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Thursday, August 27, 2015

Why It Is a Loser's Game to Bet Against China's Leadership

Fred Hu 

Founder and Chairman of Primavera Capital Group; member Berggruen Institute’s 21st Century Council

BEIJING -- The rout in China's stock markets has sent shockwaves across the world, dragging global equities, currencies, bonds and commodities into the worst tailspin since 2008. Both domestic and international investors seemed to have lost faith in China's once fabled ability to manage its economy, hence the deepening gloom and spreading panic everywhere. While there are very valid concerns about China's economy and financial system, market reactions are vastly exaggerated.
To start with, China's falling domestic equities do not necessarily herald a sharp contraction in its broader economy. Historically the country's immature and extremely volatile stock market has been a poor predictor of GDP growth. With retail trading dominating the market place, share prices are mostly driven by short-term sentiments, not by any rational expectations of economic fundamentals.
Since mid 2014 the Chinese equity market was gripped by sudden spikes of speculative frenzies, in part fanned by the official Party media, and started a stunning rally. As valuation quickly soared to astronomical levels, a sharp correction, and even a spectacular crash, just seemed inevitable. That is exactly what has happened over the past few months. With Shanghai now down by more than 42 percent from its peak, the current stock valuation has factored in most of the bad news -- manufacturing malaise, weakening exports and capital outflows. Chinese equities are now traded at a discount to major emerging market peers that face far worse macroeconomic conditions. The risks of further sharp decline in China equities appear to be limited.
The Chinese stock market remains a sideshow as far as China's Main Street is concerned.
Unfortunately, the Chinese authorities' market interventions have done more harm than good. Far from stabilizing the markets, massive stock buying by state-owned institutions such as China Securities Finance Corp and Central Huijin Investment Ltd. have distorted the functioning of the stock market, caused widespread confusion and aggravated the risk of moral hazard, further undermining investor confidence at home and abroad.
The unprecedented stock market interventions, many pundits speculate, must have revealed the Chinese government's deep worries about the rapid deterioration of the underlying economy. Yet the Chinese stock market, though second only to the U.S. by market capitalization, remains a sideshow as far as China's Main Street is concerned.
So what has happened to China's economy? Accustomed to growing at the double digit pace, it is now struggling to reach the official target growth rate of 7 percent. But the GDP growth slowdown has been both gradual and moderate, far from being the disaster that has so spooked global investors. Even at 5 percent, China would generate more growth than any other country.
China's New Growth Model
Partly to address the longstanding concern about China's over dependence on investment and export led growth and its impact on global imbalances, the Chinese leadership has vowed to transform China into a more consumer centric and innovation-led economy. Recent data clearly show such a shift has been well underway, with consumption accounting for over 50 percent of overall GDP growth in 2014 and 60 percent in the first half of 2015. True, headline GDP growth has been trending down, but growth is now broader-based, more balanced, higher quality and possibly more environmentally friendly -- if only judging by the increasing count of blue sky days in Beijing.
Moderating growth rates in the range of 5-7 percent per annum reflect the higher per capita income level and the changing growth paradigm in China. A modest slowdown is a necessary and healthy adjustment for China to transition to a new trajectory of more efficient and sustainable growth. But instead of greeting such a positive "new normal" with enthusiasm, the naysayers have reacted with dismay as though they would rather prefer the old growth model.
To be sure, the shift to a wholesale new economic model is always fraught with uncertainty and risks, let alone for a country of China's size and scale. Compounding the challenges is the messy legacy the old growth model has left China with -- manufacturing glut, excess real estate inventory, heavily indebted local governments and severely damaged environment. To manage such a transition successfully, China must implement broad structural reforms while maintaining macroeconomic and financial stability.
What Is to Be Done?
Except for the stock market interventions, the authorities have so far avoided costly policy mistakes and China's track record of deft economic management remains remarkable. In response to the latest economic and market headwinds the People's Bank of China has already lowered interest rates and reserve requirement ratios. While China does not need a new credit boom, there is still a scope for additional monetary easing, to ensure adequate liquidity in the financial system, ease the debt service burden of heavily indebted corporates and local governments and forestall a possible debt deflation vicious cycle.
On the fiscal front the Chinese leadership has taken a more cautious stance in recognition of past fiscal profligacies and local debt buildup. Even so, there is room for significant fiscal actions. China should follow on recent tax cuts for small and medium enterprises with carefully targeted public spending increases.
