TIME global economy

There’s a Class War Going On and the Poor Are Getting Their Butts Kicked

Orange Farm Residents Protest Over Service Delivery
A South African man hurls a burning tire in Johannesburg during protests over squalid living conditions in 2010. Conditions for the poor are worsening around the world Gallo Images—Getty Images

Although they say they're concerned about inequality, economic policymakers continue to pummel low-income families and the jobless, and that’s bad for all of us

A year ago I asked if Karl Marx was, in certain respects, right about capitalism, and argued that class struggle was making a comeback.

The German philosopher believed the capitalist system was inherently unjust. Capitalism, Marx predicted, would inevitably concentrate wealth in the hands of a few while impoverishing everyone else. There is ample evidence that Marx’s theorizing is becoming reality.

According to a recent report from the International Monetary Fund, income inequality has risen in nearly all advanced economies over the past two decades. In the U.S., the share of income captured by the richest 10% of the population jumped dramatically from around 30% in 1980 to 48% by 2012, while the portion grasped by the population’s richest 1% more than doubled, from 8% to 19%. Other data shows that since 2009, the 1% captured 95% of all income gains; the bottom 90% of people got poorer.

The good news is that more politicians and policymakers are waking up to the problem. “Inequality has deepened. Upward mobility has stalled,” U.S. President Barack Obama said in this year’s State of the Union Address. “Our job is to reverse these trends.”

There is an emerging consensus, furthermore, that such extremes of inequality are bad for overall economic health. “We now have firm evidence … that a severely skewed income distribution harms the pace and sustainability of growth over the longer term,” IMF Managing Director Christine Lagarde warned in a February speech.

But here’s the bad news. The talk hasn’t translated into action. Economic policy for the most part is still biased against the poor — in some ways, it is becoming increasingly antipoor.

The war against the poor may be most pronounced in the U.S. Washington sliced $8.7 billion from the food-stamp program in February, even though nearly 47 million people, or about 1 out of every 7 Americans, currently rely on it. A new bill to extend emergency unemployment benefits is almost definitely dead on arrival in the Republican-controlled House of Representatives.

The standard conservative argument against such welfare programs is that they make people dependent on “nanny states” and discourage initiative. But statistics say otherwise. According to the Center on Budget and Policy Priorities, more than 60% of families with children who receive food stamps have a member who works. The problem is that too many people with jobs don’t earn enough to buy sufficient food and other necessities — they’re the “working poor.” But don’t expect any sympathy from Congress. The Republicans are dead set against a hike in the minimum wage that would allow these folks to buy their own food.

Meanwhile, in Europe, politicians and bankers are breathing sighs of relief that the region’s debt crisis has been quelled. But the reality is that, for tens of millions of Europeans, it hasn’t. Unemployment in the euro zone in February was a gut-wrenching 11.9% — almost unchanged from 12% a year earlier. In Greece, the latest rate is a staggering 27.5%. No wonder angry Spaniards protested in the streets of Madrid in March, more than five years after the economic crisis began. Yet the European Union remains wedded to a policy of austerity rather than growth. What happened to the emergency leadership conferences that were so common when the governments themselves were in trouble? Apparently, Europe’s impoverished aren’t worth such efforts.

In Japan, new policies by Prime Minister Shinzo Abe aimed at restarting a stalled economy are instead squeezing the Japanese people. In an attempt to shake Japan from damaging deflation, Abe is using the central bank to flood the economy with cash to raise prices. Meanwhile, to contend with giant budget deficits and rising government debt, he is also increasing the consumption tax. Yet even though corporate profits have soared — thanks to a weakened yen, also engineered by central-bank policy — those profits haven’t trickled down to the average worker. A combination of higher prices and taxes, and flat wages, means that Japanese families are getting poorer.

Even in China, policymakers talk about closing the country’s gaping rich-poor gap, but many of the necessary reforms have yet to materialize. Interest rates in the banking sector are still controlled in a fashion that punishes savers to subsidize industry, so the return on bank deposits is so meager it barely keeps up with inflation. That hurts China’s low-income families the most. Policy also continues to discriminate against the country’s 262 million migrant workers, who are deprived of proper social services.

