March 4, 2012

Is China going to crash like Japan and South Korea?

The spring is here and the bears are slowly waking up from their winter sleep. Should we expect another bear market? There's always something to worry about - from the world war 2, to the Cuban missile crisis, to increasing petroleum prices. But it is always better to know about a crisis in advance. Here's why China might experience a crisis that can affect the rest of the world.

China has risen fast from a communist country to a global player that's sometimes supposed to save the world. You often hear that China is the solution to all the problems, such as bailing out Greece, and if we move our industries to China we might make big profits.

One problem is that data about the Chinese domestic economy is unreliable. It is also hard to find some data to relate to because the Chinese growth is so fast. One can however compare with Japan and South Korea. China has used the same development model as Japan and South Korea earlier did. The model works like this:
  1. Capitalize on low wages to spark growth through exports and industrialize quickly with hefty amounts of investment 
  2. Guide the whole process with the hand of the state
  3. Use industrial policies and state-directed finance to progress into more and more advanced sectors
This model works and the growth of the country is fast - for a while until the country crashes. Japan crashed in 1990 and South Korea crashed in 1997.

The problem with this model is that it is getting the prices wrong. To generate a fast growth, the model depends on state-directed subsidization to make investing in certain industries or sectors more attractive and less risky. For example:
  • Cheap credit is made available for the industry
  • The exchange rate is controlled to encourage exporters
The problem is that these prices should be controlled by the free market - not the government. Companies may make bad investments in factories that are not needed from money they don't have. It may work for a while, but it can't go on forever.

When might this crisis happen? It took Japan and South Korea about 35 years before the model broke, and with those numbers, the crash in China might happen in 2015. 

Source: Time