Guest post: Peter Doyle on China

By Peter Doyle, former IMF official and economist.

The line of China Bulls is that “things really aren’t that bad or surprising, and there’s considerable willpower and ammunition left in Beijing should it be necessary”.

Thus:

• growth slow-downs are typical of countries in Chinas GDP/capita range;
• the shift from exports to consumption-led growth is bumpy but inevitable;
• likewise, the shift from industry to services is largely done, but still bumpy;
• plenty room for stimulus: public debt is low, policy rates far above lower bounds;
• ready resort to controls if necessary, on forex, on SOEs, on financial markets;
• stocks are small in household portfolios, so stock market drama doesn’t matter;
• the Yuan appreciated a lot in real terms since 2006, so recent falls are no big deal;
• the authorities may be bungling somewhat, but they’ll do it “China-style”;
• slower growth (from a higher base) generates the same global impulse; and any contraction may hit commodity exporters, but that helps the global core, net plus.

So, bulls say of China-cum-global bears, “get serious”.

This makes good copy, but is not persuasive.

Certainly, as Barry Eichengreen shows, growth slow-downs are typical in middleincome. But the idea that China services, which are already a large share of output, can and will just take up the slack as industry shrinks overlooks that most services are directly tied to the weakening sectors of property and industry. As George Magnus notes, the tertiary sector is concentrated in finance, property, and wholesale and transport distribution, not in business, IT, professional, health and education services. Despite its large services sector, China is much less diversified than the bull-narrative suggests.

A similar analytical error was made in 2008-09 when some argued that Eastern Europe would be fine in the global crisis because though exports would fall, demand had been led by consumption and investment, not exports. This was arithmetically true, but economically false.

The “Bull narrative” also overlooks the credit boom post-2009. Whereas Advanced Country central banks attempted to stimulate credit via interest rate cuts and QE, the PBOC actually succeeded. Numbers vary depending on definitions (and treatment of Chinese shadow finance) but by any measure, the credit boom has been colossal. (See various IMF China Article IV staff reports). And following the boom, bust.

That substantively explains the post-2009 Chinese stock and property gyrations. So though stocks are small in household portfolios, stock market drama matters to real economy wobbles because they share a common source; credit. Stocks are the canary in the coal mine: though its just a canary that ails, watch out.

Moreover, the Bull-assertion that there are large Chinese buffers for policy support against downturn needs to be heavily qualified.

Granted, headline public debt ratios are low(ish), even when extended beyond central government and to SOEs, and reasonable estimates (such as from Oxford Economics) of their surge, should stimulus be needed, do not take them into internationally (post-Lehmans) alarming territory.

But what is missing from this Bull-fiscal-comfort-blanket story are the unfunded pension liabilities implied by China’s post 1970s one-child policy. The consequent structural demographic distortion has been (largely) responsible for the extravagant personal savings rates (and Ben Bernanke’s “savings glut”). While it may consequently be tempting to assert that these pension obligations will remain Chinastyle “within the family”, the lesson from elsewhere is that such things do until something happens and then they don’t. The parallel may be found in Spain or the UK where unsustainable credit liabilities from the pre-2008 property booms migrated in very short order onto their public sectors, where they remain to this day.

This contingent liability implies that the room for maneuver in the fiscal stance now may be considerably less than the headline debt ratios and the Bulls imply. And the opacity of the one-child contingent constraint on the Chinese fiscal could significantly compromise the multiplier effects any fiscal stimulus may have, even leaving aside any supply-side constraints on China’s response to stimulus.

Likewise, on the monetary side, if rates are cut to stem a downturn, the stress on the Yuan worsens. And however that is handled (via intervention, capital controls, band widening, or/and devaluation), it aggravates the US which is in the midst of a poisoned election campaign in which anti-China retaliation already features prominently. The leading Republican contender proposes a 45 percent tariff on all imports from China, before any of this Bull-comforting-China-monetary-stimulus has even begun. And the other Republicans and the leading Democrat have been silent on the subject.

Furthermore, absent new forex controls, if the PBOC broadly holds the band and runs down reserves without sterilizing, any PBOC interest rate cuts would be China-demand-contractionary. So alongside interest rate cuts, the PBOC would have to fully sterilize just to maintain the demand status quo, let alone to stimulate. Alternatively, if it lets the Yuan really float (down), it will be disorderly for lack of a policy framework to back a float, and it will set off major global currency shocks.

But most fundamentally, the Chinese authorities cannot reconcile the lessons they learned from Gorbachev (that Perestroika plus Glasnost equals collapse) with need for reform. It is this, rather than entrenched corruption, which stands in the way.

Lessons from 1970-80s Hungary reinforces their skepticism. Market(ish)- mechanisms, open trade, and soft budget constraints can yield middle-income growth under communist rule. But it is badly imbalanced, runs out of steam, and when the reckoning comes, such “reformed” economies get hit just as hard as the “purist-communist” unreformed.

The China-cum-global-Bull-narrative misses all of this.

The Chinese credit boom is already over. That is already reflected in empty new cities, contracting Chinese imports of commodities, hence (largely) their 2014-15 price slump, and weak overall Chinese imports (hence the stagnation in global trade volumes since mid-2014).

If the credit-cum-property-cum stock bust continues, there are significant constraints on the macro policy levers to check it with. Instead, policy response will have to focus on retreat from market mechanisms; direct controls. This option will likely avert catalytic catastrophic events (bank runs Lehman’s style, or sovereign debt sudden stops Euro-style) to the apparent comfort of the Bulls. But this option cannot stop sclerotic seizure and, indeed, it aggravates that problem.

Ignoring these constraints, international commentary has tended to sneer at the “hash” that Chinese policymakers are making with exchange rate policy and circuitbreakers and the like in the meantime. But the authorities don’t have, from their viewpoint, good alternative macro options.

The true global impact of the post Lehmans and Euro Crises on the world has been masked by the Chinese credit boom post 2009. Though China may intone that in various spheres (environment, financial, etc), its not ready for full global leadership, just imagine what the post Lehmans world and the Euro Crisis would have looked like to date, absent the Chinese credit boom. China’s role has been pivotal.

But the chickens (or should that be canaries?) are now coming home to roost.

In sum, the “China Bull” case is not that we should all just “get serious”; it is that the worst of the China credit bust is already over and so doesn’t need major policy intervention from this point on.

The problem with that assertion is twofold: that the Bulls, like the Chinese authorities themselves, have no idea if its true; and if its false, then the global economy core, with elevated debt levels, policy interest rates still near floor-bound, and the Euro still half-baked, has few policy levers with which to respond.

If you think we’ve already seen the worst of global secular stagnation since 2009, I’d say be prepared for worse.