Globalization

Stewart Paterson | China, Trade and Power: Why the West’s Economic Engagement with China Has Failed

China’s admission to the WTO

From Lauren Kyger at the Hinrich Foundation:

Western policymakers and multinational corporations encouraged China’s entry into the World Trade Organization (WTO) in 2001 as a way to bring the country into the fold of the global trading system, with the greater hope that it would move toward a democratic market economy.

With the benefit of hindsight, it’s clear that China’s WTO accession — while a resounding success for China — did not bring about the political or economic changes forecast by the West at the time of its accession. Perhaps the opposite scenario has arisen, where China’s state-driven, mercantilist economic model is now being held up as an alternative to the Washington Consensus. In addition, the United States has directly assisted in the development of an economic and geopolitical rival.

In his new book, “China, Trade and Power: Why the West’s Economic Engagement with China Has Failed”, author and financial economist Stewart Paterson describes the consequences of the West’s policy of engagement with China, which allowed the country to enter the WTO without first requiring appropriate economic reforms like a floating exchange rate, capital account convertibility and reform of state-owned enterprises.

One of the biggest consequences that Paterson brings to light is how the deflationary impact caused by China’s entry into the global trade system coupled with inflation-targeting by Western central banks as a response, directly contributed to the global financial crisis of 2007-2008.

Paterson argues that after China’s WTO accession in 2001, the global market was flooded with cheap labor and goods — leading to a supply side shock and triggering deflation. As a response to these deflationary pressures, the US Federal Reserve initiated aggressive inflation-targeting policies. This ultimately led to asset price inflation and over-investment in the US housing market.

Essentially, the extra money pumped into the US system to fight the deflationary shocks caused by 750 million Chinese workers entering the global trade system at just 10 percent of the cost of Western workers, helped fuel a housing bubble and the resulting financial crisis — a crisis which discredited capitalism in the eyes of many around the world and directly called into question the economic systems which underpin Western democracies. It led to a widening wealth gap and growing inequality in the West, fueling social disruption.

At the same time, the Communist Party of China (CPC) was able to capitalize on its trade opportunity to provide a rapid rise in living standards for its people — lifting hundreds of millions of people out of poverty, creating an increasingly affluent middle class, while further legitimizing and strengthening the CPC’s power.

While Paterson’s analysis focuses largely on policies of the past, it also contains important warnings for the future. The West’s policy response of monetary easing to target inflation has only led to more debt being accumulated, which begs the question — are we right back where we started and do we have the capacity to bail ourselves out from another financial crisis if it arises?

Asian middle class

Homi Kharas from Brookings Institute says that China and India are at the forefront of expansion of the global middle class and the world economy can be expected to increasingly rely on these two countries as sources of global demand.

He projects that 66% of the global middle class will reside in Asia by 2030.

A rising middle class is likely to exhibit strong demand for:

• Consumer durables (housing, appliances, home furnishing and motor vehicles);
• Communications and infrastructure;
• Food, especially protein sources like meat and dairy;
• Beverages;
• Personal products;
• Iconic consumer brands;
• Travel and tourism; and
• Energy and technology.

China’s debt bubble

Worth Wray quotes Michael Pettis from his 2013 book, Avoiding the Fall: China’s Economic Restructuring, about the future path of China’s debt-laden economy:

Every country that has followed a consumption-repressing, investment-driven growth model like China’s has ended with an unsustainable debt burden caused by wasted debt-financed investment. This has always led to either a debt crisis or a lost decade of very low growth.

We couldn’t agree more. China is no different to Japan or Brazil. Investment-driven growth is only sustainable where investment earns a higher return than the long-term cost of servicing the debt. With diminishing returns on additional investment, returns dwindle and a debt/investment imbalance develops.

The recent slowing of credit growth to the Chinese real estate sector was forced by the growing imbalance. Slowing debt growth is likely to result in a sharp slow-down in GDP growth which in the past was unsustainably supported by credit-fueled investment spending.

Pandemic

While the global COVID-19 pandemic in 2020 is not a direct result of globalization but it was certainly accelerated and amplified by it. Key trends that have emerged are:

• Work-from-home
• Decline of mass transport
• Vaccinations
• Vaccine passports

We are also experiencing repeated waves of pandemic as new mutations of the COVID-19 virus arise.

While vaccines have succeeded in reducing the weekly death toll, they have not had much impact on the spread of new cases.

At this stage it is uncertain as to when the pandemic will end — or whether it is the new normal.

The Divorce

China and the West’s political and economic systems have proved largely incompatible. Donald Trump attempted to address this by imposing trade tariffs. That heightened political tensions — reducing cooperation to contain the COVID-19 pandemic — and has not succeeded in reducing the US current account deficit.

In the longer term, we are likely to see:

• Increased emphasis on supply-chain security in the West;
• On-shoring of critical supply chains;
• Continued trade tariffs;
• Increased use of carbon taxes to restrict import from countries (China) with lax emissions standards; and
• Broad de-coupling from China.