China's economic miracle will be proven unprecedented only in its massive scale, set to follow the same economic path as its smaller, regional predecessors – the Asian Tigers of the late 1980s and 1990s.
In the postwar era, Japan was the first to unleash its economic potential through modernization. In the 30 years after 1960, the country's gross domestic product grew fivefold. Taiwan followed, quadrupling its GDP per capita starting in the early 70s.
The economy of South Korea – the main Asian Tiger before the Asian financial crisis of 1997 – is likely to prove most instructive. China's annual GDP growth for the past decade very closely tracks South Korea's experience in the 10 years ending in 1993.
There are, of course, major differences between the state-driven Chinese economic model and South Korea's export-driven expansion. But China's current situation is very similar to South Korea's 1990s predicament in an important respect – a sharp deterioration in the current account (essentially the net revenues from foreign trade) and a massive subsequent increase in high-risk short-term borrowing to sustain economic growth.
In 1991-93, South Korean corporations attempted to extend the life of the country's economic expansion with short-term debt issued to foreign countries. Eventually, issuers were unable to make payments on this debt because the returns on investment were too low. Without the financial assistance of the International Monetary Fund, a collapse of the country's financial system would have been inevitable and resulted in sovereign debt default.
In China, wealth-management products are serving the same purpose – and creating the same danger of financial catastrophe – as South Korea's foreign borrowing.
As a percentage of GDP, China's current account balance has fallen from almost 10 per cent in 2007 to barely positive at 2.3 per cent. To compensate for the lack of foreign capital from trade, China has seen an explosion in infrastructure funding through wealth-management products – short-term notes sold to retail investors.
Funds invested in wealth-management products topped $2-trillion (U.S.) in 2012 from virtually nothing in 2007. The quality of these instruments has long been suspect, as noted by People's Bank of China chairman Xiao Gang in a recent interview with Reuters:
"The quality and transparency of wealth-management products was worrisome," Mr. Xiao said, adding many assets underlying the products were dependent on real estate or long-term infrastructure projects that might find it impossible to generate sufficient cash flow to meet repayment obligations.
"To some extent, this is fundamentally a Ponzi scheme," Mr. Xiao told Reuters.
Just to recap: China's economic growth is currently dependent to a significant degree on a $2-trillion asset class that the head of the country's central bank describes as a Ponzi scheme.
The experience of other Asian nations strongly suggests that a significant Chinese economic slowdown is imminent. The endgame for China's economic miracle will likely not exactly mimic the Asian Financial Crisis. But like Japan, Taiwan and South Korea, China has reached a stage where the "low hanging fruit" of profitable investment and modernization are exhausted.
For Canadian investors, the implications are obvious and significant. China's insatiable demand for commodities is no longer a reliable investment thesis for the mid term. At the very least, new investment funds should be put to work in other market sectors.
In the end, China's economy is not a New Paradigm of development – it's merely a much larger version of a cycle we've seen before.