Without Reform from Beijing, ‘The World Will Endure More China Scares’

On Jan. 21, billionaire investor George Soros said he was betting against Asian currencies, telling Bloomberg Television that “A hard landing is practically unavoidable” in China. The Chinese currency has dropped 5.7 percent since August, when the central bank allowed it to depreciate. “I’m not expecting it,” he added. “I’m observing it.” Though Soros didn’t specifically mention the renminbi, China’s currency, ruling Communist Party mouthpiece People’s Daily attacked him in a Jan. 26 article for suggesting he might short the renminbi, comparing such a move to “declaring war on China’s currency.” In this ChinaFile conversation, experts discussion if Soros may be right.

Arthur R. Kroeber, Managing Director of GaveKal Dragonomics:

Just how much economic trouble is China in? To judge by global markets, a lot. In the first few weeks of 2016, stock markets around the world plummeted, apparently thanks to China. The panic was triggered by an 11 percent plunge on the Shanghai stock exchange and by a small devaluation in the renminbi. Global investors — already skittish following the collapse of a Chinese equity-market bubble and a surprise currency devaluation last summer — took these latest moves as confirmation that the world’s second-biggest economy was far weaker than its rosy headline growth numbers suggested. At the World Economic Forum in Davos in mid-January, two of the world’s most prominent hedge-fund billionaires, George Soros and Ray Dalio, warned that China is headed for a hard landing and may be forced to devalue its currency even more.

It is tempting to argue that markets are overreacting. After all, China’s economy grew by a solid 6.9 percent in 2015. Financial media headlines bewailed this as “the lowest growth rate in a quarter century,” but neglected to mention that this is still by a good margin the fastest growth of any major economy except for India. Even at this slower pace, China continues to grow more than twice as fast as developed economies. There are some doubts about the reliability of China’s economic statistics, of course, but most credible alternative estimates (based on hard-to-fake indicators of physical output) suggest that China is growing at around 6 percent, and that if anything there was a slight pickup in activity in late 2015. The tumult on equity and currency markets can be explained as an uncomfortable but necessary part of the country’s transition from an investment-led command economy to a consumer-led market economy.

This sanguine reading is partly true. China is unlikely to see a collapse in economic growth any time soon. Construction and heavy industry, the mainstays of its growth from 2000 to 2013, are faring poorly, but the service economy and consumer spending remain strong, underpinned by strong employment and wage gains. Everything is slowing down a bit, but another year of six percent-plus growth should be achievable in 2016.

Nor is financial crisis a serious short-term risk, despite the breathless discussion of capital fleeing the country. Most of the so-called capital flight is simply a matter of companies prudently paying down foreign-currency debts, or hedging against the possibility of a weaker renminbi by shifting their bank deposits into dollars. In the main, these deposits remain in the mainland branches of Chinese banks. Domestic bank deposits grew by a healthy 19 percent in 2015 and now stand at $21 trillion — double the country’s GDP and seven times the level of foreign exchange reserves. So long as China’s financial system stays so securely funded, the chance of a crisis is low.

Yet in another sense, Soros and other investors are right to sound the alarm. China presents two risks that are more fundamental than the ones now catching the headlines. First, the global impact of its growth has contracted far more rapidly than the headline GDP numbers. Second, there are strong reasons to doubt that the government of Chinese President Xi Jinping is really committed to crucial market-oriented reforms, because these would require an unacceptable dilution of Communist Party power. Until Xi steers a credible course in favor of markets, the world will endure more China scares.

China’s economy is slowing only modestly in local-currency terms, but its contribution to global growth has already plunged dramatically from its peak. Remember that when China reports its GDP growth, this reflects how much its spending grew in inflation-adjusted renminbi terms. But to measure China’s impact on the world in a given year, it is better to look at its nominal growth — that is, not adjusted for inflation — in terms of the international currency, the U.S. dollar. This is because nominal U.S.-dollar figures better show the impact that Chinese demand has on the revenues of international companies, both in volume terms (buying more stuff) and in price terms (pushing up the prices of the stuff it buys).

Viewed through this lens, China’s growth slowdown has not been modest and steady, as the official data show, but precipitous and scary. At its post-crisis peak in mid-2011, China’s nominal U.S.-dollar GDP grew at an astonishing 25 percent annual rate. During the four-year period from 2010 to 2013, the average growth rate was around 15 percent. By the last quarter of 2015, though, it had slowed to a tortoise-like 2.4 percent. In short, while investors are wrong to complain that China distorts its GDP data, they are right to observe that, for the rest of the world, China’s slowdown feels far, far worse than Beijing’s numbers imply.

