Failed States Index: China in Worsening Economic Decline

 Stuart Staniford  in his blog entry notes that China is in Worsening Economic Decline. Working with The Fund for Peace/Foreign Policy Failed State Index, he lists the fastest degrading countries and finds China to be in position 6 on that list.
China declined from an overall score of 72.3 in 2005 to 84.6 in 2009, just 5 points from hitting the 90 threshold to be on “Alert” status – the highest category on the list, along with Zimbabwe, Somalia, and Afghanistan.

An Alarming Downward Trajectory

If the average trend of the last five years were to continue, it would reach this status in about 2011:

Causal Factors

The many factors in this are shown in the list and graph below:

  • I-1. Mounting Demographic Pressures (Demographic Pressure)
  • I-2. Massive Movement of Refugees or Internally Displaced Persons creating Complex Humanitarian Emergencies (Displaced People)
  • I-3. Legacy of Vengeance-Seeking Group Grievance or Group Paranoia (Vengeance Seeking)
  • I-4. Chronic and Sustained Human Flight (Human Flight)
  • I-5. Uneven Economic Development along Group Lines (Uneven Development)
  • I-6. Sharp and/or Severe Economic Decline (Economic Decline)
  • I-7. Criminalization and/or Delegitimization of the State (Criminal State)
  • I-8. Progressive Deterioration of Public Services (Deteriorating Services)
  • I-9. Suspension or Arbitrary Application of the Rule of Law and Widespread Violation of Human Rights (Human Rights)
  • I-10. Security Apparatus Operates as a “State Within a State” (State within State)
  • I-11. Rise of Factionalized Elites (Factionalized Elites)
  • I-12. Intervention of Other States or External Political Actors (External Intervention)

This shows how these indexes have been evolving over time for China:

The largest component of the worsening score is “Sharp and/or Severe Economic Decline” – which has soared from 0.5 to 4.5.  By comparison, Spain in 2009, in the midst of major post-bubble recession, has an economic decline score of only 1.3.

According to Staniford. this is so unbelievable given China’s rapid and precipitous growth, that he questions the validity of the calculations:

Economic decline is one of the few things on the Failed State Index measures for which there are reasonable quantitative indicators: the IMF produces GDP estimates for just about all the countries in the world, so it’s easy for others to figure out if a given country’s economy is contracting or growing.  If the Fund for Peace can’t get “Economic Decline” in the largest population country in the world right, then they certainly don’t deserve a big spread in Foreign Policy magazine every year.

New News is Bad News

I have addressed the serious long-term structural problems that threaten to derail the Chinese economy over the next few decades here before. To make matters worse, short term prospects have dimmed considerably of late. Growth has slowed precipitously in the short term – down to 7.5% from 10%, and a real estate bubble is threatening to burst.
Now, there’s more bad short-term news: the slowdown that’s been underway since late last year is definately accelerating. The rebound that most economists had expected in China in the second half of the year following rate cuts in June and July has failed to materialize.  Data showed inflation fell to a 30-month low and industrial production dropped to the lowest in just over three-years, while retail sales numbers also missed expectations. The numbers are prompting some bears to grow more confident that the much-feared “hard landing” scenario for China is finally underway.
Patrick Chovanec, Associate Professor at Tsinghua University’s School of Economics and Management, told CNBC that China’s economy is, in reality, probably growing at about 4 to 5 percent right now. Growth of around 5 percent or below, is seen by many economists as a “recession” in China’s case.

China July trade surplus unexpectedly shrinks

V. Phani Kumar in MarketWatch  notes that China’s trade surplus unexpectedly narrowed in July. Exports barely grew from the prior month, while imports increased at a smaller rate. Following reports of anemic growth in monthly industrial output and retail sales, concerns about China’s economic outlook adversely affected equities, commodities and “risk currencies” like the Australian dollar.
  • The trade surplus dropped from $31.7 billion in June to $25.1 billion for July, 2012.
  • It fell far short of estimates of $35.2 billion in a Dow Jones Newswires economists’ survey.
  • Exports rose just 1% from last year vs. an 8% expectation, and June’s 11.3%.
  • Imports expanded just 4.7%, vs. an expected 7%, and June’s 6.3%.
IHS Global Insight economists Alistair Thornton and Xianfang Ren write:
Trade data has come in dramatically below expectations — the worst export growth number (excluding Chinese New Year) since November 2009 — highlighting the risk that the external environment poses to an economy. This confirms that the strong export numbers in May and June were, as expected, complete anomalies.

Is a Stimulus Coming?

