Further considerations on the Chinese rebalancing

 

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The last few months have witnessed a series of ever-increasing problems for the Chinese economy. The stock market crash, the devaluation of the currency (and the prospects for additional rounds), the lacklustre performance of the Chinese export sector and the likely deceleration of the economy, just to name a few problems, have provoked general turmoil in financial markets and have created a widespread sense of skepticism in the global media. It has also propelled the idea that a major Chinese slowdown could have serious consequences for the global economy. However, most of these articles get very specific about this or that problem, and they miss the real and broader problem that the Chinese rebalancing process poses. In this article, we will see that the implications of the stock market crash and of the devaluation of the renmimbi for the rebalancing process are not as important as many believe.

The stock market crash has been the most prominent phenomenon in the financial press. The Shanghai Index, for instance, stood at 3,350 points at the beginning of 2015, peaked around 5,100 in the middle of June and since then has lost the staggering amount of 40% (yesterday closed at 3,170). For Western standards, that correction has been brutal. But it is also widely known that government ownership in many companies is high and that households have invested very little in stocks so far. So, beyond firms that may have posted some shares as collateral for their loans, the direct impact of the stock market on the Chinese economy should be very limited- actually, a bulk of the losses have already been anticipated by international investors. We think that the stock market crash should thus be interpreted as a sign that the perception of the Chinese economy is changing, rather than as a first cause for further financial distress.

However, the devaluation of the remimbi should be viewed slightly different. The Chinese renmimbi has been pegged to the dollar in the last few years; while this fixed exchange rate regime turned out to be particularly favourable since 2004, the recent appreciation of the dollar against a broad currency index has carried the yuan along, as we can see in the following graph:

China real effective exchange rate (basket)

This unfavourable evolution must have been a source of concern for Chinese authorities. As we explained in our previous post on the Chinese rebalancing, we think that:

Regarding the external sector, a comeback to the period 2003-2007, when the balance of payments largely contributed to Chinese growth, would be very welcome by Chinese authorities. It is paradoxical that an attempt to rebalancing may rest on a comeback to the export-led growth model. Internal pressures for a strong devaluation of the yuan will be significant, and it remains to be seen the impact of such a decision in China’s international commercial partners.

For such a goal, the devaluation made so far has been minimal; we reckon that a devaluation of an additional 20% (ballpark figure) would be necessary to make a real impact. We thus consider the devaluation movements seen in August as a modest test of things to come – i.e. to test trading partners’ reactions to further devaluation rounds.

What does it all mean for the rebalancing process?

In a recent post, professor Michael Pettis has followed similar lines in explaining the relative importance of recent events for the long-term dynamics of the Chinese economy. Although we would partially disagree with him on the role the external sector will play for alleviating the pressures the Chinese economy will have to face (Pettis argues that the recent devaluation has been done in order to qualify for SDR, rather than for trade purposes), we agree with him that these events should be put into context. There is especially one paragraph (which we fully subscribe) that summarises in a neat way the nature of the Chinese rebalancing process:

a) imbalances could persist and grow for many years before eventually rebalancing, b) the more rigid the institutional structure of the economy, the deeper imbalances were likely to get, c) the longer they persisted, the more disruptive the rebalancing was likely to be, and the less significant the “trigger” that set it off, and d) there are many ways rebalancing can occur, and the way it actually occurs depends on institutional constraints and rigidities.

However, when it comes to the conclusions, we differ with professor Pettis on how the rebalancing process will develop. We certainly agree that the rebalancing process will take place, for sure, sooner or later – almost as a matter of arithmetical necessity. But it seems that Pettis has in mind a long-landing scenario where the Chinese economy will follow a sort of Japanese path, where the recognition of losses in the balance sheets takes times and the growth in GDP can still be well above zero:

In fact I fully agree with him that a banking crisis is unlikely, and have written many times that while it is possible, and the risk of its happening should not be dismissed out of hand, I do not think China is likely to have a banking collapse, any more than Japan in the late 1980s and early 1990s was ever likely to have a banking collapse.

To clarify our differences with Pettis in how the rebalancing process will take place, in our previous post on the arithmetic of the Chinese rebalancing we concluded that:

As a conclusion, we can venture that a Chinese soft landing towards a less investment oriented model is highly unlikely. The only chance is through a large increase in government spending and exports, which we think is not feasible. The change to a consumption-led model is bound to produce severe problems in the Chinese economy. The temptation to stick with the current model is thus irresistible – this is very evident given the latest attempts to promote mammoth investments in telecommunications and internet – something that will compound the problems later. When investment stops in China, the lack of alternatives in the short-run will be evident. At that moment China will have its severe crisis; it will overcome it, and then will be able to keep growing in a more balanced way.

As of today, we still stick with this position. In other words, we believe that a financial crisis (with negative GDP growth rates) is the way the Chinese economy will rebalance and we do not expect a Japanese path. First, although the GDP growth rates in Japan were positive as Pettis says, there was a banking crisis in Japan (see here), which spanned over the 90s. But beyond that, there are many important differences between the Japanese experience in the 80s and the Chinese one nowadays. The main one is that the Japanese economy never reached the astonishing levels of fixed investment reached by China recently – Japan peaked “only” 32% in 1990 and 1991, while China has surpassed the level of 50%. So the Japanese economy was accumulating less debt for capital formation than China now. Most of the Japanese debt bubble was related to finance the purchase of “second-hand” real estate properties and financial assets (both items by definition contribute very little to the GDP figure), so when the crisis struck the financing needs for capital formation were not as great as we envisage in the Chinese case – in 1994, four years after the Japanese crisis struck, the investment share still stood at 28% of GDP.

Summing up, the problems that the Chinese economy faces right now go well beyond the stock market correction, the renmimbi devaluation and the progressive slowdown of economic activity. As soon as the reduction in capital formation takes place and thus the rebalancing process moves forward, the financial situation of capital goods and construction industries will be unsustainable and all the bad loans granted to them in the last few years will sit heavily on the balance sheet of the banking sector. From this point, there are many ways a financial crisis can take shape, but for sure they will depend on the choices (some of them political) the government will have to make.

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