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Economists warn senators of global risks caused by China’s market meddling

The post below is an opinion piece written by award-winning journalist Richard McCormack, the founder and publisher of Manufacturing & Technology News. McCormack also served as the editor of the 2013 book on revitalizing manufacturing, ReMaking America. You can follow him on Twitter at @RichardAMc.

It's not often that two economists from conservative Washington think tanks tell the Senate Banking Committee that the world needs to prepare for a Chinese financial system meltdown. But here we are.

The question isn't whether China’s debt bubble will burst -- that is a given -- but when, and what the ramifications will be, according to economists from The Heritage Foundation and the American Enterprise Institute.

Two other members on the panel presenting in July before the committee concurred: China’s debt bubble is already creating hardship throughout the world. Chinese banks are investing in state-owned industrial enterprises to build additional unneeded industrial capacity. And this output is swamping global markets and depressing prices.

The Chinese Communist Party refuses to change course because it is desperate to stay in power by maintaining full employment through its long-standing investment and export-led economic strategy.

China continues to pile up debt at faster and unprecedented rates. The country's debt load has soared from 150 percent of GDP in 2007 to almost 300 percent of GDP this year, and is headed toward 400 percent of GDP. Chinese state-owned banks are lending money to Chinese state-owned companies – "zombie" companies -- at a rate never before experienced in human history.

In the first quarter of 2016, the Bank of China "permitted yet another burst of credit as reflected in a more than 40 percent increase," according to Desmond Lachman, resident follow at the American Enterprise Institute and formerly a managing director at Solomon Smith Barney. William Wilson, a senior research fellow with The Heritage Foundation, noted that the level of borrowing was the “largest three-month increase on record” and that “two-fifths of the new debt is swallowed by interest on existing loans. Less credit is going to good firms for productive uses." Chinese overleveraging is “dangerous,” he notes, and "is not a sustainable equilibrium."

Since 2009, an increase in Chinese debt “has been at a pace that exceeds those that have preceded other major economic and financial crises,” said Lachman, who predicted the U.S. housing bust in 2007. These previous and similar pernicious financial bubbles include Japan’s lost decade in the 1990s; the Mexican peso crisis in 1994; the Thai financial crisis in 1997; and the mother of all busts, the U.S. financial system collapse in 2008.

The result of the lending taking place in China is the colossal rise of over capacity in steel, aluminum, rare earths, solar panels, cement, and oil refining in concurrence with bubbles in China's residential and commercial real estate sectors (with the creation of empty “ghost cities”) and its equity markets.

China's economic stimulus package of 2009 amounted to 20 percent of GDP. “the mother of all stimulus packages,” said Wilson from The Heritage Foundation.

"I know this as a banker,” he said. “If you lend out that much capital over a short period of time, most of the loans will go sour. There is no doubt about it."

The Chinese Communist Party refuses to change, locked into a system of self preservation based on the knowledge that its population of 1.4 billion is willing to give up its collective political freedom in exchange for full employment. “That contract could expire very shortly," Wilson warned.

The necessary shift in China's economy that is 45-percent dependent on investment and exports to one that is 30-percent dependent on those two inputs "is a huge undertaking," says Lachman. With China unable to change its economic model and refusing to do anything about its excess capacity problems "I'm pessimistic," says Lachman added.

The economic signs are already pointing to some rough times ahead. China’s gross domestic product grew by 6.8 percent during the first quarter of this year, far less than the annual 10 percent rate of previous years. But this figure is in dispute.

"Any government exercising such a significant role in managing the direction of an economy is highly likely manipulating official statistics," Wilson told the senators. 

It is doing so for one reason: to keep itself in power. It is more likely that GDP growth in the first quarter was 4 to 5 percent, added Lachman, who calls China's GDP numbers to be "fictional... They are serving the Communist Party that wants to stay in power."

Sen. Elizabeth Warren (D-Mass.) said at the hearing that China is exhibiting signs of a "classic sign of a credit bubble that's going to burst." As the country props up growth, there will be a "bigger crash down the line."

Americans need to prepare themselves for the fallout. “There should be no room for complacency in U.S. policymaking circles about the Chinese economic outlook,” noted Lachman. The global economy, already sclerotic, could experience a deeper level of pain, especially for countries that supply raw materials to China's industrial sector. American banks that lend to these countries are "hugely exposed," says Lachman.

China could double down on its export-led strategy by further reducing the value of its currency, creating unrest in the currency markets.

"A further Chinese economic slowdown could trigger other major fault lines in the global economy in countries like Brazil, Italy, Japan, and Russia," said Lachman, a Ph.D. economist from Cambridge University. "That would argue against being overly complacent about potential Chinese economic developments at this delicate juncture in the global economic cycle."

Both Wilson and Lachman say the United States should not recognize China as a market economy.