We’ve entered a new phase in the debate about China’s economy.
Now, instead of talking about whether or not the country is going to have a hard landing, we’re going to talk about whether or not the government is doing what it needs to do to stop the bleeding.
And we’re not just talking about short term problems here. We’re talking about the hard stuff — restructuring massive, indebted state owned enterprises (SOEs) and getting rid of excess supply in floundering industries like property and manufacturing.
For a long time, the consensus in the world of economics and finance has been that the Chinese government is competent enough to handle moving its economy from one based on investment to one based on domestic consumption and all of the challenges that come with it.
But now it’s looking like its going to be a more gargantuan feat than anyone had imagined, and that’s what has people wondering if the government is going to be able to pull it off.
Moody’s is not impressed
We got a sense of how this new phase will impact the country when Moody’s recently changed its outlook for China’s government bonds from stable to negative.
It’s this part of Moodys’ outlook decision, that tells you what’s coming in the next phase of the China debate [emphasis ours]:
…China’s institutions are being tested by the challenges stemming from the multiple policy objectives of maintaining economic growth, implementing reform, and mitigating market volatility. Fiscal and monetary policy support to achieve the government’s economic growth target of 6.5% may slow planned reforms, including those related to SOEs.
Incomplete implementation or partial reversals of some reforms risk undermining the credibility of policymakers. Interventions in the equity and foreign exchange markets over the past year suggest that ensuring financial and economic stability is also an objective, but there is considerably uncertainty about policy priorities.
Without credible and efficient reforms, China’s GDP growth would slow more markedly as a high debt burden dampens business investment and demographics turn increasingly unfavorable. Government debt would increase more sharply than we currently expect. These developments would likely fuel further capital outflows.
In other words, China has to act now. In fact, it should have acted yesterday. The problem is that it’s busy putting out fires. Even people who think the government can handle this, are worried that it’s too busy handling short term problems.
Ray Dalio is a perfect example of this.
In an interview with Bloomberg TV on Thursday, Dalio said that he had faith in the competence of the Chinese government. There’s just one problem — capital flight and dwindling foreign exchange reserves.
“While there’s a balance-of-payments challenge … [China’s] tools … and capabilities to manage it are equal to the best that exist in the world,” Dalio said.
That may be true, but we haven’t seen much in the way of planning yet. We have seen some damage control like the decision to set aside $15 billion to take care of the 1.8 million workers who will be fired from the steel and coal industry.
China instead has also been doing everything it can to keep money flowing through the economy. It has made it easier for people to buy cars, and it has cut interest rates. It is making money easy, and the same debt-laden corporations that China is trying to delever are just raising more debt in the country’s booming corporate bond market.
But in terms of long term reform, little has materialised and people are getting anxious. In the coming weeks we should know more. The Chinese government will meet and discuss some of the reform plans, but they have been talking about a lot of this stuff since last fall, and nothing has really gotten going yet.
In the meantime, economist Michael Pettis pretty much nailed the moment when we can say the worst is over in a recent blog post:
It is only when credit growth begins to decelerate much more rapidly than nominal GDP growth that we can begin to talk hopefully about China’s moving in the right direction, and it is only when credit growth falls permanently below the growth rate of the economy’s debt-servicing capacity that China will have adjusted.
Until then, hold fast.