Before anyone attacks me as a liberal opposed to free enterprise — the usual slander slapped on those who think the destitute deserve better — please be clear that I see pro-poor policies not as charity, but simply good business and smart economics. Improving the financial health of the average family can build a stronger foundation for economic growth. The soccer mom in Wichita, Kans., who stops by her local bakery to buy a birthday cake for her 5-year-old son, or purchases a new Ford from her local dealer, is every bit as important to the overall economy as any Manhattan tycoon.

What I find baffling is how business leaders and economists fret over retail-sales figures and consumer-confidence surveys, but then advocate practices and policies that crimp people’s incomes and ability to spend. Companies won’t pay a living wage and then wonder where their customers have gone. This isn’t just a matter of improving current economic growth, but our future economic potential as well. U.S. Congressman Paul Ryan recently lambasted America’s school-lunch program, which provides meals to poor kids, as offering “a full stomach — and an empty soul.” Yet is it fair to expect a student with an empty stomach to perform as well on exams as those with full bellies? Ryan isn’t encouraging hard work. He wants to tilt the playing field in favor of the wealthy.

The same is true around the world. Why Abe thinks a poorer population can restart Japanese growth is hard to fathom. China won’t be able to reshape its broken economic model and produce more sustainable growth without pro-poor reforms. With astronomical youth unemployment, Europe is looking at a segment of its population possibly facing economic peril for years, perhaps decades, to come. Is it any surprise euro-zone GDP is expected to grow a mere 1% this year?

The fact is that there is a class war going on, and the little guy is losing. Perhaps that won’t result in revolution, as Marx assumed. But until our politicians and CEOs understand that the average family on Main Street is as critical to the global economy as the bankers on Wall Street, our economic outlook will be just as grim.

TIME Emerging Markets

New Leaders Aren’t Going to Solve India’s and Indonesia’s Problems

General Election Campaign Begins In Indonesia
Indonesian presidential candidate and Jakarta Governor Joko Widodo, center, shakes hands with his supporters after making a speech in Jakarta as the election campaign kicks off on March 16, 2014 The Asahi Shimbun

Hope that economic reform in the two sprawling democracies will be jump-started when new administrations are in power might be misplaced

Rarely has the mere announcement of a candidacy been met by such investor relief. On the day, earlier this month, when Joko Widodo was nominated for President of Indonesia by a major political party, the stock market surged and the currency strengthened. The country had been battered in recent months by nervous investors, but the mere hope that Jokowi, as he is commonly called in Indonesia, will triumph in July’s presidential election gave hope to the business community that much needed reform would progress in the world’s fourth most populous nation.

The situation is similar in India. After years of lackluster reform, the business community is abuzz that the opposition Bharatiya Janata Party (BJP) will likely win general elections starting in April and install the controversial Narendra Modi as Prime Minister. The hope in the world’s second most populous nation is that Modi, a proven economic reformer, will tackle the problems that have caused the economy to stumble.

But is the hope justified? Both Asian giants are badly in need of a jolt of new reforms, and perhaps fresh leadership will spur the effort forward. Yet even if Jokowi and Modi manage to win their elections, there is no guarantee of progress. Both could get entangled in political conflicts that could thwart any attempts at rapid change.

That could be a problem. India and Indonesia are two of the “fragile five” — the emerging economies deemed most vulnerable to the U.S. Federal Reserve’s tapering of its unorthodox stimulus program — and beginning in the summer of 2013, both countries’ currencies have experienced periods of dramatic decline as investors fled.

India is probably in worse shape than before. A do-nothing, Congress-led administration allowed political disagreements to stymie the promarket reform that sparked India’s rapid growth. As a result, the GDP growth rate has shrunk to half what it was just a few years ago. Most desperately, the country needs to cut red tape to prevent the overbearing bureaucracy from smothering investment projects.

