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Will, or can China put change before control?

First published: 29th January 2016


One of John McDonnell’s economic advisory team, David Blanchflower, recently wrote in the New Statesman, “The new Labour leaders are not economists and are going to have to learn fast. They will have to accept the realities of capitalism and modern markets, like it or not.” You can find the piece here. He makes a fine point, and on reading it, I immediately thought that it could equally be made about China.

The leadership is no longer new, and for them the realities of capitalism and markets are not the same: they are prepared to incorporate market mechanisms and go along with western capitalism only to the extent that they, a) do not compromise the interests and primacy of the Chinese Communist Party; b) help the Party further Chinese economic and political power;  c) bolster the competitiveness and efficiency of state institutions. What the leadership does not want is a central role for markets and prices in the determination of the ownership, allocation and distribution of resources.

This much, if you did’t know it before has become evident to global audience in the seemingly parochial world of finance.

On the one hand, China has taken the initiative to set up the Asian Infrastructure Investment Bank under the umbrella of what President Xi Jinping has called the One Belt, One Road project, or to you and me, a 21st century Silk Road by land and by sea; and most recently won the IMF’s backing to include the Yuan in the so-called Special Drawing Right, the IMF’s accounting unit. We could also point to other initiatives to encourage greater use of the Yuan in the settlement and invoicing of trade, the denomination of international bonds, and the composition of central bank currency swaps; and to encourage foreign capital to come into Chinese financial markets.

Many analysts and researchers have been bowled over by these things, insisting that they constitute proof that China is on an unstoppable course of reform as it strides, altruistically, towards greater global prominence. If they do have substance, they are much more about the pursuit of power and influence than about changing the way the world economy works. It is not even clear that some of the headline-catching initiatives have the full backing of leading Chinese economic thinkers.

But the main thing the world has learned since last summer, is that when it comes to the relative microcosm of equity and foreign exchange markets, Chinese policy-making has become confused, contradictory and quite the antithesis of market-based reform. Most investors outside China aren’t involved and don;t worry too much about the Chinese stock market. But while everyone knows and cares about the Yuan, no one knows now what official policy is. And when you think about the possible causes and consequences of a Yuan devaluation, it is easy to see why.

Christine Lagarde told the Davos crowd the Chinese had a communications problem, but this goes a lot further than communications. It is about uncertainty at least, maybe even conflict that reaches into the bowels of public policy affecting not only the exchange rate but the wider reform and rebalancing agenda.

I was privileged to have been invited to participate in an excellent China conference last week at the Danish Institute for International Studies in Copenhagen. Several China specialists spoke, and many were in the large audience too. Amongst the things that struck me was the extent to which some prominent participants discussed reform and rebalancing without even referring China’s biggest economic problem of the moment, namely its passive attention (at best) to excessive credit creation and debt. And the extent to which many present had clearly swallowed the narrative, hook, line and sinker, that China is different, all pronouncements must be true, and all economic problems can be solved in the context of continued high growth. I do think nowadays that foreign thinking on China has changed from the hype we have been peddled for so long, but it may have some way to go if this was representative.

The always interesting Ambrose Evans-Pritchard says here that hysteria about China has become ridiculous. I would agree that people, and policymakers in governments and central banks in the west, have been far too quick to assume China is going into the deep-freeze. It isn’t. But at the same time the likelihood of a more serious growth crunch between  2017-19, with or after a financial crisis reckoning that brings the funding of rapid credit creation and non-performing loans to a head is very likely scenario.

The economy ended 2015 soft, but more stable as housing transactions and prices, at least in Tier 1 and Tier 2 cities, picked up a bit, responding to prior stimuli and easing of mortgage restrictions. Inventories of unsold houses and apartments have dropped but remain between 20-35 months of supply in most cities. The economy will probably remain soft but relatively stable in the first quarter, and then in or by March’s National People’s Congress, there will most likely be a new round of fiscal stimulus, probably focused on infrastructure and tax cuts. If the exchange rate picture is stable, there may also be further reductions in interest rates and banks’ reserve requirement ratios, though these are hardly needed when credit creation is China’s numero uno problem. So, an imminent economic collapse is unlikely, even if you think, as a few respectable forecasters now do, that growth in China has already lapsed to around 4% or so.

4% is plausible but if that indeed were the case, or even lower, would we not be seeing much stronger anecdotal evidence of a weak labour market? There are stories periodically in the South China Morning Post of Chinese migrant workers being told to go home arly for the Chinese New Year holidays. Some are about workers being told not to return. The employment component diffusion index in the monthly manufacturing PMI is continuously below 50, ie employment is falling. The number of labour unrest incidents doubled to almost 2500 in 2015. These things are worrying, not least for the leadership. And so on.

At the same time, the idea that growth is 7%, when a barrage of indicators including profits, incomes and retail transactions are is falling or growing nowhere as high, looks increasingly suspect. Another idea you can read here is that China’s growth has slumped in Manchuria and other provinces where there is a concentration of old and heavy industry, and or exposure to the real estate sector that is now in decline, but still doing very nicely thank you elsewhere.

This reminds me of what far too many people said in the West in 2006-07, such as ‘It’s only the housing sector that’s overextended’, or ‘subprime loans are a miniscule proportion of bank assets’, or ‘it’s just sector-specific’. Yeah, right. What they missed was the rest of the iceberg of leverage and indebtedness, and how a a sudden interruption in funding, asset prices and growth exposed something that was systemic, not sector-specific.

This is what I think these optimistic analysts, and some cheerleaders, miss. China’s real estate downturn is the leading edge of something broader. Rebalancing is kind of happening by default, as the investment side of the economy falters, rather than by design of pro-household wealth transfers. Reform, including the newest focus on ‘supply side reforms’ that some erroneously liken to those of Thatcher and Reagan, will count for nothing if the government fails to lower the pace of debt accumulation or to allocate the costs of paying for bad debt to itself and to companies, including notably state enterprises. You can, and should if you have the time, read much more about this from the venerable Michael Pettis here. Be warned, it’s 72 pages, but it’s nail on head stuff.

So, David Blanchflower scored a hole in one, I think, with his warning shot to Corbyn et al, and vital it is to the UK, of course. But China’s leaders and Xi, himself, need to get a grip on the economics of what they’re grappling with too, and they aren’t economists. They’re mostly engineers, who think about problems and solving them rather differently. Li Keqiang, the Premier, is a PhD economist and highly regarded in the international community, but his political position has been sidelined by Xi’s centralisation of power around himself and his creation of ‘small leading groups’, or large Party agencies that are usurping ministries, and the economic power and influence of the Premier, himself.

Meantime, watch the Yuan. Management of the Yuan may ostensibly lie in the hands of the economically sound  People’s Bank of China, but the strategy call lies with non-experts elsewhere. For now, things have quietened down. I discount the idea that the Yuan will be floated, because this would be to lose control.

The options are a drip-feed depreciation against a strong US dollar, while keeping the basket value stable, the least contentious. Or a small 5-10% devaluation that only serves to trigger more capital flight and depreciation expectations. Or a large 20-40% devaluation that sets off financial instability in China and around the world. We might get all three, in that sort of sequence, but if you twist my arm, I’d go for the limited  depreciation option, perhaps the second, but in any event accompanied by the tightening of exchange and capital controls, and the rollback of financial liberalisation. Control, after all, is the raison d’etre of the Party.

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