We need a new framework for understanding and interpreting what is happening in China. As a friend recently commented to me, there should be three categories of economies: developed, developing and China. China may struggle, but it will struggle in a uniquely Chinese way, and inevitably pose deep questions about the future of capitalism. Pundits, especially of the bearish persuasion, are fond of deriding the comment that “this time it is different”. But are things always the same? Analytics should match the subject matter (methodology should match ontology), and what has happened in China already is very different to anything yet seen. It has been the most sustained wealth creation in history, largely unpredicted. Two recent comments reported on MacroBusiness, one by Michael Pettis and the other by Nouriel Roubini reveal the problem.
Both pundits focus on China’s extremely high levels of investment, which is about half GDP, instead of about a tenth in most developed economies. Viewing China through the lens of a developed economy, they argue there is trouble ahead. But Pettis, also sees the frameworks used for developed economies start to fail:
So is credit growth tight? A lot of analysts are saying that it is, but I have a different view. It seems to me that credit expansion is so great that it isn´t really useful to think of credit conditions as being tight, even though so many borrowers in the economy are desperate to access credit.
Instead I would argue that investment – especially infrastructure, SOE and other official investment – is so great that it is managing to overwhelm what would otherwise be considered very loose credit conditions. If credit were in fact tight, growth would slow dramatically but at least we would be rebalancing the economy and limiting future demand on household wealth transfers. As it is, I don´t think we are rebalancing at all.
This is, to return to my hobby horse, a symptom of the lack of a cost of capital in China. Due to the immaturity of the capital markets, for the most part, but also the extremely heavy bias towards reinvestment, especially in housing, that is a function of not being able to park the money where it gets a decent return. Interest on savings deposits is negative in real terms, so you lose money if you bank your profits. The stock market is small in terms of the number of companies and mostly government owned — a nice, very big, casino, but not much more — there is almost no corporate bond market and other types of finance are only nascent. So the best option is reinvestment of earnings in capex or storing wealth in property.
What everyone should be watching is what China is doing in its finance system, and it is moving very fast (and the shadow banking system is moving even faster). It has reformed the four key banks, allowed foreign banks to come in a limited way, managed its SOEs, started to develop a securities industry, started to develop a corporate bond market. But it is quite a balancing act. It still lacks the micro-infrastructure, such as accounting law, securities law, governance structures and so on that are necessary to having a fully functioning cost of capital – that is, capitalism (of a twentieth century type, as opposed to the much sicker, twenty first century type appearing in the West). The aim needs to be to stop the heavy dependence on various forms of lending, by instigating a shift to a better balance between shares, bonds and bank deposits as the capital structure (in developed economies they are roughy in balance). Big equity and bond markets are much safer than a system that depends mostly on bank lending because equity markets and bond markets can reprice without the system breaking, whereas banks break. So it is an issue of national security for the Chinese leadership.
Roubini made a similar observation about over investment, drawing similar conclusions to Pettis:
The problem, of course, is that no country can be productive enough to reinvest 50 per cent of GDP in new capital stock without eventually facing immense overcapacity and a staggering non-performing loan problem.
He argued that to ease the constraints on household income, China needs more rapid exchange-rate appreciation, liberalisation of interest rates and a much sharper increase in wage growth. In other words, the usual prescriptions for developed economies. A revaluation of the yuan would require keeping it fixed. If the yuan was floated it would almost certainly go down, at least in the short to medium term, as money flooded out of China. That means keeping China from becoming like other developed economies.
As for liberalisation of interest rates, lending to private firms is already extremely “liberal”, running at very high rates from diverse sources (including offshore), as Macquarie recently noted. The SOE/state banks nexus could be “liberalised” but that is reducing in importance, as The Economist noted in its study of “bamboo capitalism” . It is a fast shrinking proportion of the Chinese economy. Banks only account for half of total financing according to the Financial Times.
Roubini need not worry about wages growth, either. It is forecast even in the Five Year Plan to increase at about 20% a year; in many parts of Eastern China it is running at about 30%.
He then said this:
More importantly, China needs either to privatise its SOEs, so that their profits become income for households, or to tax their profits at a far higher rate and transfer the fiscal gains to households.
China is already trying to link the SOEs to consumption, but not in the way Roubini advises. It is looking to develop 100 global corporations whose profits can be used to fund the health and education systems. That is why they had a tax break. In other words, there is a version of privatisation under way (not privatisation of ownership, but privatisation of profits). Given the dubious record of privatisation in the West, which has not exactly been a highly successful exercise in wealth distribution — it has accelerated more concentration of wealth — the Chinese strategy makes sense (which is not the same as saying it is achievable). The reason the Chinese save so heavily is that health and education have little or no government support (oddly for a former communist country). That has to be fixed before consumption will increase and the Chinese leadership knows it.
No country can escape the basic arithmetic of money and over investment will create problems. But some deep questions need to be posed about what kind of capitalism China will pursue. To say the least, that has repercussions for capitalism everywhere else, especially when Western capitalism is in a process of being destroyed by the uber capitalists with their $4 trillion daily trade in cross border capital, their $US600 trillion of derivatives, about twice the capital stock of the world, their algorithmic trading that accounts for about half of the turnover in the US stock exchange. All those, by the way, are “different this time”. They have never existed before, it is a new variant of “capitalism”.
China is essentially choosing what kind of capitalism it will pursue; what kind of rules it will adopt. Similar to what the Japanese did, who decided to keep most of their transactions within the country, “who cares about the cost of capital”? China’s official financial system is still closer to communist than capitalist. And it is making the choice at a time when Western capitalism, courtesy of a rampant and irresponsible finance industry, is fragile in the extreme. The Chinese leadership has stopped feeling triumphant about its version of “capitalism” after seeing the failures in the West from the GFC. But there is still a serious and deep debate going on within the leadership about what direction to take. On that debate depends a large part of the future of world capitalism; that is, what we mean by “capital” (which is just rules). It is not just the scale of China’s growth that is skewing the world economy.
It would be a fool who thinks the Chinese don’t understand the challenge; they do. Having your life on the line if you get it wrong does rather tend to concentrate politicians’ minds. To get to the top in China on your merits when there is a billion people ensures some serious quality; we can safely assume that some of the Chinese leadership has significant intellectual grunt. It would be worthwhile to listen very closely to what the Chinese say about their understanding of capitalism and what it is doing at the micro, institutional level with its financial system, not so much what it does with the macro-economic levers. That would include taking seriously their claims that they remain “communist”.
Perhaps it is not that we need a new framework for China, but that we need to listen a lot more closely and watch what the Chinese are doing.