Dangers of an Overheated China, by Tyler Cowen, Commentary, NY Times: ...Several hundred million Chinese peasants have moved from the countryside to the cities over the last 30 years... To help make this work, the Chinese government has subsidized its exporters by pegging the renminbi at an unnaturally low rate to the dollar...; additional subsidies have included direct credit allocation and preferential treatment for coastal enterprises.
These aren’t the recommended policies you would find in a basic economics text, but it’s hard to argue with success. ... Those same subsidies, however, have spurred excess capacity... China has been building factories and production capacity in virtually every sector of its economy... Automobiles, steel, semiconductors, cement, aluminum and real estate all show signs of too much capacity. ...
Regional officials have an incentive to prop up local enterprises and production statistics... Chinese fiscal and credit policies are geared toward jobs and political stability, and thus the authorities shy away from revealing which projects are most troubled or should be canceled.
Put all of this together and there is a very real possibility of trouble. ... What will the consequences be ... if and when the Chinese economic miracle encounters a major stumble? A lot of Chinese business ventures will stop being profitable, and layoffs and unrest will most likely rise. The Chinese government may crack down further on dissent. The Chinese public may wonder whether its future lies with capitalism after all, and foreign investors in China will become more nervous.
In economic terms, the prices of Chinese exports will probably fall, as overextended businesses compete to justify their capital investments... American businesses will find it harder to compete with Chinese companies, and there will be deflationary pressures in both countries. And ... the Chinese ... may have less to lend to the United States government. ... The United States will face higher borrowing costs, and its fiscal position may very quickly become unsustainable.
That’s not so much a prediction as a very possible contingency, and we should be prepared for it. For now, we should avoid two big mistakes. The first would be to assume that just because borrowing costs are now low, we can postpone fiscal responsibility and keep running up the tab — with the aid of Chinese lending, of course. The history of financial crises shows that turning points can come swiftly...
The second mistake would be to demand too many concessions from the Chinese. What we see in the numbers today are a growing China... Yet there’s a real chance that, soon enough, Chinese economic weakness will be a bigger problem than was Chinese economic strength.