Worse, when we break down growth by sector, we find that industry and construction — which for years powered the demand for equipment, materials, and commodities that made China the world’s leading importer — are in outright recession. From 2010 to 2013, these sectors reliably produced about $100 billion more each quarter than they did in the previous annual period. In 2014 this figure fell in half, to $50 billion. By the last quarter of 2015 it was negative, to the tune of $50 billion. In other words, for those selling machinery or raw materials to China, the market isn’t simply growing a bit more slowly — it’s shrinking. In effect, the world has already experienced a China hard landing.

This helps explain why markets react in such terror at every hint the renminbi might fall in value: a weaker renminbi reduces the dollar value of the goods China can buy on international markets, at a time when demand from its traditional industrial and construction sectors is already declining.

This downshift in Chinese demand is part of a necessary adjustment away from the infrastructure-focused growth of the past towards a consumer-led growth model. But now we come to the second problem. Although China’s Communist Party leaders have professed their desire for this adjustment to a more market-driven economy, they seem unwilling to make any of the political sacrifices needed to make it happen.

Ever since reforms began in the late 1970s, the party’s desire to maintain absolute political control has lived in tension with its almost equally strong desire for a booming economy. For many years its leaders proved skillful at tactically surrendering control over ever-bigger pieces of economic real estate (agriculture, goods prices, housing, foreign trade, manufacturing) in ways that stimulated growth without undermining the party’s ultimate power. They gradually introduced markets that functioned pretty well most of the time, and intervened mainly to smooth out volatility, not to institutionalize false prices.

This system worked thanks to two conditions. First, the main job was to pump more capital into the system, rather than to maximize the return on each dollar of capital. Second, the important markets were for physical goods (grain, pork, coal, houses). The government could regulate these markets by creating a pool of inventories and then operating a sluicegate that released these inventories or held them back, depending on whether the market was tight or in glut.

Neither of these two conditions now applies. China has mobilized more capital than it can productively employ. Economic growth can no longer come from throwing more capital into the system; it must come from improving efficiency. To improve efficiency, new markets are needed — not the physical markets of the past, but financial markets. Unlike physical markets, financial markets cannot be controlled by inventory management, and they are intrinsically more volatile.

Unfortunately, officials in Beijing have spent much of the last year trying to control financial markets in the same way they control the markets for grain and coal, with terrible results. In June, when a short-lived stock market bubble popped, they forced state-owned enterprises (SOEs) to buy up shares to stop the rout. This stabilized the market for a while, but left people wondering what would happen when the SOEs started selling down the shares they had been forced to buy. To enable SOEs to sell their holdings without disrupting the market, the authorities instituted a “circuit breaker” which automatically suspended stock-exchange trading when prices fell by five percent in one day. Instead of calming the market, this induced panic selling, as traders rushed to dump their shares before the circuit-breaker shut off trading.

Similarly, Beijing got into trouble in August 2015 when it announced a new exchange-rate mechanism that would make the value of the renminbi more market determined. But because it paired this move with a small, unexpected devaluation, many traders assumed the real goal was to devalue the renminbi, and started pushing the currency down. So the People’s Bank of China (PBOC) intervened massively in the foreign exchange markets, spending down its foreign-currency reserves to prop up the value of the renminbi. This stabilized the currency, but undermined the government’s supposed commitment to a market-driven exchange rate.

Then, in December, the PBOC made another change, by starting to manage the renminbi against a trade-weighted basket of 13 currencies, rather than against the U.S. dollar as in the past. Because the U.S. dollar has been very strong lately, this in effect meant that the PBOC was letting the renminbi devalue against the U.S. dollar. Again, the PBOC argued that its intention was not to devalue, but simply to establish a more flexible exchange rate. And again, it undermined its credibility by intervening to prevent the currency from going what it perceived as too low.

The motivations behind the stock-market and currency policies differ. The PBOC is genuinely, though clumsily, trying to establish a more market-driven exchange rate, whereas the stock market regulator is just trying to keep stock prices at an artificially high level. But the political constraints are the same: a government that refuses to let market prices rule when it thinks those prices are too low, and a system that adamantly flouts well-established international standards for transparency. At no point in the last six months has PBOC governor Zhou Xiaochuan stepped forward to explain what he is trying to achieve with his new currency policy. The leaders of the Federal Reserve, Bank of Japan, or the European Central Bank would never dream of staying silent while global markets were being roiled by their actions.

