The global economy is transitioning through an extremely complex and uncertain phase, and there are no clear answers in sight. On the one hand, if forecasts by the Organisation for Economic Co-operation and Development (OECD) are to be believed, the advanced economies of the United States, the European Union and Japan are emerging from recession. Their GDP growth, incomes and employment levels are showing signs of revival, even if these indicators remain somewhat anaemic at present. What is not clear is whether these spring shoots will survive the withdrawal of the massive and sustained stimulus that continues to be injected into these economies.
We have already seen how emerging markets have been thrown into turmoil with the prospect of the impending withdrawal. What will happen when the withdrawal actually takes place? It should be understood that a mere reversal of financial flows from the emerging economies to the advanced economies will not be an answer to our current global imbalances. Unless sanitised or retired from circulation, these reverse flows will inevitably result in asset bubbles and inflation in advanced economies, plunging them into a fresh round of crisis - having already roiled the emerging markets on their outward trajectory. Therefore, there is a need for co-ordinated action by both emerging and advanced economies; this was sadly missing at the recent G20 summit in St Petersburg.
Look at China. The country is the world's second largest economy, the largest exporter, the chief and growing consumer of commodities, and an increasingly significant source of capital investment. The health of the Chinese economy is no longer the concern of the Chinese alone. Any crisis or even the possibility of a crisis in that economy can only add to the woes of the global economy, in particular the major commodity producers.
In my article "The myth of chinese invincibility" (October 19, 2011, Business Standard), I argued that global imbalances that led to the global financial and economic crisis of 2008 were as much a challenge for China as for the US and the West. If the US had been consuming beyond its means and incurring ever larger volumes of debt, then China, in a mirror image, had been accumulating increasing trade and current account surpluses, investing and exporting far beyond sustainable levels. If the US had to consume less and reduce its debit account, China would have to consume more and reduce its credit account in tandem to permit rebalancing.
That is not what has been happening. The US has, in fact, tried to spend its way out of trouble, thereby postponing for the future the more painful measures required to reduce and limit its debts. The Chinese also adopted a massive stimulus programme of more than $650 billion, but this was aimed at further fuelling investment rather than encouraging domestic consumption. Despite the public commitment to shifting China from a pattern of investment- and export-led growth to one that relies increasingly on consumption and domestic demand, the ground reality has not changed in any perceptible manner.
Though Chinese figures are notoriously unreliable, it is estimated that current domestic consumption has remained around 36 per cent of GDP, while investment remains above 60 per cent. The slowdown in China's growth to around seven per cent per annum despite capital investment on such a scale means that the country is already in a phase of diminishing returns, where progressively smaller GDP increments result from larger capital inputs. According to one estimate, China is now spending $4 to obtain a $1 increase in output.
Over-investment has already resulted in huge overcapacity in Chinese industry and its real estate sector. This has led to a ballooning debt overhang, which is already more than 200 per cent of the country's GDP, according to the ratings agency Fitch. Official figures show non-performing assets (NPAs) of Chinese banks at a comfortable 1.1 per cent of GDP, but this may not present the true picture since state-owned banks routinely roll over debts of large state-owned enterprises and local government entities.
This also does not take into account the informal banking and finance sector, which is now estimated to be as large as the formal banking sector. According to one report, the NPAs of this informal, or "shadow banking", sector could be more than 70 per cent of the assets it holds. If something went wrong, the bailout would be much greater than what happened in the mid-1990s, when the Chinese government set up four state-owned "bad banks" to take over more than 1.4 trillion yuan of bad loans from four of China's largest banks. This amount in 1998 constituted 15 per cent of all bank credit at that time. According to Fitch, the Chinese banking system's assets increased by a whopping $14 trillion between 2008 and 2013, which is "equivalent of adding the entire US banking system to its banks' balance sheets".
Though such data are not without uncertainties, it is clear that the comfortable assumption that China's state-dominated economic system can absorb bad debts in the same manner as it did in 1998 despite their current scale is not sustainable. China is postponing D-Day mainly through the rolling over of bank debts by using its domination of the banking sector and persisting with its policy of financial repression. But this only compounds the problem, since overcapacity is further exacerbated owing to the availability of cheap credit. The empty city of Ordos in Inner Mongolia is a telling symptom of what is going wrong across many urban developments fuelled by plentiful and cheap credit. Ordos has a current debt of over 300 billion yuan, while its annual income is scarcely 80 billion yuan. People in China refer to it as China's Detroit, referring to the iconic American city that recently went bust.
It is possible for China to avoid a hard landing and achieve a graduated rebalancing through judicious fiscal and monetary policy. Even so, there is no escape from a significant slowdown of its GDP growth precisely at a time when the global economy has become ever more dependent on the country's role as an engine for growth.
The inescapable fact is that today the world's major economies have become so deeply interconnected and integrated that there is really no escape from collaborative and co-ordinated governance. Unilateralism will prove damaging and ineffectual in the economic sphere, as is already evident in the political and security realms.
The writer, a former foreign secretary, is currently chairman, National Security Advisory Board and Research and Information System for Developing Countries, and senior fellow, Centre for Policy Research (New Delhi)