Review: The Dragon's Tail (The Lucky Country after the China Boom)
In 140 characters or less:
An insightful yet concise review of China's boom, its huge effect on Australia's economy, and why it is ultimately unsustainable.
Why you should read it:
China's boom, and correspondingly, Australia's double-decades of unbroken growth are anomalies that have seemed to defy laws of economics. This has led many people to question long-held beliefs about how an economy should be organised.
Can governments really allocate capital better than markets? Does an authoritarian regime's power make it a more effective form of government for economic growth? Can Australia keep its recession-free streak going?
The author, Andrew Charlton, addresses all these topics and more while offering an excellent framework for understanding China's growth.
The lessons of economic history are ominous for both Australia and China. Charlton stops short of forecasting impending doom, but the implications are clear. The current model of growth for both countries is unsustainable. If something can't go on forever – it won't.
Key lessons for investors:
#1: Australia's recent commodity driven boom and its impact on our standing in the world should be understood in the context of prior booms. Australia's position as one of the world's top few wealthiest countries is not a given.
#2: This commodity driven boom has been underpinned almost entirely by China's growth, and importantly, its huge investments in property development and infrastructure.
#3: China is often held out as a unique and exceptional case. Many have even gone so far as to suggest that China has created a new blueprint for how to manage a modernising economy.
This is wrong.
In truth, China is the latest in a long line of economies to modernise through an authoritarian growth model. Each country that has successfully applied the model has tended to achieve a faster rate of economic growth than those before it.
Interestingly, the success of those countries has often led to their growth being heralded as evidence for a new ideal economic template. Economic commentators have short memories.
Germany used this model prior to World War II to modernise. Soviet Russia successfully applied the model for decades, even outpacing the United States. Leading to some hubris from Russia, and fear in America.
"The time is not far distant when we shall catch up with and surpass the United States" – Nikita Kruschev, 1957
"We stand today on the edge of a new frontier; are we willing to match the Russian sacrifice of the present for the future?" – John F. Kennedy
We know how that ended up working out. (As a sidenote, by the late 1980s Soviet Russia was spending 50% of its national budget on the military to try and keep up with the United States. 50%!)
In the 1980s it was the 'Asian Tigers' of Japan, Korea and Taiwan that were applying the model, again it was heralded as a revolution – until the 1997 Asian Financial Crisis.
#4: The authoritarian growth model has three key components
1. The country must have a strong government – authoritarian regimes or one party states only please (the next two points explain why).
2. The model requires the government to confiscate resources from its people. The model works by suppressing consumption, forcing people to accept lower living standards in the present in exchange for higher economic growth.
Policies that explicitly or implicitly confiscate resources:
- High taxation
- Suppressed wages growth (e.g. through banning or controlling trade unions)
- Currency depreciation (effectively a consumption tax on ordinary people)
- Powerful State-owned enterprises
- Financial market intervention
3. The model requires the government to use resources confiscated from its people to fund rapid growth of investments (often exports).
Policies used:
- State subsidies
- Low wages
- Subsidised borrowing
- Direct investments in infrastructure
- Direct investments by State-owned enterprises
#5: Unfortunately the success of the model can not be sustained.
There are two problems with the model that ultimately make it unsustainable.
First, the distortions introduced inevitably start to lead to poor capital allocation decisions.
"(Countries) start by powering the economy with investment by the state to build manufacturing capacity and infrastructure. However, the gap between what the country has and what it needs closes quickly, and then it is difficult to recognise what isn't needed." – Michael Pettis
This model works well during the 'catch-up' phase as capital deepening improves productivity. Once capital intensity starts to approach developed market levels the model breaks down as capital allocation efficacy becomes more important.
Second, the problem of overinvestment ultimately ends in a debt crisis.
Wasteful investment continues until the whole financial system chokes on bad debt. With their capital locked up in underperforming investments, the banks have to lend more to the developers, some of which they will use to fund the next project, and the rest to repay old debt.
More and more of the new credit starts to be eaten up paying imaginary returns on the growing pile of bad debt.
Eventually the lenders, realising they will never be repaid, stop making new loans. At that point the investments stop, and the whole cycle of expansion starts to operate in reverse. Less loans, mean less investment, mean less growth, mean less loans.
#6: There is some good news. China is more resilient than most countries, and the debt crisis doesn't need to lead to a financial crash.
"If this is starting to sound dire, note a few pieces of good news. The first is that while an investment-led growth strategy always ends in a painful adjustment, it doesn't always end in disaster. Countries can unwind some of the policy distortions that led to excessive investment and eventually put their economies on a more balanced growth path"
"A number of East Asian economies in the 1980s and 1990s experienced painful adjustments following the bursting of their government-induced investment bubbles, but each pulled through and established a foundation for future growth and stability. In particular, Korea, Taiwan and Singapore emerged from the Asian crisis in 1997 as stronger economies and more democratic nations"
China's US$3 trillion of reserves would allow it to bail out its banks during a debt crisis, and lower the rate of investment. The author makes the point that this would lead to a reduced rate of economic growth, but it would not necessarily involve a financial crash.
Given the scale of China's investment boom, and the vested interests of Party officials that it has fostered, I am less optimistic than the author about China's ability to sidestep a financial crisis. However, given the immense control that the government has, and its currency reserves, it can't be ruled out.
If China is able to engineer a smooth transition from an authoritarian investment-led growth model to a more open consumer-led society, it will deserve to be regarded as an exceptional case.
The last word:
These few key lessons for investors have barely done justice to a great essay. For anyone interested in Australia's future, or China's growth (and that should be all of us) I highly recommend giving it a read.
Where to buy it:
The essay format makes this is a quick but insight-packed read. You could easily get through it in an afternoon. Kindle versions are the cheapest bet. https://www.quarterlyessay.com/issue/dragons-tail-lucky-country-after-china-boom