In short, it seems that when market-friendly measures conflict with the party’s demand for control and secrecy, control and secrecy win out. This belies Xi’s pledge three years ago to give market forces a “decisive role” in China’s economy. The lack of credibility of Xi’s market reforms makes it less likely that China will manage its difficult economic transition. For all their faults, Xi’s predecessors consistently gave domestic and foreign investors confidence that over time, there would be more space for markets and the private sector, even if there were plenty of potholes along the way. In economic reform, general direction matters more than speed.

Today China is a country without a clear economic direction, and this shows up in a steadily slowing rate of private investment. The fault for this lies squarely with Xi. We have no idea whether he understands what modern markets require, or how he hopes to reconcile their demands with the Leninist-Confucianist paternalism he is busy imposing on the rest of society. China is unlikely to collapse. But it does risk losing its way.

Stephen S. Roach, Senior Fellow at Yale University’s Jackson Institute of Global Affairs and former Chairman of Morgan Stanley Asia:

No hard landing in China. Time and again, momentum driven investors draw erroneous economic conclusions on the basis of pyrotechnics in financial markets. It’s happening again in early 2016. But the real side of the Chinese economy — the ultimate arbiter of a hard or a soft landing in any nation — is holding up much better than most believe.

Yes, economic growth is slowing in China. The real story is not in the aggregate GDP but in important shifts in the mix of the Chinese economy. In 2015, an 8.3 percent expansion in the services sector outstripped that of the once-dominant manufacturing and construction sectors, which together grew by just 6 percent in 2015. The so-called tertiary sector rose to 50.5 percent of Chinese GDP in 2015, well in excess of the 47 percent share targeted in 2011, when the 12th Five-Year Plan was adopted, and fully ten percentage points larger than the 40.5 percent share of secondary-sector activities (manufacturing and construction).

This significant shift in China’s economic structure is vitally important to the nation’s consumer-led rebalancing strategy. Services development underpins urban employment opportunities, a key building block of personal income generation. With Chinese services requiring about 30 percent more jobs per unit of output than manufacturing and construction, combined, the tertiary sector’s relative strength has played an important role in limiting unemployment and preventing social instability — long China’s greatest fear and the most likely candidate for a smoking gun on the hard landing watch. Yet even in the face of decelerating GDP growth, urban job creation hit 11 million in 2015, above the government’s target of 10 million and a slight increase from 10.7 million in 2014.

The bad news is that China’s impressive headway on restructuring its real economy has been accompanied by significant setbacks in its financial agenda — namely, the bursting of an equity bubble, a poorly handled shift in currency policy, and an exodus of financial capital. Fortunately, China’s massive reservoir of foreign-exchange reserves provides it with an important buffer against a classic currency and liquidity crisis.

To be sure, China’s reserves have fallen enormously — by $700 billion — in the last 19 months. Given China’s recent build-up of dollar-denominated liabilities, which the Bank for International Settlements currently places at around $1 trillion, external vulnerability can hardly be ignored. But, at $3.3 trillion in December 2015, China’s reserves are still enough to cover more than four times its short-term external debt — well in excess of the widely accepted rule of thumb that a country should still be able to fund all of its short-term foreign liabilities in the event that it is unable to borrow in international markets.

Of course, this cushion could all but vanish in a few years if foreign reserves were to continue falling at the same $500 billion recorded in 2015. This was precisely the greatest fear during the Asian financial crisis of the late 1990s, when China was widely expected to follow other so-called East Asian miracle economies that had run out of reserves in the midst of a contagious attack on their currencies. But if it didn’t happen then, it certainly won’t happen now: China’s foreign-exchange reserves today are 23 times higher than the $140 billion held around 1997 and 1998. Moreover, China continues to run a large current-account surplus, in contrast to the outsize external deficits that proved so problematic for other Asian economies in the late 1990s.

Still, fear persists that if capital flight were to intensify, China would ultimately be powerless to stop it. Nothing could be further from the truth. While Chinese authorities have no desire to close the capital account after having taken several important steps to open it in recent years, they would most certainly rethink this position if capital flight were to become a more serious threat.

