Did China Just Blink?

Is China’s currency devaluation a sign of desperation?  Is a hard landing now unavoidable?

 

Everyone knew China’s double-digit growth rate couldn’t last forever. Optimists were hoping for a “soft landing” as the economy adjusted from the early years of hyper growth. Now debt levels are through the roof. Four interest rate cuts and two reserve requirement cuts in 8 months have had no demonstrable effect. The stock market boomed, then busted, and is now, despite massive government intervention, teetering on the brink of a complete collapse. Exports have gone from weak to weaker and the overall economy seems to be going from slow to slower. Given the above, as China devalues its currency, it is perhaps reasonable to wonder if this is the final act of a desperate government. Is China convinced that only the most draconian of measures can stave off a dramatic economic reversal? If so, what does that mean for China’s economy and the world?

 

China has experienced tremendous growth

Gradual liberalization and foreign investment have been the keys

Any discussion of China’s economy ought to start with the tremendous growth that has occurred since liberalization began in 1980 and the fact that China’s economy has outperformed virtually every other low income country in the world. China’s tremendous growth is due to its gradual transition to a market economy and it success in attracting foreign investment.

 

China prospered in the 2000’s, but important reforms were delayed

After the Global Financial Crisis, a new model was needed

Through the 2000’s, when money was cheap and the global economy was booming, China, like the rest of the world, took a “let the good times roll” approach. Exports exploded via a unique arrangement under which China would sell to the rest of the world, the rest of the world would pay China (mostly in US dollars), and China would lend that money back to world so the world could buy more stuff from China. It worked until the global economy (and China’s main customers) imploded under a mountain of debt. After the Global Financial Crisis of 2008-09 it was obvious China needed a new path to growth that didn’t involve lending capital and selling goods to highly indebted, slow growth economies. China needed a “soft landing” from the heady and unsustainable growth of the past and it wasn’t too difficult to imagine a path to such a transition. In the short term, in order to mitigate the impact of the financial crisis, China would use government stimulus (i.e., inject credit debt into the economy). Then China would continue down the path of gradual economic liberalization which would support continued growth. It was a reasonable, workable approach. Only it never happened.

 

China started “stimulating” and never stopped

Debt levels have risen to a very unhealthy level while reform has been slow and limited

China opened the “stimulus/debt” spigot and never closed it. The debt to GDP ratio exploded from roughly 120% in 2010 to an estimated 280% currently, which is dangerously close to crisis levels. Relative to economic liberalization, China made some impressive moves relative to certain aspects of its financial system, mostly the currency, which it began to internationalize, and interest rates, which are becoming more market-oriented. But beyond that, China’s liberalization efforts have been fairly tepid. Most importantly, reforms to local government finances and the financial connection between state-owned banks and state-owned companies have not been made which has allowed those two financial channels to continue to plow money into unproductive investments, thereby exacerbating China’s debt problem.  

 

2015 was supposed to be year of adjustment. It hasn’t been.

China has yet to seriously attempt to control debt creation in the economy

Still, all hope is not lost. China simply needs to curtail the growth in debt, adjust to slower but still decent growth, and then continue the liberalization that will lead the way to further prosperity. As 2015 started, all the rhetoric coming from the government indicated that this would be the path China would follow. Again, it hasn’t happened. China has pursued policies—interest rate and reserve requirement cuts, among others—meant to create more debt, which in fact has happened. The stock market boom, which was fueled by a 5-fold increase in margin that resulted from a policy change, seems like an unnecessary and careless distraction, not at all helpful as relates to the addressing the economies main challenges. From a rhetorical point of view, the catch phrase from the government seems to have changed from adjusting to a “new normal” to “stabilizing the economy,” which sounds a lot like “keep the debt flowing if that’s what it takes to keep people employed.”

 

Currency devaluation could be another step in the wrong direction

China still doesn’t seem to be focused on the looming debt problem

Most recently we have the currency devaluation, which as an isolated event isn’t terribly significant but as the possible first step in a new policy direction could be extremely significant. If China specifically pursues a policy of currency depreciation, choosing export stimulus over debt control, it will likely get neither. And its problems will continue to grow.

 

Collapse is unlikely. Prolonged stagnation is possible.

Kicking the can down the road won’t solve the debt problem.

The concern is not that China’s economy is about to collapse or even that growth will grind to a halt in the short term. Both of those outcomes are still unlikely. The concern is that the currency devaluation is yet another sign that China lacks the will to address its growing debt problem and will continue to kick the can down the road as so many other countries have done, only to find that the can has become so big it can’t be kicked around anymore.

 

China’s long-term growth prospects remain excellent. It would be a shame if China pursues a course that favors the short-term at the expense of the long-term. Hopefully China’s most recent policy adjustment isn’t a sign that they are going to continue down that path.