A bumpy road for China and the world!
Beijing’s Economic Inexperience Has Been Exposed
by Dr Paola Subacchi – 28 August 2015 – The past week of turmoil confirms what we already knew: China is a pivotal player in the global economy. Too bad they have no idea what they’re doing.
What better way for China to cement its role in the global economy than to be the trigger of a global financial crisis? It was the United States in 2008 and Europe in 2011 and 2012; now it is China that is sending shockwaves through financial markets. Just as Beijing insists, the global economy is now multipolar — no longer an American-dominated block with the dollar at its core. And like it or not, China has become one of these poles — perhaps before it was quite ready.
To appreciate how much the world and the role China plays within it have changed, think of various recent financial crises. In 1997, at the time of the Asian financial crisis that devastated a number of economies in the region, from Thailand to South Korea, China remained at the margins of the turmoil. Back then, despite its fast growing economy and strong exports, China was a financially isolated economy with an non-convertible currency and was still at the edge of the international trade system; at that time, the Chinese leadership was busy implementing the reforms necessary to join the World Trade Organization, which finally happened in 2001.
In 2008, when the collapse of Lehman Brothers almost brought to a halt the American banking and financial system — which had significant impact on the rest of the world — China, once again, was to a large degree financially isolated, with a non-convertible currency. Thus, like other developing countries, it managed to keep itself largely immune from the financial contagion, but it experienced second-round effects on the real economy — indeed, the crisis in the United States and then in Europe resulted in a drop in Chinese exports.
This time is different. China is no longer at the margins as in 1997, nor is it an innocent bystander as in 2008. It is at the core of the current episode of financial instability. With approximately a 16 per cent share of the world’s output, China is a key component of the global economy. And, with many advanced countries in the grips of the new normal of low growth and deflationary pressure, a slowdown in Chinese economic growth spells trouble throughout China’s global supply chain.
The demand for commodities by Chinese companies has dropped — imports of many industrial commodities are down for the first half of 2015, including a decline of 1 per cent for iron ore, and 11 per cent for copper. Recent figures on economic activity — including year-on-year declines of 0.1 per cent on value-added industrial production growth, 0.2 per cent in retail sales growth and 2.1 per cent in fixed asset investment growth — have also dented investors’ confidence, both in China and abroad. And finally, the deep drops in Chinese stock markets and the badly timed adjustment in the value of the renminbi — allegedly to make the Chinese currency’s value more market-based — have thrown global investors off the rails.
Not ready to play the game
It didn’t take a very big straw to break this camel’s back. Markets have been nervous about China for some time. After all, this is a country with murky governance and a level of indebtedness of more than 250 per cent of gross domestic product, unique among middle-income countries. Limited options for savers beyond poorly remunerated bank deposits have fed bubbles — such as in the real estate sector and, more recently, in the so-called ‘shadow banking’ sector, whereby savers are lured into high-risk wealth products by higher interest rates than those provided by bank deposits. In addition, the huge increase in the market value of Chinese companies between May 2013 and May 2015 — more than 150 per cent — appeared in suspiciously stark contrast to the smaller growth in many advanced economies. As valuations looked increasingly unsustainable, market participants were more and more sensitive to bad news that could trigger a significant adjustment.
Even the slowdown in the Chinese economy, which has been in the cards for some time as part of the plan to reform China’s model for growth, has become an area of concern. The idea is to shift the focus to domestic demand — as opposed to exports — and to promote a more productive and balanced use of resources, including financial capital. The reform of the banking and financial sector to build a market economy with ‘Chinese characteristics’ is part of this overall plan, and includes making both the interest rate and the exchange rate more market-oriented, instead of being determined by the authorities on the basis of their policy goals.
Implementing this plan is politically complex, and so far it has been messy, often with contradictory policy measures. For instance, the decision early this month to allow more flexibility in trading of the renminbi was so poorly timed that the People’s Bank of China had to intervene repeatedly to support the currency — exactly the opposite of the expected outcome. Possible explanations include a lack of experience in communicating with markets — the bank’s governor didn’t even show up for its press conference on the subject — a lack of credibility, or both. The reality is that China has become an integral part of global markets, but isn’t yet ready to play the market game. As its policymakers struggle to find their way, stock markets in the United States and Europe have felt the effects, and currencies in emerging markets economies — from Malaysia to Russia — have been abruptly punished by the renminbi’s depreciation.
Even more significantly, the pressure is now on the Federal Reserve to keep interest rates on hold until the Chinese authorities get the situation under control, or at least until markets believe that they have it under control.
Of course, China has some of the tools to clean up its own mess. With $3.69 trillion in foreign exchange reserves, down from a peak of $3.99 trillion in 2014, Beijing still has considerable scope for maneuvering — either by supporting the renminbi or by buying into securities markets. But this is exactly the problem. Market intervention feeds expectations for more market intervention, down into a self-fulfilling spiral that takes China further away from liquid capital and currency markets capable of solving some of their own problems. Not long ago, the discussion about China centered on its efforts to make the renminbi an international asset and a reserve currency. But how can it be, when the authorities are expected to and regularly intervene in the stock market and manage the exchange rate?