The story is similar in Indonesia. After a burst of reform early in his presidency, Susilo Bambang Yudhoyono’s effort got strangled in politics within his coalition. Much like India, Indonesia needs to clear up confusing regulation and improve infrastructure to boost investment and growth.

Can Modi and Jokowi deliver? Jokowi, as the governor of the capital, Jakarta, is known as a man of the people, taking regular jaunts onto the streets to talk with voters and instituting improvements to welfare programs. But running a city — even one as large and unwieldy as Jakarta — and governing the nation are two very different things. As President, Jokowi would have to push reforms through parliament, the members of which will be elected in April. Whatever happens, Indonesia’s parliament will likely be a messy place filled with contending political movements. Also, on national policies, Jokowi has said little, so we just don’t know much about what his policy platform will be.

“We believe that his overall policy bias is likely to be market-friendly, supporting investor confidence,” was the best economists at Barclays could say about him in a recent report.

Modi has a more developed track record. As chief minister of the state of Gujarat, he is credited with engineering an economic “miracle” there with probusiness reforms like streamlining bureaucracy and improving infrastructure. (For more, see my colleague Krista Mahr’s analysis of Modi’s record.) Yet achieving similar results at a national level will be much harder. It is likely that even if the BJP garners the most parliamentary seats in the election, the party may still have to govern in a coalition, raising the possibility that squabbles between its members will block reform as they have done in the current Congress-led government. Nor is it clear that the BJP is any more proreform than Congress, especially when it comes to politically sensitive issues. According to a recent report by Capital Economics, no BJP-governed state — including Modi’s — approved a controversial Congress reform opening up the retail market to multibrand stores. “The BJP’s recent record suggests that it is less committed to progrowth reform than many assume,” the research firm noted.

So in the end, whatever the intentions of Jokowi and Modi, they could get trapped in the same political problems that consumed their predecessors. What it will take to press reform in these two big democracies is some serious political will. We’ll have to wait and see if these two men have it.

TIME

Sanctions? Russia Is Just Going to Shrug Them Off

Russian Stock Price Reaction To Crimea Referendum At Micex Index
An electronic board displays a rising stock index curve at the Russian Micex Stock Exchange in Moscow the day after the Crimean referendum on independence from Ukraine March 17, 2014. Bloomberg—Bloomberg via Getty Images

Russian president Vladimir Putin sees his country’s economic future in the East, not the West.

You’d think that the U.S. and Europe could apply some pretty heavy economic pressure on Russia. After all, the European Union is Russia’s largest trading partner and source of foreign investment, and right now, the country can ill afford any threat to that economic lifeline. The Russian economy, a member of the once high-flying BRICs, clocked meager 1.3% growth in 2013.

But as the U.S. and E.U. begin to impose economic sanctions on Russia over its grab of Crimea from Ukraine, Putin hasn’t blinked. Perhaps he assumes sanctions from the West will only cut so deep. With Europe as reliant on Russia – for its oil and gas – as Russia is on Europe, Putin has some economic leverage of his own.

And there may be another reason why Putin is unmoved by Western economic sanctions. His gaze has turned East.

Just as U.S. President Barack Obama has been trying to engineer a “pivot” to Asia, so has Putin. And why not? Tying his country’s future to a rapidly expanding Asia instead of a debt-ridden and slow-moving Europe makes perfect sense. In the East, Putin can find eager consumers for Russian raw materials, like China – without the hectoring on human rights he receives from the West. Putin has been signaling this shift to Asia for some time. “We view this dynamic region as the most important factor for the successful future of the whole country, as well as development of Siberia and the far east,” Putin wrote in the Wall Street Journal in 2012.