Despite early signs of housing price stabilization, unsold housing inventory across China remains at elevated levels, especially in the so-called third-tier and fourth-tier cities. The central government should provide significant tax and credit incentives for first time homebuyers, especially rural migrants and low income families, to spread affordable home ownership and broaden the urban middle class base, while redressing the overhang of pass real estate excesses.
The central government should provide significant tax and credit incentives for first time homebuyers.
China should significantly increase transfer payments to the elderly to raise their retirement income, improve health and medical benefits coverage for both urban and rural populations, and provide more generous financial aid for secondary, vocational and university students with less income means. While China is right about resisting the European style social welfare state, it is imperative to reform and strengthen the country's basic social security system. Academic studies have identified inadequate social protection as a key factor for extraordinarily high household savings. Improved pension, health and education benefits for China's rapidly growing urban population would weaken the incentive for precautionary savings and boost personal consumption.
While past over-investment has led to excess industrial capacity, China's environmental infrastructure, a vital public good, is woefully underinvested. Though China has made encouraging initial efforts, it should launch and can afford a far more ambitious public investment program to promote clean energy and control pollution. Public Investment in clean tech is essential for China to meet its climate change targets. Increased investment spending in clean tech not only helps make up the near-term demand shortfall caused by falling manufacturing exports and infrastructure spending, but also may likely spurt a new growth industry that could establish China's global leadership in renewable energy and clean technology.
Contrary to prevalent market fears, China retains a broad range of monetary and fiscal policy options to cope with its stock market woes and economic downward pressures. But perhaps the most powerful weapon of all in China's policy arsenals is the opportunity to pursue sweeping economic reforms. Indeed, ever since the inauguration of the Xi Jinping leadership, investors have been expecting the so-called "reform dividends," because robust reforms promised by President Xi will correct structural imbalances, curb intrusive and arbitrary powers of the state bureaucracy, stamp out endemic corruption and level the playing field for private sector and small medium sized enterprises. In other words, President Xi's reform agenda, if fully implemented, should allow the market forces to play a decisive role in resource allocation -- promoting open competition, increase market transparency, boost efficiency and productivity gains and stimulate entrepreneurship and innovation.
Public investment in clean tech is essential for China to meet its climate change targets.
Perhaps nothing is more disappointing than the lack of progress to date on reforms concerning state-owned enterprises. Despite early achievements of SOE reforms initiated by former Prime Minister Zhu Rongji, there has been little new progress and possibly backtracking in recent years. It is plainly clear that the SOE sector has impeded competition from the private sector and dragged down economic efficiency.
Privatization, restructuring, better corporate governance, strong market-based incentives and professional management are, among others, required to turn SOEs into productive commercial enterprises. As shown by the case of PetroChina, China's biggest state-owned petroleum company, there is a close linkage between political patronage, abuse of state assets and corruption. Hence, a complete overhaul of China's large SOEs should also bolster the effectiveness of President Xi's popular anti-corruption campaign.
The Stock Crisis Will Prompt Faster Market Reforms
True, the string of recent bad economic news and the stock market selloffs have dampened short-term sentiments, but worse still, investors and the Chinese people might completely lose hope for the country's medium and long-term prospects if the government fails to deliver genuine reforms.
Fortunately, China has the capacity to contain the near-term economic and financial pressures through a judicious combination of strong monetary and fiscal stimulus measures. More importantly, the recent market gyrations have sent a loud and clear message to the Chinese policy makers and will likely prompt the top leadership to embark on fundamental reforms as pledged at the Third Party Plenary two years ago. Bold reform actions can restore investor confidence that the stock market interventions could not. Pessimists are wrong to declare that China is out of options.
It is a loser's game to bet against China's new generation of reformist leadership.
For several decades China has been a major engine of global growth and a strong anchor of global stability. Now China is being tested again whether it can weather the current market turbulence. The short term challenges are real and the transition will be bumpy. However, China will likely manage its current financial and economic problems far better than expected.
China has the financial resources, the policy tools, and crucially -- the political will -- to meet its challenges. Past reforms have laid a solid foundation and expected new reforms will significantly improve the outlook for future growth. China's accelerating urbanization, rapidly expanding middle class, a strong human capital base, tremendous entrepreneurial energy and innovative potential portend an attractive prospect ahead. It is a loser's game to bet against China's new generation of reformist leadership.