However, Deepanshu Bagchee,  Managing Digital Editor, CNBC International notes  that, rather than being glum, investors are betting on still more stimulus, propelling stocks and the Australian dollar higher.  China’s Shanghai Composite finished up 0.6% on release of the bad economic news Thursday, August 9, 2012  John Woods, Chief Investment Strategist for Asia Pacific at Citi Private Banking said on CNBC’s Worldwide Exchange:

It’s one of these situations where it’s so bad, it’s good. The numbers were pretty lackluster… there were some signs, in my view of stability, but little in the way of recovery.

Some Optimism

Economists and strategists expect more rate cuts as well as cuts in the reserve requirement ratio (RRR.)

The government has expressed their intention to bring future investment projects forward, and now that growth is their top priority.

On top of that, local governments have been, in the last few months, announcing massive plans to stabilise growth, and some have suggested banks to lend to local governments for growth stabilisation purpose.

Much Doubt

Most analysts don’t expect China to go in for another big stimulus package along the lines of its 2008-2009 program, when China announced spending worth $586 billion or around 14% of its GDP.

Economists also point out that the window for more monetary stimulus may be closing, as higher food prices are likely to lead to an acceleration in inflation later this year, limiting the room to manoeuvre. And, further, incremental rate cuts may not work any more, so Jing Ulrich, Chairman of Global Markets, China at JPMorgan, says policymakers will have to “get much more creative to boost the economy.” In fact, that stimulus spending is blamed for many of China’s economic problems in subsequent years, including local government debt and over-investment in housing and higher inflation.

Business Insider explains the low expectations for government stimulus:

There is very little doubt, to our mind, that this series of weak numbers will put more pressure on the government to ease policy further. However, let us review a few facts: the People’s Bank of China has already cut interest rates twice and RRR has been reduced three times since late last year.

Regarding local governments’ moves to stabilize growth:

Surely, many of these have not been implemented (especially the local governments stimulus), and we still have no idea just how much of these investment plans will actually come through. However, with the easing that has been done, obviously it is not working yet. This is consistent with our belief that it will require much more stimulus in order to ensure growth can get above 8%. What have actually been implemented (mainly in forms of interest rates and talks of stimulus) were far from what we would regard as “enough”. The problems that are left now is whether the government is willing to stimulate the economy like crazy (as they did in 2009), and whether the government still has that ability.

What can China do? Not much. Jing Ulrich holds out one last hope – that China could try cutting taxes to support domestic demand:

China is in a unique position because it does have a very strong financial and fiscal position. The central government has a very strong tax intake, it can afford tax reductions, while other governments cannot.

That’s doubtful since the U.S. historical example shows that tax cuts haven’t  had any effect as an economic stimulus.

 Is the Government Willing to Undertake Massive Stimulus? 

According to Business Insider, no:

The fact that the real estate market warming up in the past few months has already caused some concern. As we believe that it is next to impossible to ease policy to stimulate growth while at the same time cool the real estate market, this leaves the government in a position that limit their willingness to implement full-on easing. While the government is not likely to implement extremely harsh measures to curb home prices at this point as the economic slowdown is getting much worse than most expected, it is not likely that they would like to ease either.

Is the Government Able to Undertake Massive Stimulus? 

Recent data indicates that the government actually has few tools to wield. Despite interest rate cuts, loan growth isn’t growing, and deposit  growth remains weak.

Business Insider’s guide to China’s monetary policy explains that the central bank creates money to prevent Chinese Yuan from appreciating during the period of inflows and massive trade surplus, to create more liquidity in the banking system. However, the central bank has been doing the opposite – withdrawing money from the foreign exchange market to prop up the Chinese Yuan, and tightening the money supply. Even though the central bank can cut reserve requirement ratio – and has already done so in the past – to offset this, it can only cut the ratio about 20% or so.

While the government could run up a higher deficit to create growth, the smaller trade surplus and capital outflow severely limit the central bank’s ability to ease credit.  And while government directed lending (i.e. forcing state-owned banks to lend) has been a key monetary tool, banks’ ability to extend credit when the country is facing shrinking trade surplus and capital outflow is still very limited.

 “Staring down the bottomless pit”

Business Insider points out that the phrase, “the consensus is expecting a recovery in next quarter during every quarter” remains unsupported.

Unfortunately, we just don’t see that, and we doubt if the government has the willingness at this point to do much more, and we doubt whether the government really has the ability as the market thinks. We do not see convincing signs of recovery (except, perhaps, Wen Jiabao making waves every other week), and we even struggle to see signs of stabilisation.

If we see anything, we are seeing a bottomless pit.

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