Putin has been making some progress. In the 1990s, trade between China and Russia was practically nonexistent. Not anymore. According to Asian Development Bank data, total trade between China and Russia increased from $5.5 billion in 1995 to over $88 billion in 2012. The two are cooperating on investment as well. In 2012, Beijing and Moscow formed the Russia-China Investment Fund, a multi-billion-dollar pool of money aimed at investing in projects to enhance economic ties between them. To smooth the flow of people and products between Russia and East Asia, Moscow is undertaking a major upgrade of the Trans-Siberian Railroad, which, Putin said in a recent speech, “will act as a key artery between Europe and the Asia-Pacific region.”

Of course, China and its neighbors are no replacement for Europe, at least not yet. Nearly 80% of Russian crude exports heads to Europe, compared to only 18% to Asia, according to the U.S. Energy Information Administration. But that’s set to change. Igor Shuvalov, Russia’s First Deputy Prime Minister, predicted last year that the country’s trade with Asia would surpass that with Europe over the next five to 10 years. Russia, for instance, has pledged to more than triple the quantity of oil it ships to China annually. In 2013, Russian oil giant Rosneft inked a deal to ship $270 billion of oil to China over the next quarter century. China is also becoming a source of investment. State-owned China National Petroleum Corp. agreed last year to take a stake in a Russian liquefied natural gas project. In 2013, the China Investment Corp., Beijing’s sovereign wealth fund, pledged to up its investments in Siberia.

All of these plans and goals are easier to talk about than achieve, however. Russia has long held on-again, off-again dreams of becoming an Asian power. In the 19th century, the Tsars tried — and failed — to build a massive empire across the northern Pacific stretching from Siberia to California. Today, Russia still plays a minor role in East Asian trade, and the country cannot automatically redirect its exports from Europe to Asia. It isn’t clear, furthermore, how Russia’s oil industry will be able to satisfy its commitments to China. “Unfortunately for Putin, Moscow has limited capacity to make its pivot dreams a reality,” analysts Fiona Hill and Bobo Lo commented.

Still, Putin’s Asia dreams lay bare an uncomfortable truth facing Washington and Brussels and they attempt to resolve the Ukraine crisis. In the new world order, with varied centers of economic power, the West cannot isolate Russia. There’s always someone else ready to ignore politics and do business.

TIME

China is Trying to Buy a Car Industry

CHINA-ECONOMY-CARS
Workers on the assembly line at the Sino-French joint venture Dongfeng Peugeot-Citroën Automobile (DPCA) plant in Wuhan in China's central Hubei province, Dec. 2013. PETER PARKS—AFP/Getty Images

Struggling Chinese automakers are turning to foreign acquisitions for a competitive edge

China has had dreams of turning Shanghai into a 21st-century Detroit – no, not a bankrupt basket case, but a major center for the global automobile industry. But those hopes have been dashed. Though China is the world’s largest car market, and Chinese have become avid drivers (as you can read in my latest TIME magazine story), the nation’s automobile manufacturers have struggled to catch up with their international rivals.

Generally lacking technology, experience and brand power, Chinese carmakers have faced hurdles even competing in their home market, where Chinese consumers think homegrown cars are of poor quality. As a result, foreign brands like Volkswagen, Buick and Hyundai, command 70% of the Chinese market, Overseas, Chinese cars tend to get exported to other developing countries where shoppers care more about price than nameplate.

What to do? Chinese car companies appear to be trying to buy the technology, know-how and market presence they have struggled to develop on their own. Recently, the global auto industry has seen a series of high-profile deals by Chinese car companies. In February, state-owned Dongfeng Motor agreed to invest some $1.1 billion in troubled automaker Peugeot-Citroen, as part of a rescue package that includes the French government. A few days earlier, Chinese car parts maker Wanxiang won an auction for the assets of Fisker Automotive, a bankrupt U.S. manufacturer of hybrid sports cars. (Last year, Wanxiang also completed the acquisition of most of bankrupt U.S. battery maker A123 Systems.) Then, earlier this month, a unit of China’s FAW inked a joint venture with Michigan-based EcoMotors, a start-up backed by Bill Gates, to manufacture the latter’s environmentally friendly engines. The FAW subsidiary is picking up the entire bill for the Chinese facility, an investment of more than $200 million.

