Just a few short years ago the economy of the People’s Republic of China was the envy of the world. Today the markets and economy in the Middle Kingdom are in such sorry shape that there are widespread fears they will collapse and trigger a global economic meltdown.

China’s stock markets seem to be justifying these worries. Reuters reported that January was the worst month for Chinese equities since October 2008, at the end of the last great financial crisis. Chinese benchmark indexes lost $1.8 trillion (€1.65 trillion) in value during the month.

The market losses were caused by reports of a drop in factory activity in the nation and fears that the People’s Bank of China is planning to devalue the nation’s currency, the yuan. The fears have been amplified by George Soros and rumors that the man who broke the Bank of England is out to destroy the yuan. Soros told Bloomberg that he is betting against the yuan by buying U.S. Treasury bonds.

Devaluation rumors have been fanned by reports that authorities in Beijing are trying to stop a massive flight of capital, The Economic Times reported. China’s foreign reserves have fallen by around $700 billion in the last 18 months.

It’s the Government

So what happened? How did China’s economy go from the engine driving global economic growth to a complete mess? Most experts point their figures at China’s government and the ruling cliques within the Communist Party.

Many economic decisions in Beijing are being made by politicians, which Elizabeth C. Economy, a senior fellow and director for Asia Studies at the Council on Foreign Relations, dismissed as “Communist Party Hacks.” These apparatchiks often ignore economists and make decisions for the good of the Party rather than for the nation.

One problem is that these leaders are reluctant to make any sort of reform that lessens the power of the Party. That includes modern financial regulation or efforts to put industrial planning in the hands of economists and other trained professionals. Another is that they want to keep growth going at all costs to buy popular support for their rule.

This explains why the Chinese government propped up the market over the past year. Caroline Yu Maurer, the head of Greater China Equites at BNP Paribas Investment Partners, told Reuters that she thinks the government was propping up the Chinese stock markets.

That strategy has failed because the market has run out of what Maurer called “natural buyers” for stocks. The market is slowing because the demand for stocks simply does not exist in China; instead, the nation relies on a very unstable banking system for capital.

Unstable Banking System

One of the biggest problems facing China is its unstable banking system. Much of the growth in China over the past few years has been driven by shadow loans issued by mid-tier banks, UBS reported. These instruments now make up around 16.5% of all commercial loans in China.

Disturbingly, these loans are being structured into complex instruments reminiscent of the mortgage-backed securities that triggered the subprime lending crisis in the United States in 2007. China’s shadow loans are currently valued at $1.8 trillion, and that number grew by around one third.

To make the situation worse, many of these loans are shown as “low-risk” instruments on the balance sheets. That enables banks to keep issuing more and more of these loans.

Such lending makes China’s banks extremely vulnerable to slowdowns in manufacturing and drops in exports because much of the nation’s manufacturing boom has been underwritten by it. This means that any downturn in the U.S. economy could trigger a banking crisis in China.

China’s Consumer Economy Is on Shaky Ground

The fast growth of China’s consumer economy is also being underwritten by this kind of lending. Much of the phenomenal growth in retail and related industries in China is being funded through these shadow loans.

One area that could be highly vulnerable to collapse is franchises. One American company alone, Yum Brands (NYSE: YUM), the parent of KFC, Taco Bell and Pizza Hut, has 6,900 restaurants in China. It is highly probable that a large percentage of those franchises could be financed with the shadow loans.

That means a banking crisis in China could trigger the collapse of Yum Brands and other franchisers based in the United States. Companies like Yum and McDonalds (NYSE: MCD) are vulnerable because of drops in revenue and sales in the United States in recent years.

China Cannot Support a Consumer Economy

The unstable consumer economy is a major threat to China’s future because the nation is currently transitioning from a Leninist command control industrial economy to a modern consumer society. The party seems to be pinning its hopes on increased consumer demand to fuel future growth and make up for slowing demand from the United States and Europe.

This strategy may not work, because average incomes are still very low in China. Statista estimated that the average urban worker in China earned around 56,360 yuan a year in 2014, the equivalent of $8,558.27 or €7,862.08. Therefore China’s people may simply lack the buying power to support a modern consumer economy.

Wages have been growing dramatically in urban China. In 2004 the average worker earned around 15,920 yuan ($2,417.45 or €2,220.8) a year. The growth has been impressive, but the average income is still far below that needed to sustain a modern consumer economy.

In contrast, the average annual wage in the United States in 2014 was $46,481.52 (€43,061.12), according to the U.S. Social Security Administration. That means to support an economy like that in the United States, the average salary in China would have to rise to around 306,101.42 yuan.

China’s economy is unstable because the current levels of personal income are simply not sufficient to sustain the kind of modern consumer economy its leaders are trying to build. That means China’s economy and markets are going to stay unstable and messy for the foreseeable future.

Like other nations, China will have to go through several boom and bust cycles and possibly the accompanying economic collapses before it achieves a modern economy. Those who thought China could avoid the kind of messy economic development that other nations, like the United States and France, experienced are being proven sadly mistaken.


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