Chinese Overcapacity is Everyone's Problem

The problem with economics is that economic theories work for a while until they stop working. Unlike the natural sciences which are dependent on the laws of nature, economics is a social science and is dependent on the behavior of millions of individuals. The problem with human beings is that they are prone to mass hallucinations and group think.

In the aftermath of the great depression, Keynesian economics of big government and demand stimulation worked brilliantly, until it stopped working in the seventies. The world economy struggled through the seventies until monetarist and supply side policies implemented by Reagan and Volcker got the world economy home. The decades of the nineties and 2000s saw the creation of the Greenspan-China nexus driven by massive financialization of developed economies fueled with debt and monetary accommodation and a resurgence of the Ricardian theory of comparative advantage.

Looking back, it is mind-boggling how strong the nexus was between monetary accommodation in the west, capacity creation in China and the ability of the China price to keep inflation down in the west thereby fueling further monetary accommodation. The theory of comparative advantage suited everyone because the Chinese bought global commodities at high prices, converted them into goods at low prices and allowed the developed world to focus on pushing financial pieces of paper around.

The problem is that like all economic theories of yore that worked for a while, the Greenspan-China nexus has collapsed, and spectacularly so. China has maxed out its capacity creation and neither the world, nor China needs what it can produce. This has a dual impact, one on the capital account and the other on the current account. The impact on the capital account is that China cannot absorb the world's capital (goods), this has an impact on the global financial sector which has seen an abrupt halt of financial capital flowing to China and on manufacturing economies like Germany and Japan that supplied hi tech capital equipment that enabled capacity creation in China. In commodities, China's consumption involved a part that was used in capacity creation and a part that was used as raw material for production of goods. The two are hard to distinguish, but it is reasonable to assume that the massive contraction in demand of commodities experienced recently has been primarily driven by the freezing up of capital investment in China. Whether the demand for commodities used to produce goods will dry up remains to be seen.

It is very clear to even the most casual observer that China is producing goods and dumping them on global markets at prices below cost of production to keep its unneeded factories running. The pain of this is being felt by the industrial side of economies around the world. The reason the pain appears more exaggerated in emerging markets like India is because the industrial sector forms a larger part of emerging economies than of developed economies. The overcapacity in China has therefore become the overcapacity of the world. Thirty years of Ricardian kool-aid has "globalized" the world economy. Supply-chains are now so complexly intertwined that it is impossible for economies to protect themselves from dumping without experiencing an even bigger crisis. Because of this capacity overhang, capital investment in production of goods has globally ground to a halt. The size of the overhang is so large that no amount of monetary stimulation or demand creation whether in the rest of the world or in China can absorb it.

The only solution for the world economy is for the bad capacity in China, and there is lots of it, to shut down. The problem is that this will create a gigantic political crisis in China and the Chinese government will not allow it, even at the cost of destroying its entire banking sector and financial system. The unfortunate reality is that that is where China is headed. China is institutionally weak to begin with, and the desire to prevent an economic crash is going to make it institutionally bankrupt. As was evident in the aftermath of the collapse of the Soviet Union, a beautiful physical asset (like a factory for example) is useless in the face of institutional collapse. The world is drawing comfort from China's $3+ trillion of foreign exchange reserves and the maneuvering room that it gives the Chinese government. The world and the Chinese government may realize that when there is a run on the system, even $3+ trillion is not enough.

If the above scenario does play out, we could see a rout in the exchange rate of the Chinese Yuan versus the US dollar. This will lead to an equivalent collapse in the currencies of all emerging market currencies (as well as those of developed market commodity exporters like Australia and Canada). The key indicator to watch in 2016, therefore, will be the exchange rate of the Chinese Yuan versus the US dollar. Until stress is visible on that front, the global industrial sector will remain depressed and will continue to experience deflation due to Chinese overcapacity.

Emerging economies especially find themselves between a rock and a hard place. While India is relatively better placed than many other emerging economies, the size of China's economy and the size of China's problem is so large that it cannot be wished away by any economy whether emerging or developed.