These latest deals follow in the footsteps of the granddaddy of Chinese auto acquisitions: In 2010, private Chinese carmaker Geely bought storied Swedish firm Volvo from Ford. Recently, the two said they were expanding cooperation to develop a new subcompact model.

What’s happening here is that China’s carmakers, with ample access to financing, are using their money muscle to buy technology, market share and access to new product lines that would have been difficult and time-consuming to develop on their own. (In this way, the auto deals are similar to those recently announced by Chinese PC maker Lenovo for Motorola’s handset business from Google and IBM’s low-end servers.) That’s why China’s asset grabs have led some critics to fret that the West is handing Chinese automaker critical know-how that will help them compete with heavyweights like GM and Ford, or even worse, can be used in military applications. After Wanxiang’s purchase of A123 was approved by a U.S. government panel, one senator complained that such technology developed in America “should not simply be shipped off to China.”

Yet as the old saying goes, beggars can’t be choosers. The Chinese (for the most part) are investing in companies or buying assets that have a very troubled history. It is an open question if France’s loss-making Peugeot, for instance, could even survive without a fresh capital injection. Chinese firms like Dongfeng have the money to save the day. Buying assets, however, is much different from using them wisely. It remains to be seen if these Chinese companies can capitalize on their purchases to turn themselves into better auto companies, or if they are capable of helping to turn around their troubled new investments. China’s car industry may find that cash can buy you stuff, but not easy shortcuts.

TIME China

Why There Is Good News in the Bad News on China’s Economy

Construction workers stand on a street corner at the financial district of Pudong in Shanghai on March 11, 2014 Carlos Barria—Reuters

Premier Li Keqiang’s realistic comments show policy may be changing in critical ways

As Chinese Premier Li Keqiang held his annual press conference at the close of the National People’s Conference, economic writers like myself were waiting for any clues about where Beijing’s policy team is heading on reform. To say this is a real press conference is something of an overstatement — like all government events, it is stage-managed, with all questions carefully vetted and selected in advance. But it is still a rare opportunity to at least hear directly from the otherwise unapproachable Chinese leadership. And though Li offered few details (as usual) and his language was vague (as usual), he did indicate that the government’s attitude toward the economy is changing in extremely important ways for the nation’s future.

Here we can find good news in the Premier’s bad news. The substance of Li’s comments suggested that China is heading for a rough patch, but he and his policy team are not going to pump it up at all costs. “We are not pursuing GDP growth alone,” he declared. This is an especially meaningful statement. In the past, China’s government felt compelled to supersize growth rates as soon as the economy showed any signs of faltering, as they did after the 2008 global financial crisis. But that has led to all sorts of problems for the economy — rising levels of debt, a shaky financial system and unhealthy excess capacity. Economists almost universally agree that Beijing has to start balancing its desire for growth with tough reforms to fix the negative fallout from that growth. In that way, China’s economy would be set upon a more stable future.

Li indicated that the days of blindly building GDP are over. Though he confessed that “China’s economy still faces severe challenges this year,” he went on to admit that “the space for wielding fiscal and monetary policy has limits, and [macroeconomic] regulation certainly faces many hard choices.” Instead, Li acknowledged that the economy has serious problems that must be addressed — terrible pollution, too much debt, inefficiency — and that the government needs to strike a balance between ensuring economic expansion and repairing its weaknesses. “We need to face up to the difficulties and challenges and make the most of the favorable conditions,” Li said. “Only a sharpened ax can cut through firewood.”

However, the question he left open is: How sharp is his ax? Li’s prudent comments are exactly what economists and investors want to hear — that Beijing will start to prioritize reform to set the stage for healthier growth rather than sacrificing everything for growth. Yet how committed are they to that course? Some economists are forecasting growth rates well below the government’s 7.5% target. How far will Li and his team allow growth to slip? Li left open the possibility that the government would jump in. “The acceptable lowest limit of GDP growth needs to ensure enough employment and that people’s incomes are increasing,” he said.