The Huffington Post

Saturday, August 22, 2015

The Devaluation of the Yuan----Prabhat Patnaik

THE Chinese central bank’s decision last week to let the yuan depreciate in three stages by almost 4 percent against the US dollar, was officially explained as a move towards greater market determination of its exchange rate. Though this explanation pacified stock markets around the world, China’s devaluation of the currency portends a serious accentuation of the world capitalist crisis.
To see this devaluation in its proper context, we have to remember that the Trade Weighted Exchange Rate (TWER) of the yuan (i.e., its exchange rate against a basket of currencies whose composition is determined by the importance of that currency in China’s trade), had appreciated by as much as 50 percent since 2005. Even compared to the year 2009 which had witnessed a major appreciation, China’s TWER had appreciated by a further 20 percent until recently, which means that other countries’ goods were becoming relatively cheaper compared to the Chinese goods, without the Chinese government doing anything about it. This had allowed other countries, including even the US, to experience higher growth than they would otherwise have done, while the Chinese economy itself had not experienced any marked slow-down in its growth rate, since its domestic demand had been rising owing to an asset market bubble. The appreciation of the yuan in other words had contributed towards imparting some degree of stimulus to the economies of the rest of the world.
China’s economy is now beginning to slow down; the asset market bubble in China has collapsed; and China is now looking for an export thrust to boost its growth rate, which is why it has devalued its currency. All this means that the stimulus which the world economy was getting until now from an appreciating yuan will now no longer be forthcoming. And this augurs ill for the world economic crisis. True, the extent of the depreciation of the yuan that occurred last week is small as yet; but, coming after a gap of nearly 20 years during which there had been no depreciation in the yuan, it shows a new turn in Chinese economic policy. The current depreciation therefore is likely to be a precursor to other similar depreciations in the days to come.