Yes, China has stumbled badly in the recent implementation of many of its financial reforms. These missteps should not be taken lightly — especially in light of China’s high-profile commitment to market-based reforms. But in light of impressive progress in the early stages of China’s structural rebalancing, its recent financial accidents do not spell the hard landing that many believe is now at hand.

Orville Schell, the Arthur Ross Director of the Center on U.S.-China Relations at the Asia Society in New York:

China’s financial markets — at best a hybrid confection of marketized Leninism that mixes together elements of real markets and a government-managed casino — have not only recently been sending tremors through China, but unnerving global markets as well. Gone are the days of Mao Zedong’s “self reliance” when China’s economy was an autarky and global markets, such as they were, paid little attention to Beijing’s economic successes and failures. However, now that enthusiasts of globalization have woven an ever-tighter fabric of interdependence between all the world’s major economies, what happens in China matters elsewhere. For better or worse, we are all in a common enterprise from which there is no escape.

And so, when Soros, one of the global market’s arch prognosticators who until recently was quite bullish on China, suddenly ups and says, as he did at Davos on Jan. 21, that “a hard landing is practically unavoidable” for China, and that he’s not only “expecting it,” but “observing it,” we ought to at least wonder how he arrived at his judgment. What factors would make one come to such a bearish conclusion?

It is undeniably true that China’s rather immature financial markets are not coterminous with its economy. One does not equal the other. Here Stephen Roach is right when he says above, “Time and again, momentum driven investors draw erroneous economic conclusions on the basis of pyrotechnics in financial markets.” China’s economy has a quarter of a century of real and impressive expansion and continues to register a growth rate of just under 7 percent that remains the envy of most countries. In short, it remains a global economic powerhouse.

But as we watch China’s financial markets seesaw up and down once more, what we should pay attention to is what Beijing’s reaction to this challenge tells us about how the party’s almost autonomic response mechanism has sought to handle to the past crises in their financial markets and, thus, when economic push again comes to shove, how officials can be expected to react when challenged elsewhere. Xi may have publically proclaimed that market forces must be allowed to play a greater role in the allocation of capital, but when the economy actually comes under siege, the party’s response seems to inevitably marshal massive state intervention, greater regulatory controls, and more manipulation of the press. We saw these dynamics first come into play in summer 2015 when China’s Shanghai and Shenzhen stock markets went into meltdown. And then we saw the same response come into play again when a second bout of panic selling erupted this winter just as certain market restrictions (like preventing larger corporate shareholders from selling large blocs of securities) were scheduled to be lifted. As Arthur Kroeber suggests, such behavior raises real concerns about the party’s abilities to effect the kind of deep economic reform Xi claims he supports and that the economy now sorely needs.

However, if it pleases Xi to continue playing a version of China’s latter day “great helmsman” — a leader so invincible that he is always capable of seamlessly controlling all aspects of Chinese life — there will be an ineluctable tendency for him and the party to react reflexively in often retrograde and counter-productive interventionist ways every time a major economic crisis approaches in order to keep up appearance and preserve official face. It is this dynamic of avoiding both tough decisions and the unpleasantness of passing disarray that could continue to militate against the government’s ability to push through comprehensive economic reform.

From this perspective, it is logical to look at how the party has been responding to the recent series of crises in its financial market sector, because it helps us extrapolate how it will probably respond to other crises in its economy as a whole. In this sense, China’s admittedly epiphenomenal stock markets may viewed something like a petri dish in which we can see one very telling experiment in progress that shows the party’s willingness to actually let market forces play a more significant role in China’s economic future, especially when they may lead to large corrections.

Alas, as Kroeber has pointed out, recent government actions do not suggest that Xi’s apparatus is flexible or risk-tolerant enough to actually allow really meaningful market reforms to take place, especially in a crisis situation.

An official Xinhua news agency editorial indirectly criticized Soros on Saturday for his statements, condemning “those who want to bet on the ‘ultimate failure’ of the Chinese economy,” and warning against “reckless speculations and vicious shorting.”

Instead of reading Soros’s admonition as a warning that markets are wary of China’s management style, the party seems to view it as a threat, and has gone into attack mode. But this is precisely the self-defeating mindset that has led it also to prop up a dysfunctional status quo of its financial markets over the past year, when what was really needed was to allow market dynamics to establish their own new equilibrium, even if that involved a temporarily much lower evaluation, and significant dislocation.

As the classical Chinese expression puts it: “Simultaneously listen to all sides and be enlightened; Listen to only one and be benighted.”

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