If the economy continues to slow over the course of 2014, Beijing may have to make a difficult choice — growth or reform — that will likely shape the direction of the economy for years to come. So, as usual, Li told people what they wanted to hear. We’ll have to see if he means it.

TIME Emerging Markets

Forget the BRICs; Meet the PINEs

University student interns monitor trading at the Philippine Stock Exchange in Manila's Makati financial district
University interns monitor trading at the Philippine Stock Exchange in the financial district of Makati, Philippines, on Feb. 7, 2014 Erik de Castro—Reuters

While many emerging markets are taking a beating, a fantastic growth story in the developing world is widening and drawing in new countries

Emerging markets are taking a beating these days, most of all the famous BRIC economies ­— Brazil, Russia, India and China. These four once seemed poised to dominate a post-American world. Not anymore. Brazil and India are posting growth rates that are only a fraction of what they were a couple of years ago. Russia’s prospects, already hampered by an overbearing state, are unlikely to improve as its aggressive moves into Ukraine could force Europe and the U.S. to impose economic sanctions. Even mighty China, while still notching admirable growth, must confront rising debt and a distorted financial system. The supremacy of the emerging world suddenly seems very far off.

But look past these headline grabbers, and you’ll find other emerging economies continuing to show economic strength. So for now, forget the BRICs; take a look at the PINEs. The PINE economies are the Philippines, Indonesia, Nigeria and Ethiopia. I have to confess I made up this acronym, and I fear it isn’t quite as catchy as BRIC. But I’m trying to make a point here. What the PINEs represent is something very important for the future of the global economy and quest to alleviate poverty. The PINEs are all performing very well right now, and that shows that the advance of emerging economies is far from over. In fact, the fantastic growth story in the developing world is widening and deepening, drawing in countries and regions that had previously been left out.

Take, for instance, the Philippines. When most of East Asia emerged from colonial rule after World War II, the Philippines was considered one of the new countries with the greatest potential for development. Sadly, things didn’t turn out that way. As much of the rest of East Asia zoomed ahead on its economic miracle, the Philippines got left behind. Millions of Filipinos were forced to search for jobs around the world, creating a diaspora from Hong Kong to Dubai. Now, though, the Philippines has become one of the region’s best performers. Even after getting smashed by Typhoon Haiyan last year, GDP still surged by 7.2%, and the IMF expects the country to post similar rates over the next several years.

(MORE: The BRICs Have Hit a Wall)

Indonesia has staged a comeback as well. Though the Southeast Asian giant had been a strong performer in the past (during the early 1990s, for instance), political upheaval and regional conflicts scared off investors, especially after its 1997 financial crisis. But now Indonesia has returned to the ranks of the world’s most desirable emerging economies, thanks to a stable democracy and a burgeoning consumer market. Foreign direct investment increased a hefty 17% last year. Though the stampede from emerging markets after the U.S. Federal Reserve signaled it would scale back its stimulus efforts pummeled the country’s currency, and growth dipped a bit last year, the economy is still forecast to growth at about 6% annually over the next several years.

The strong performances of Nigeria and Ethiopia are even more exciting. Africa generally stood on the sidelines while Asia and other parts of the developing world experienced giant gains in welfare over the past half-century, but now, finally, the continent seems to be joining the party. Nigeria is the largest country in sub-Saharan Africa and has long been seen as a potential economic heavyweight, and now that a more stable government is implementing some much needed reform, investors are flocking into the nation. Ethiopia may be even more exciting. Once synonymous with poverty, peace and strong economic management have turned the nation around. The International Monetary Fund sees growth in the 7% range in the coming years for both countries, and there’s even talk of a group of “lion economies” rising up in the same way the “tigers” of Asia did in the late 20th century.

There are, of course, risks that these countries will falter, if politics or corruption gets in the way. And though the advance of the PINEs may not have the same global impact as the BRICs —­ China and India are so big they’re in a class by themselves —­ the PINEs still represent a major opportunity for international companies to invest, expand and find new customers. The PINEs, after all, have a combined population of about 600 million people. So don’t be too quick to dismiss the emerging-markets story. The meek may yet inherit the world.

