Guest Post: China's Difficult Choice
Submitted by Zarathustra of Also Sprach Analyst,
Over the weekend, we pointed out that the old mechanism for the People’s Bank of China to expand its balance sheet and create base money has been broken by new funds flow pattern, and it will sooner or later require some sort of large scale asset purchases programme a.k.a. quantitative easing to offset the impact of the broken mechanism (after other tools such as cutting RRR reach their limits). However, we also mentioned that as the private sector is currently quite overstretched and will start the deleveraging process (if they have not already started), and that would render traditional monetary tools useless, and quantitative easing ineffective. And that would necessitate deficit spending at both local and central government levels.
Quite a number of commentators (particularly those within China) believe that there is no money for the government to spend to offset the current slowdown. Many points to some statistics showing that local governments obviously do not have enough tax revenue to support any large-scale investment projects (as we have mentioned some of the figures here), not to mention that many local governments have also become quite overstretched after the massive credit expansion post-financial crisis.
These are not inaccurate, yet we believe that the idea that the Chinese government can actually run out of money is not correct. The idea that a country can possibly run out of the money which they print is absurd. This applies to countries like the United States, but not for countries like Greece, which has surrendered their ability to create money to the European Central Bank. We think the same should hold for China just as well. With the Chinese banking system dominated by state-owned banks, and with the most powerful tool to control credit growth being state-directed bank lending, there should not be any actual funding constraints for stimulus programme in the forms of investments into infrastructure and productive capacity. The only way that China can really run out of money is when the government decides that “enough is enough” and imposes spending constraints deliberately.
Even so, the choice between stimulating the Chinese economy aggressively or not is not a straight forward one. We have noted for quite a long time that the massive stimulus after the 2008 financial crisis has been widely regarded as a big mistake by commentators and economists within China, and we believe that some inside the government’s decision making body share that view. This has very likely contributed to the delay of (much anticipated) stimulus, and the stimulus (if any) will not be as massive as the previous one. Some economists and commentators within China also believe structural reform should be the top priority. After all, the economy urgently needs rebalancing, and more investments into overcapacity will only delay the process of rebalancing. On top of that, some also believe that the involvement of the state should be minimised, thus government deficit spending will not be at odd with such an idea. The biggest critics of China’s economic policies for the past few years are anyone from the West, but many economists and commentators within China.
If we have read the social mood correctly that China might be more pro-austerity than pro-Keynesian, and if policymakers indeed share that view, then the consequence in the near term could be rather grim. The delay in stimulus as well as the small size of it so far has already done damage, if you like. The economy is already on course to hard landing. Companies are now in trouble as sales fall, inventory increases, profit squeezed, credit standard becomes higher, leverage becomes too high, mutual guarantee scheme blows up, etc. Some who have invested/speculated heavily in real estate will probably in trouble. The whole scenario is consistent with debt deflation. Private sector is too highly leveraged, and those with assets will be forced to dump them to repay debt, while other individuals and companies go bankrupt or something. If there is zero government intervention and minimal central bank monetary easing, this will continue and get worse.
There is another choice, of course. Given a stimulus which is large enough (let say RMB4 trillion to be spent every year, to exaggerate things a bit), the government can create GDP simply by spending money into investments in infrastructure and productive capacity. The private sector might be deleveraging and destroying jobs, but government spending could offset that as long as it is large enough, and asset prices would probably fall in an orderly way.
The longer term consequences will be different of course.
If austerity is the choice, it will be very painful in the short-term. We will not be talking about a sub-7% or so GDP growth. In fact, we might be looking at a downright economic contraction. Longer term, however, after unprofitable businesses are closed and investments into new excess capacity are stopped, those who survive might have a chance to see their returns on investment enhance over the medium term. And although consumption will be hard hit in the short-run, with investments grind to a halt, the economy will probably rebalance rather quickly regardless. The economy will no longer be growing at 7-8% after the recovery, but that is hardly an important consideration. The short-term outlook will become almost apocalyptic, yet without doubt, there will come a life-time opportunity to invest.
In the “economy on steroid” option, the economy can keep growing at whatever rate the government sees appropriate. The government can invest in ever more infrastructures and productive capacity despite already absurdly low capacity utilisation. While private sector shrinks, the state-owned sector increases to pick up to slack. Meanwhile, PBOC can perform quantitative easing to ease liquidity. For the sake of maintaining jobs, state-owned companies can be instructed to maintain production even though it will not make any profit. The long term consequence is that growth will slow down, yet you are not going to see any dramatic contraction of economic output or massive deflation. However, economic growth cannot be possibly maintained if government withdraws its support one day. In other words, the economy will need permanent government support, and the support required will probably be growing as government stimulus (we suspect) will decrease in effectiveness.
These two extreme scenarios are, of course, exaggerated and imaginative on purpose to illustrate the two ends of the spectrum, namely, “do nothing policy” and “whatever it takes policy”. The actual scenario to be played out will most likely be something in between, although our current judgment is that the choices being made leans towards do nothing. As a result, the economy will continue to perform disappointingly, particularly for those who have been hoping for massive stimulus. Of course, our judgment may change should the government become much more proactive.
There is one final thing that we must make clear: advising the government what to do is the last thing we are interested in. Although we occasionally have views on what the “right” thing should be, we are not making any judgment on which policy choice will be the “right” one. We really do not care. As someone interested in investing in China, the only thing we really care is the likely policy path, the consequence of that, and how we might position ourselves to take advantage of the economic consequence.
Other than that, we leave the discussions of “what China should be doing” for the wonks. We couldn’t care less.
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