As the West contemplates a new phase in the global financial crisis, China — the second biggest economy on Earth — appears to some executive decision makers to be well placed to sail through the doldrums of the global financial markets or even use her wealth to come to the rescue of the rich world.
Is this wishful thinking or is it grounded in facts? Despite its rising pre-eminence on the world stage, China is unlikely to save the world if the West slides back into recession. Why?
1. China sits on a $3 trillion mountain of foreign exchange reserves
Local Government Finances and Property Bubble
The World Bank has warned that China’s “strained local government finances” are a big risk to its growth and stability. Granted that China holds the world’s largest foreign exchange reserves, but the figure of $3 trillion does not seem large when compared to China’s local government debt. In 2009, while the world slowly recovered from the recession, the Chinese economy grew the fastest at 8.7 per cent. The growth was pushed through via a record 4 trillion yuan stimulus of which the central budget financed a big tranche. Since late 2008, local governments went on a project-planning spree. Those governments set up 8,000 local investment companies and provided land as collateral to borrow loans amounting to 11.4 trillion yuan or 1.7 trillion dollars by 2009. In 2009, Chinese banks lent a record 9.5 trillion yuan, sparking concerns of a massive property bubble. It is estimated that more than a quarter of the loans are already bad debt and the proportion of bad loans is steadily rising. The Chinese banking system will have to bear the brunt of this toxic fallout as the economy slows in tandem with the global economy, necessitating a massive bailout from China’s national budget and foreign exchange reserves.
In the last decade, China’s gaping trade surpluses and her uninterrupted buying of dollars to suppress the yuan’s value have led the reserves to balloon 17-fold! The stockpile has grown so big because China refuses to let the yuan rise faster for fear of hurting her exports, much to the frustration of her trading partners. China’s $3 trillion reserves are now nearly triple Japan’s holdings, the world’s second-biggest official currency reserves. At first glance, the colossal stockpile appears to be a symbol of China’s fast-growing wealth. But on deeper inspection, the vast cash holdings are an unflattering testimony to much that is wrong with the world’s second-largest economy. Why? They reveal:
i. How undervalued the yuan is;
ii. Why it is so difficult to control inflation in China; and
iii. How much more their government could be investing domestically to engender sustainable growth.
Too much of a good thing can be bad?
China’s reserves are clearly too much, excessive to her needs, and more importantly, extremely damaging to her economy. For every dollar that goes into her reserves, China prints about 6.5 yuan, adding even more cash to her economy. This is worrying since China is already at pains to drain excess money, with inflation running near its fastest in three years. This is knocking the national economy out-of-balance and leaving the country’s money managers with a near impossible assignment.
Bank Reserve Ratios
To neutralise all the money that has been created, China has conducted what are known as “sterilisation operations.” Her primary tool has been to increase banks’ reserve requirements, forcing them to lock up cash that they would otherwise lend. Required reserves are already at a record 20 per cent of deposits for China’s biggest banks, denting their profitability. The room for further increases is now extremely limited.
2. China registered growth of 9.5 per cent in the first half of this year
In an interconnected global economy, decoupling is a beguiling myth! As fears mount that the developed world is shifting from slow growth to no growth, emerging markets seem to many executive decision makers better placed to weather the storm than they were able to during the great financial crisis of 2008-09. While the economic fundamentals look better in many emerging economies than they did in 2008, policy makers generally have much less leeway. China is an overbuilt and overinvested economy. Tourists to China gaze at the towering skylines and massive bridges, highways and airports from the boomtowns to neat new cities. China has been building and borrowing in excess. Several of those skyscrapers and industrial zones remain partially empty.
3. China exported 24 per cent more than in the same period of 2010
China relies too much on exports to the Western world. As a result, it would not be left unscathed if the rich world fell into recession, and reduced demand for her exports would have a knock-on effect on commodity prices and producers. For example, if either the European or US consumption were to shrink just 10%, the decline would rival what an entire nation of Chinese consumers might spend in a year. At present, China cannot generate nearly enough demand internally to keep her own people employed at existing levels, should most major nations slow their consumption by just 10%. How many Europeans or Americans have cut back their spending by 10% in the last three months or will do so in the coming three months? Ergo, China cannot generate additional demand in a short space of time to replace a decline in Western demand in the US alone. Counting on China to jump-start the global economy is wishful thinking, unless its massive population magically metamorphoses into a nation of spenders as opposed to savers. China’s consumption levels remain too small relative to those of the US, Europe, and to a lesser extent Japan. China is still in need of steering its economy from capital spending towards private consumption.
4. China has become the lender of last resort to the US Government
There is the perennial problem of finding a safe place to invest $3 trillion. Any chief investment officer in the world would find it difficult to look after such a huge pile of cash. Its monstrous size precludes China from most markets except US Treasuries, leaving Beijing vulnerable to the dollar’s fortunes. As the US treasuries rise in value, the point is not how successful the Chinese have been in their investments. The real failure is the lack of an exchange rate regime that is fully dictated by market forces. To let the yuan float would help control inflation but the reason why the Chinese are loathe to do that is because this would further depress their exports to Europe and the US, those being their first and second largest export markets.