MORE: Viewpoint: How Elections Could Impact Five Emerging Economies

TIME China

Has China Reached its ‘Bear Stearns’ Moment?

A company logo of Chaori Solar is seen at the 12th China Photovoltaic Conference and International Photovoltaic Exhibition in Beijing on Sept. 5, 2012. Reuters

The country’s first-ever bond default could potentially reshape the entire financial sector

In Shanghai on Friday, a solar energy equipment maker you’ve probably never heard of before, Chaori Solar Energy Science & Technology, couldn’t pay investors interest due on its bonds. In normal times, such an event might not get that much attention. But matters in China’s financial industry are far from normal these days. A dangerous build-up of debt and an explosion of risky and poorly regulated shadow banking have raised serious concerns about the health of China’s economy. That’s why the Chaori default — the first ever in China’s domestic corporate bond market — has sparked fears that the country could be headed for a full-blown economic crisis like the one that slammed Wall Street in 2008. “We believe that the market will have reached the Bear Stearns stage,” warned strategist David Cui and his team at Bank of America-Merrill Lynch in a report to investors.

The concern of Cui and others is that the Chaori default will be the tip-off point for an unravelling of China’s financial system. The default could wake investors and bankers to the realization that companies they thought were safe bets are potentially not, and they could begin to reassess other loans and investments to other corporations. In other words, they might start redefining what is and is not risky. That could then lead to a credit crunch, when nervous bankers become wary of lending money, or lending at affordable interest rates. More bankruptcies could result. That eventually causes the financial markets to lock up — and we end up transitioning from a Bear Stearns moment to a Lehman Brothers moment, when the financial sector melts down. “We think the chain reaction will probably start,” Cui wrote. “In the U.S., it took about a year to reach the Lehman stage when the market panicked … We assess that it may take less time in China.”

Such an outcome could be devastating to for China and ripple through the entire global economy. How likely is this scenario? Unfortunately, we can only tell what triggers a financial crisis after the trigger has been pulled. The general feeling among economists is that at least for now the default may not have a big impact. Chaori Solar, after all, is a much small firm than Bear Stearns was, and far less connected to other aspects of the economy.

But the Chaori incident could end up having a major effect on the way China’s financial sector works. Right now, your access to loans in China depends on who you are, not on how strong your business is. If you’re a state-owned enterprise, or a politically connected businessman, you can get credit whenever you want at low rates of interest. If you’re an ordinary entrepreneur or small private company, you’re stuck scrounging around for cash, often finding it only an exorbitant cost. That means money has been priced incorrectly and heads to the wrong people and companies. Making matters worse is a widespread perception among investors that the government or state-owned banks will always step in and prop up indebted borrowers (as they have in the past), further encouraging good money to flow to bad companies. All this has led to all sorts of problems — excess capacity, high levels of corporate debt and the emergence of alternative shadow banking on a giant scale.

For China to fix its financial system, and lay a strong foundation for future growth, money has to get allocated more intelligently — to good businesses that use it wisely. That transition is extremely difficult to achieve and is fraught with risks. Yet it is also inevitable if China is to reach a more advanced stage of development. The fact that the government did not step in and organize a bailout for Chaori is a signal that China’s leaders are willing to undertake this important transition. “Allowing Chaori to default will help correct the long-standing and recently growing assumption by investors that the Chinese government will not permit a default,” noted Brian Jackson, China economist at IHS Global Insight

Ultimately, then, we could look back at this default not as the trigger to a financial crisis, but a turning point when China started healing a very damaged economic system. The Chaori default could begin the process of changing the country’s financial system so money gets to the right companies and investments by encouraging more careful assessment of risk. Yet managing the process will be extremely tricky. China’s leaders must somehow allow bankruptcies and wean state enterprises off easy money, all without toppling the system into a crisis. We should all wish them luck.

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