The Shanghai stock market went through a free fall last August and again a couple of weeks ago. Soon thereafter, world stock markets followed suite, chilling investors and worrying policymakers and business leaders around the globe. Gloom is back. Dark predictions abound. Well, cheer up, the announcement of a worldwide crisis is highly premature.
Yes, China is the second largest economy in the world, so its economic and economic travails are bad news for the rest of us. On the surface of it, many signals are ominous. In order to avoid being drawn into the 2009 depression, the Chinese government has embarked on spectacular fiscal and monetary expansions. Banks have been instructed to lend without restraint. Regional governments have been told to borrow and spend, mostly on infrastructure. Corporations have been invited to borrow and spend on productive investments. This has been called rebalancing, shifting from export-led growth to domestic demand-led growth. As a result, China sailed through the terrible years after the Great Financial Crisis with double-digit growth. This was borrowed growth. A time of reckoning had to come. Here we are.
Borrowing to invest, especially when interest rates are low, is smart if the investments are productive. The highways, train lines, electricity grids built up during these go-go years are, in principle, highly productive. Unfortunately, these huge achievements come way ahead of actual needs. These public investments will, one day, pay off, not yet, though. Similarly, the huge buildup of production capacities has created massive overcapacity in industry.
It is rumored that China can now produce all the steel that the world needs, but the world will not buy all its steel from China. Apartment buildings have sprung up like mushroom in autumn and many citizens have borrowed to move to modern facilities. Even so, dark empty apartments dot the night skylines of many major cities and serving loans is proving challenging to many people. It will be even more challenging if the economic slowdown lasts. Industrial production has been declining for more than one year and the official goal of 6% annual GDP growth could well be out of reach for a while.
Too much debt, at every level
In classic capitalist style, China is now suffering from overborrowing, at every level. The US financial cycle that led to the 2008 crisis seems small in comparison; after all, it mostly concerned housing and subprime follies. At this stage, it seems obvious that a bust must follow the Chinese boom. Well, not necessarily so. China is not really a market economy, and it makes a huge difference. The big overborrowers are largely in the government sphere: regional governments, state-owned and state-protected corporations.
The big lenders, the banks, are also state-owned. If you consolidate the liabilities of the borrowers and the assets lenders, you get about zero. It does not take a genius to understand that and it is not difficult to do it when one man makes all the big decisions. If some money is needed to plug holes here and there, the People’s Bank of China is not an independent central bank and it can provide the cash that is needed, and more. The question is therefore one of politics and of those details where the devil loves to hide.
Will the leadership perform the Great Consolidation? No one outside the leadership knows, so we are left to guess. The current buzzword in Beijing is «supply side». In the West, supply side policies are about breaking entrenched interests to spur growth. Over the last thirty years, China has conducted the most spectacular supply side policies ever seen on earth, with amazingly success. Hundreds of millions of people have been lifted from abject poverty. A hopeless third-world country has become a world power. Surely, the leaders are not rediscovering the merits of supply-side reforms.
«Great Consolidation» or «Great Cleanup»
So what does the new official orientation signal? It could be an effort to reduce the importance of the state-owned sector. It could be a strengthening of the anti-corruption drive since, indeed, corruption is one of the most powerful inhibitor of growth. In both cases, the Great Consolidation is not in order. We could expect, instead, the closing down of de facto bankrupt corporations. Eventually, such a Great Cleanup would reignite growth but, in the mean time, it would lead to a further slowdown.
Alternatively, the emphasis on the supply side really means the end of the demand-side expansionary policies that have created the massive distortions described above. There is no doubt that expansionary demand-side policies cannot be permanent, a reversal is unavoidable. But the timing is wrong. Withdrawing demand-side support when the economy is undergoing a marked slowdown is bound to deepen the slowdown while aggravating the excess capacity problem and boosting debt service difficulties, which can only further hurt already shaken banks. In this interpretation, as well, growth is bound to slow down.
Whether we will see a Great Consolidation, a Great Cleanup of the public sector or the withdrawal of demand-side support, the central bank will have to play a major role. Regional governments and banks must be kept afloat. A continuing slowdown will depress corporate profits, further hitting stock markets. The Shanghai market has lost half of its value since the bubble-style peak of last June, declining about 20% since the beginning of the year, and going. The authorities’ initial gut reaction, complaining about the ubiquitous speculator and jailing some financiers, only makes things worse. Surely the People’s Bank of China will be called upon to stop the slide. It is no surprise, therefore, that the exchange rate is under pressure.
Central bank lacks a clear strategy
In a stunning case of mismanagement of expectations, just when the stock markets were falling last August, the People’s Bank of China announced that it was starting to implement its earlier decision of introducing some flexibility in its management of the exchange rate. The markets immediately interpreted the move as a signal that the currency would be depreciated. It does not matter that the depreciation then was a mere 2.8%, cumulating to 5% since then, the markets now see the renmimbi as a doomed currency. The gloomy overall picture is not going to change these expectations, prompting large-scale capital outflows, which already have reduced the country’s mammoth foreign currency reserves from $ 4000 billion to $ 3300 billion. The central bank’s reactions are not helping. It has not yet come up with a strategy. Will the currency float or not? Will it continue liberalizing capital flows as initially intended, or will it reinstitute the old controls?
The most likely interpretation is that leadership is deeply worried and confused. Economic and financial liberalization nearly always result in turmoil. When stuck in the middle of the river, every time the question is whether to step back or to keep crossing. Turmoil is likely to last. But one thing is sure: the authorities will want to retain control and they can do it because they control nearly everything. Barring huge mistakes, always possible, China will not plunge in a crisis. Even if it only grows at 5%, or even 3%, this is still better than in the West. It is bad news for primary commodity exporters, and some of these countries may suffer deep shocks.
Meanwhile the capitalist countries are likely to continue recovering, slowly perhaps, unless new policy mistakes are done, for example in the Eurozone.