Viktor Shvets is Macquarie’s head of global equity strategy and Asia-Pacific equity strategy.
We recently spoke with him about the biggest problem facing the Chinese economy.
This is part two of a series. Part one was a discussion on the populism that’s sweeping the globe and the role technology has played.
This interview was lightly edited for clarity.
Jonathan Garber: China’s FX reserves have been falling for almost three years now. Is that China’s biggest problem, or is it something else?
Viktor Shvets: The essence of China’s problem is not reserves but the fact that their saving rates are too high (45%+ of GDP). When you’re saving so much money, you either have to invest it or you have to export it to other countries. China has been doing both. So the problem China has is that as it continues to invest within the country itself, gradually return on investment and viability of those investments keeps declining. They’re running now into constraints on how much they can invest within China, and on the other hand, the global economy increasingly can no longer absorb China’s surpluses, because global trade is not growing and all other countries (including the US) are trying to de-globalize. Global trade is only growing zero to 2%. It’s not growing 6% anymore the way it did over the previous 25 to 30 years.
Every country is trying to export their domestic problems and adjustments to other countries. That’s why Germany is running 8%, 10% current account surpluses and why the US doesn’t want to run the same current account deficit the way they used to in the past. That’s the problem. China is a little bit like a squirrel in a wheel, they have to continue running faster and faster in order to stand still.
The problem is, as returns on investment continue to go down you need to keep on borrowing, and so debt levels escalate. This is pretty much what happened in Japan in the 1970s and 1980s. That’s what happened in the US in the second half of the 19th century when you had booms and busts on railways and canals. That’s what happened to Brazil in the 1960s, 70s, leading into the early 1980s. That’s what happened to Thailand and Malaysia in the 1980s and 1990s leading to the Asia-Pacific crisis. China is on exactly the same trajectory: a high level of investment, high level of debt, and declining return on investment.
Eventually, those sorts of processes blow up, but there is a difference between running an externally or an internally based economy. What I mean by that, if you think of Brazil in the 60s, 70s, early 80s, they were the miracle child prior to China. But as Brazil ran out of savings, it started to depend more and more on foreign capital flow. Brazil was sustaining rising current account deficits. In other words, they had a high level of external vulnerability. When you’re externally based and your leverage reaches a certain level, you just collapse, because the foreigners decide, “OK, enough is enough.” That’s what also happened to Malaysia and Thailand leading to 1997, 98.
On the other hand, if you have an internalized model, whereby most of the things are done internally with very limited external vulnerability — an example of that was Japan through the 1970s and 1980s — then externally nobody can push you around. These countries tend to have very high saving rates and run current account surpluses, and so what happens is that those sorts of countries tend to collapse much more slowly. These countries tend to look very strong until suddenly they do not. Younger people tend to forget how strong Japan looked in the 1980s and the then prevailing view that Japan would take over the world.
That’s what China’s going through. ROEs are declining, return on invested capital is declining, overinvestment is growing, total factor productivity, we talked about the US being almost at zero, in China it is negative. Leverage levels are now higher than they are in the US if you include the financial sector. All the signs are there, but at this stage, it’s still sustainable.
The reason it’s sustainable is that unlike the US, or unlike Brazil back in the 60s and 80s, in China there are no significant differences between fiscal and monetary policies. There are no differences between monetary policies and banking policies. Although, notionally, the private sector is more than half of China’s corporates, the reality is quite different. In most cases, there has never been a proper delineation of asset claims between the public and private sectors. If you happen to be a property developing company, you’re still basically piggybacking on what the government wants to do and how the government and local administrators want to allocate the land. If you are a coal mining company, you’re still in the same position. If you’re a cement company, you’re still in the same position. There are certain areas of the Chinese economy where the state never had claims in the first place. In those areas, there are real private sector companies. They tend to be mostly in IT and technology areas, but in most of China, there is really very little difference in my view between the public and private sectors.
If you’re in a position that you don’t have a difference between fiscal and monetary policies and you don’t have a difference between monetary policies and banking policies and there is no difference between the public and private sector, then effectively you just keep pumping liquidity with limited consequences, because you are not really facing currency and bond market constraints. That’s part of the reason why China has been recently negating some of the capital deregulatory moves that they have done over the previous two years.
To put it another way, how can Donald Trump make fiscal policy proactive to a stage that it actually makes a difference? Fiscal policy can make a difference if it’s large, quick, and it’s funded by brand new money. If it’s small, slow, and you borrow to fund it, it makes little difference. Hence, China can have a significant short-term impact, but most developed countries cannot because they tend to have a separation between fiscal and monetary policies as well as between monetary and banking policies. However, there are no free lunches, and China’s high degree of policy flexibility creates significant domestic dislocations.
Garber: What’s large for China? What size is needed?
Shvets: For example, global reflation in 2016, it’s all due to China pretty much. China delivered for everyone improvements in leading indicators and manufacturing output. Why can China do that and the US cannot? The reason is, go back to my original point.
In China, there is no difference between fiscal and monetary policy. There is no independence of the central bank. There is no difference between monetary policy and banking policy. In China, the People’s Bank of China just injects liquidity and directs the banks where that liquidity should go. As we discussed a second ago, in most instances there is no difference between the public and private sector, so basically corporates do in many ways what they’re supposed to do. The transmission mechanism is there, and every time China invests, effectively it’s brand new money coming into the system.
In the US, we can debate how much the Federal Reserve has been politicized or not politicized, but there’s no question the Federal Reserve enjoys much greater independence. Fiscal and monetary policy are only loosely coordinated. In fact, sometimes they actually act in opposite directions. In the US, there is a real private sector that, as I said, it will bend towards the public sector and politics but it doesn’t break. The private sector does not necessarily do what they’re supposed to do, and they don’t necessarily push the money the way they’re supposed to into the real economy. That’s part of the reason why QE ended up just being trapped in the financial sector and not really going down to the ground at all.
The incoming administration suggested that it wants to invest $1 trillion over 10 years (remember China does $1 trillion every seven, eight months). My principle is that to make a meaningful difference it has to be large, quick and funded through new money. If you spread it over time whilst trying to fund it through off-balance sheet vehicles which by definition makes it much smaller in size and if you can’t push it through Congress, or if you do push it through Congress but it ends up making small projects here and there to satisfy the local requirements of their districts, and in order to fund it, if you borrow the money, then you’re crowding out other investments and you actually are not going to achieve much at all.
On the other hand, the way China does it is that it is large and they inject fresh money quickly. They determine how much provisioning banking sector will do, how much of the loans they will evergreen. They direct the banks to increase or decrease lending, which the banks generally do, and then on the other side of the coin, you actually have industries that in many ways will do exactly as intended. As I said, there is a real private sector in China, but it’s much much smaller than what people think it is. It’s certainly not over 50%, which is what statistics indicate. In China, therefore, you have a control and command system. That works.
Ultimately, that control and command system creates domestic anomalies. That’s why there are property bubbles and wealth management bubbles. That system can only work within protected barriers. In other words, you have to have capital controls in place so that you’re actually trapping that liquidity exactly where you want it to be. China would argue that even they cannot really determine the outcomes, and that’s true. But they have a much higher degree of control, and that’s why China can stimulate, and why it can have a dramatic impact on the global economy.