China has let the genie out of the bottle and does not know how to push it back in again. So should the authorities just let markets adjust? Such an adjustment might wipe out the savings of many households, as a large proportion of China’s stock market is in the hands of retail savers. Or should the authorities intervene and, for example, put limits on share sales? This would preserve financial stability and the nation’s wealth at the costs of international credibility.
There is no easy option. One thing, however, is for sure: China has grown into a key player in the global economy before completing the necessary rebalancing of its economy and financial reforms, and following this new road will be very bumpy for China and for the world. This Analysis republished by Yerelce with the courtesy of Chatham House. – To comment on this article, please contact Chatham House Feedback
A Balance-Sheet Approach to Fiscal Policy
by Kemal Derviş – AUG 18, 2015, WASHINGTON, DC – Everyone is talking about debt, citing huge nominal figures that strongly affect public-policy debates worldwide. But all debt is not created equal.
For starters, when it comes to public debt, there is a big difference between the gross and net figures. While Japan’s gross public debt, for example, is a massive 246% of GDP, the net figure, accounting for intra-government debts, is 127% of GDP.
Moreover, what should really matter about a country’s public-debt burden is the expected annual cost of servicing it. As Daniel Gros recently pointed out, debt that can be rolled over indefinitely at zero interest rates is no debt at all. This is an extreme example; but the closer a fixed interest rate gets to zero, and the longer the maturity becomes, the lower the burden of the stock of debt.
Although Greece’s public debt amounts to about 175% of GDP, low interest rates – which are fixed for a large proportion of it – and long maturities mean that it may be more manageable than it seems. Greece’s ratio of public-debt service to GDP is similar to that of Portugal, or even Italy. Indeed, that is why the latest deal with Greece, which entails even more bailout funds, could work, as long as the country is accorded the debt reprofiling that it needs to reverse the decline of its GDP, reduces its primary surpluses, and pursues balance-sheet-strengthening reforms.
Such considerations underscore why it is a mistake to focus only on annual budgets, without adequate regard for the long-term balance-sheet implications of how borrowed money is used. This narrow, short-term focus differs from the approach taken for publicly traded companies, for which the strength of the balance sheet and the economy’s potential are emphasized, alongside annual income statements.
Imagine, for example, that Germany borrows at a 1% fixed real interest rate with a ten-year maturity and invests the proceeds in repairing domestic transport infrastructure. These investments bring a modest real financial rate of return of 4% through fees, tolls, and, in the longer run, tax revenues (stemming from an increase in GDP). Such investments would directly strengthen Germany’s public-sector balance sheet. This does not even take into account social returns, accrued through reduced traffic congestion and cleaner air.
Beyond infrastructure, spending to improve education – specifically to ensure that the next generation receives the skills they need to contribute to the twenty-first-century economy – would also result in faster GDP growth. And it, too, would likely yield significant social returns.
For governments with access to today’s extremely low – and often negative – real interest rates, it may seem like a no-brainer to borrow and invest more in projects with long-term benefits. Doing so would strengthen their balance sheets, crowd in the private sector, and generate employment. But balance-sheet calculations are rarely at the center of political debate.
To be sure, some progress is being made toward bringing longer-term considerations into annual budget rules. Bodies like the European Commission increasingly distinguish between the structural and cyclical components of a budget deficit, and thus consider potential output, which increases with investment, in their calculations. But this is only a small step in the right direction.
For a long-term balance-sheet approach to gain traction, politicians will have to drop the ideological biases that are distorting fiscal policy. Proponents of austerity currently use nominal debt figures to scare voters, even in countries with record-low interest rates and large private-sector profits that are not being channeled toward investment. To counter their arguments, opinion-makers should emphasize the expected long-term returns on incremental public investment, not with ideological arguments, but with concrete examples from various sectors in the recent past that have had reasonably good rate of returns.
Of course, as the economist Charles Wyplosz has explained, debt sustainability analysis is inherently uncertain. But some needs can reasonably be anticipated. Amid massive unmet demand for new climate-compatible infrastructure and for workers with modern skillsets, any semi-competent government should be able to demonstrate the likelihood of significant real returns on incremental investment.
In many countries, one could realistically expect a 4% average return on at least one percentage point of GDP worth of incremental investment. If the marginal real interest rate is 1%, an increase in public investment would actually reduce future indebtedness. Of course, it is possible for too large of an increase to put pressure on real interest rates, thereby crowding out potential private investment. If there is significant exchange-rate risk, such as in non-reserve currency countries, that, too, should be taken into account.
Current fiscal-policy debates should not focus on simplistic headline numbers. To strengthen public accounts, both conservatives and progressives should start promoting a long-term balance-sheet-oriented approach to policymaking, ensuring that the debates are based on relevant data. Otherwise, the wrong policies – and, with them, anemic GDP growth and sluggish job creation – will continue to prevail. [ l’Institut du Bosphore,]