If China is supposed to help the world by buying up assets in trouble spots in Europe and elsewhere, how can she do that without selling her US treasuries? If the American debt is sold by the Chinese, who is there to buy that debt? Further, what will happen to the price of US debt as large volumes of that debt are brought to the market for selling by the Chinese? Selling US Treasuries to fund internal projects in China would raise interest rates further for the US, slowing US consumption and driving down the value of the US dollar further, exacerbating China’s three intertwined challenges:
i. Rampant inflation with attendant social chaos;
ii. Over-reliance on exports; and
iii. Peg to the US dollar.
China’s accumulation of foreign exchange reserves also represents an opportunity cost. Given China’s high savings rate over the past decade, it was bound to have a high rate of investment. Had China let its currency rise, that investment could have taken place at home with the creation and building of much needed extra social services such as new schools and hospitals. Instead, much of that investment ended up being parked in assets like US Treasuries. China is the biggest foreign holder of US Treasuries, with $1.15 trillion at the start of 2011.
How can China help the West?
For rapid growth in emerging markets to help the developed world, imports from China and oil-producing countries would have to rise sharply, reducing their external surpluses. But in fact, the emerging world’s current account surplus is likely to increase in 2011 and remain high. In other words, far from helping the developed world out of its rut, emerging economies are becoming an increasing drag on demand in the rest of the world!
What is a balanced level of reserves?
By most estimates, China only needs about $780 billion of reserves or about a quarter of its present $3 trillion cash pile. That would be sufficient to pay for three months of imports and to cover all of China’s short-term foreign debt. This is based on the standard metrics of how much most countries ought to hold in reserves as a form of insurance in case of a financial crisis.
1. While the world’s executive decision makers eye the $3 trillion cash mountain of China as a silver bullet solution, the truth is that global economic challenges and massive debt levels are on an entirely different scale, if not at least an order of magnitude greater. What China possesses is truly dwarfed by the global debt and deleveraging task ahead. In summary, the cash reserve is:
a. Not enough to save the world;
b. Partially already spoken for to shore up local finances and black holes; and
c. In question going forwards, because of the steadily rising value of the Chinese yuan and falling exports as major Western nations’ growth slows.
2. China is experiencing a transition from an economy that depends too much on exports and on investment in infrastructure and property to one where consumers play a much greater role. That is a structural change and it is a decades long process. China is unlikely to deliver results on this side of Christmas to save the West from a financial meltdown or great recession in 2011-12. China is neither Santa Claus and nor the tooth fairy!
3. A nation that maintains such a massive trade surplus cannot be the engine that drives global recovery, otherwise all the nations of the world would simply export themselves out of trouble. Put simply, the Chinese are not the horse, they are a buggy-of-supply and they go wherever the horse-of-demand may take them.
4. China’s forceful rhetoric about how the yuan is not undervalued and how it needs to rise slowly belies a growing belief at home that the currency is simply not strong enough. Increasingly, the Chinese realise that a stronger yuan can help them fight imported inflation and give them more bang for their buck when they invest abroad. If the appreciation of the yuan continues to take place to reflect reality, the massive cash reserve of China will look like an historical anomaly.
5. Neither record fiscal nor monetary stimulus created sustainable accelerating growth in the US or China, why should anyone think that doing more of the same would work this time? The real question that the West needs to ask itself is how and why does it expect China to save the world? Why should they put their own future at risk to do so when history has shown that major nations of the world will not take the necessary steps to deal with their own massive demographic and social spending challenges?
Fundamental Question: Can China save herself if the US and European economies continue to stall or sink?
A Transformed China in Future Decades
China has shown remarkable pragmatism in the exploration of alternatives between socialist central planning and decentralized capitalism. That pragmatism may result in a different model of economic growth in future decades that would enable China to play a larger, more constructive role in helping to stabilise the inevitable swings in global economic activity.
After it had become clear that the impulse of the Cultural Revolution was not delivering benefits of growth to the entire population, Deng Xiaoping, chairman Mao’s successor was claimed to have said, “I don’t care what colour the cat is as long as it catches mice!” What he meant was the objective of his administration was to provide the optimum outcomes for Chinese people, and open market capitalism seemed to him to be the best way of moving forwards. Having so decided, he worked with a number of macro-economists to ensure the economy of China moved to a totally different model than that outlined by chairman Mao during the Cultural Revolution.
ATCA 5000 understands from some of its distinguished members in Beijing, that the highest levels of the Chinese administration now believe that economically, environmentally and socially the current model of growth and success, measured purely in terms of GDP, is totally unsustainable. They are investigating what alternative well-being based economic models might look like. So, over time, China could provide a new model for global sustainability. In other words, it is now being recognised in China that Deng’s open market capitalist cat is now getting old and does not see so well, and its sense of smell is not so good, and it is not so effective in catching mice any more. The Chinese administration is now looking for a new cat, or trying to create a new one!
Given the old model, it is recognised inside China that its economy is not currently in a position to save the world from a global financial meltdown. On the other hand, some Chinese officials see this moment in history as an opportunity to shift the system pragmatically, as China has proven it can do in the past. A new, more sustainable model may be generated that can better serve China as well as the rest of the world going forwards! In this regard, some distinguished members of the ATCA 5000 wonder whether history will judge that it was not Chinese policy makers that were in a philosophical straight-jacket in the early 21st Century, but rather the Western economic policy makers, who were trying valiantly to preserve what worked in the past but may not have been entirely appropriate for the future?