But even more significant than what the Chinese action per se would mean for the world economy, are the reactions it is likely to generate among other countries. Already several currencies of the world, including the Indian rupee, have depreciated vis-à-vis the US dollar in the wake of the depreciation of the yuan. This is because when the yuan depreciates, speculators expect that other countries too would be forced to depreciate their currencies to protect their exports against Chinese competition and to defend their domestic production against Chinese imports. Hence they move out of those currencies in anticipation of such depreciation, and thereby precipitate an actual depreciation; and the governments of these countries do not intervene to defend the value of their currencies, because they too, in their desire to ward off Chinese competition, want such a depreciation. What this means is that the bulk of the world’s currencies tend to depreciate vis-à-vis the US dollar when the Chinese currency depreciates, as indeed they are already doing.
Now, as far as the US is concerned, if the value of its currency appreciates vis-à-vis other currencies, then that affects the net exports of the US adversely, and hence its domestic activity and employment. Of late there had been much pressure on the US Federal Reserve Board to increase its interest rates which are currently as low as they could possibly be, at almost zero, since its domestic economy was supposed to have been “looking up”; and everybody was expecting the Fed to raise its interest rates in September. This, however, will now have to be postponed, since any such interest rate hike, by making the US dollar more attractive to hold, would have the effect of further raising its value vis-à-vis the world’s currencies, and hence further lowering the US economy’s level of activity even below what the current appreciation of the dollar (at near zero interest rates) would give rise to.
The problem with the US however is that even though it can postpone an interest rate hike, it can do little else to prevent a dollar appreciation. It cannot lower its interest rates any further, since they are already at rock bottom. Short of imposing import controls in open or clandestine ways, it will find it difficult to prevent a lowering of its level of activity and employment.
This explains why the US which had been pressurising China all these years to allow greater market determination of its exchange rate is so peeved when China claims to have done precisely that. The US calculation was that “greater market determination” of China’s exchange rate would produce an appreciation of the Chinese currency vis-à-vis the US dollar, and hence be of benefit to the United States in enlarging its market. As a matter of fact, since “greater market determination” has resulted in a depreciation of the Chinese currency, many US lawmakers have now started lashing out at this denouement.
Looking at it differently, with China wanting a larger share of the world market as a means of stimulating its domestic growth, which has been hit by the collapse of its asset market bubble, the competition between countries for a larger share of a more or less stagnant world market is getting intensified. On the one hand there are no factors working towards an expansion of the world market, and the collapse of China’s asset bubble has removed the last of such expansionary factors; on the other hand, every country, including China, is now joining in the race to get a larger chunk of this non-expanding world market. Not surprisingly, this can only compound the recession, since it constitutes a classic case of a “beggar-my-neighbour” policy, such as what had characterised the 1930s depression.
Two other factors are likely to work in the same direction. One is the collapse of the capitalists’ already feeble “inducement to invest”. Until now, for instance, being able to sell to China had acted as some sort of an investment stimulus for advanced country capitalists; this is now being removed. In addition, the currency price fluctuations, all of which do not move up or down synchronously, make profitability calculations much more difficult, and hence increase the risks of investment. For these reasons, again as in the 1930s, when “beggar-my-neighbour” policies were rampant, the capitalists’ “inducement to invest” would get adversely affected, compounding the recession.
The second factor is that the appreciation in the value of the dollar makes it more attractive for speculators to hold dollars rather than primary commodities, which is why world primary commodity prices, already on a falling trend (which incidentally explains the “negative” inflation in India according to the Wholesale Price Index), have fallen even more sharply after the devaluation of the yuan. This is further aggravated by the fact that China’s demand which had shored up primary commodity prices to an extent, would now be expected by speculators not to be doing so; this would also contribute to a collapse of primary commodity prices.
This fall in primary commodity prices has three effects: first, several countries like Australia, Brazil, Russia, and Chile, which are significant primary commodity exporters and whose fortunes therefore are tied up with primary commodity prices, will now experience a collapse of their growth rates. Secondly, debtor countries like Greece will now find that the real burden of their debt has gone up, which would push them further towards insolvency, and make creditor countries and creditor institutions impose even stiffer measures of “austerity” upon them. This, by reducing aggregate demand in those countries to an even greater extent, and hence, by implication, doing so all over the world, will aggravate the crisis even further.
The third effect is through what the American economist Irving Fisher, who had been a professor at Yale and had himself lost his entire personal fortune in the 1930s Great Depression, had called “debt-deflation”. It is not just countries, but all debtors who find that the real burden of the debt goes up when there is a fall in the price level. To be able to pay back their debt therefore they find themselves forced to sell some assets, which lowers the asset prices even further, raising the real burden of their debt even further, and so on cumulatively.
A “debt-deflation” in other words is a syndrome, which can result in acute crises and depressions. This is the reason why capitalists are always terrified of “negative inflation” or of “absolutely falling prices”. Once an economy begins to face declining prices in absolute terms, it can slide rapidly downhill through the unleashing of the process of “debt-deflation”, and its government and the central bank can do little to halt such a slide.
The world capitalist economy has been hovering close to such a scenario, of “deflation” or absolutely falling prices, for some time. (We know from our own experience that the Indian economy is facing a “deflation” in terms of the Wholesale Price Index largely because of international developments). With the depreciation in the Chinese yuan, and the expectations it generates regarding future Chinese growth and the future growth in primary commodity prices, there is a real likelihood of a “deflation” in the world economy setting in, and hence of the onset of a “debt-deflation” syndrome. In all these ways therefore the developments in China are likely to aggravate the capitalist crisis. We are in short on the threshold of a new phase in the world capitalist crisis which would witness its significant accentuation.