks with what happened in the rest of Asia.

The core problem in Asia -- a problem that the Chinese government is trying to address belatedly -- is that its banking systems do not allocate capital based on market forces. Loan decisions are made out of political and social considerations, and real interest rates vary depending on these relationships. Long-term business relationships in Asia receive favorable treatment from banks regardless of the actual business case to be made for a loan.

Of equal importance, these are debt rather than equity driven economies. The major source of financing does not come from sale of shares in businesses, but from direct loans. There are two reasons for this. The legal structure of Asian corporations gives limited rights and protections to shareholders, who do not collectively control corporate boards. Therefore, maximizing shareholder value is not a driving consideration. It also means that a core measure of economic performance -- the rate of return on capital -- is not a critical variable.

Essentially the argument is that the PRC is making the same errors that every other asian country has lived through. It is aided by the fact that its currency is nonconvertible but that's no panacea. It is suffering from a plague of crony loans made to connected people who have hollowed out their economy. Essentially, we're in the end stages of the PRC's economic pyramid scheme.

The stakes are quite high. If the PRC falls into crisis, it is much less likely to survive than Japan and more likely to fracture into the traditional solution of warlord dominated regional entities.

Posted by TMLutas at April 30, 2004 04:16 PM