From the early point in this blog, I have emphasised the importance of China in the world economy, and this view is now shared by the mainstream. China has rapidly moved from being an important element of the world economy into becoming one of the central actors. On a bookshelf crowded with books about China, I have a copy of James Kynge's 'China Shakes the World', a book with a title which many would have taken as poetic fancy at the time of writing. For those of us who actually witnessed the growth of China, it was simply a statement of reality. China was already shaking the world at the time that the book was written, but most of the West had simply not noticed. We are all now paying attention.
In July 2008, I had the following to say for the prospects for the Chinese economy in the economic crisis:
The Chinese economy may, or may not be, at a point where internal growth within China has the potential to take up the slack. Has it yet reached that point? It is very difficult to say. It is a finely balanced point, but the economic growth of the coastal areas is now being replicated in the interior. Can the growth in the interior maintain the momentum of the coastal cities? The Chinese government has huge reserves to draw upon should the economy falter, and may seek to use those funds to further develop the interior of the country. There is also an ongoing and dramatic process of infrastructure investment which may help carry China through the bad times.
Furthermore, China has being making ever stronger inroads into markets such as Africa, and South America. Whilst these can not replace the US and European markets, they may serve to ameliorate the effects of a downturn.
Much as I expected, there was a massive 'stimulus' for the Chinese economy, much of which is directed at the interior. A summary of the stimulus is given by the China Daily:
The Chinese government announced its 4-trillion-yuan ($585-billion) stimulus package in November last year to boost domestic demand and economic growth amid the global downturn. The money will be mainly spent on new highways, railways, housing, schools, hospitals and environmental protection projects.
I have discussed in many posts the change in the balance of the world economy, always with China in mind. For example, in an article in TFR magazine, I used the example of the SUV and Tata Nano to illustrate the changes in the distribution of consumption that would flow from the crisis. However, I had not guessed that China would actively encourage such changes. Just one aspect of the stimulus has been the subsidy of car purchases, and the result of the policy has been widely reported:
Sales of cars, sport-utility vehicles and multipurpose vehicles, rose to 858,300, the China Association of Automobile Manufacturers said in a statement today. Sales fell 6.2 percent in August 2008 as the Olympic Games damped demand.
This year, a 4 trillion yuan ($586 billion) stimulus plan has shielded China from the global recession, helping car sales jump at least 45 percent for four months in a row. Full-year sales of cars, trucks and buses may hit 12 million, the government said last week. Surging demand helped Geely Automobile Holdings Ltd., China’s biggest privately owned carmaker, to double profit in the first half.
Alongside the stimulus measures, there has been a massive surge in bank lending in China, underpinned by government policy. However, the massive growth in lending is widely believed to have fuelled a stock market and property bubble within China, such that the Chinese government is now seeking to reign in the expansion:
China will study the use of “regulatory tools” to adjust bank lending after the nation had a record 7.37 trillion yuan ($1.1 trillion) of new loans in the first half, a deputy central bank governor said today.
The People’s Bank of China will “study use of regulatory tools to adjust banks’ lending activity,” Deputy Governor Su Ning said at a forum in Shanghai, without elaborating. China’s central bank will also “emphasize” monitoring of asset price changes and watch international capital flows, he said.
China’s record credit expansion, which helped economic growth rebound to 7.9 percent in the second quarter, also raised concerns that bank loans have been diverted and used to buy shares and real estate, fueling gains in stock and property markets. Benchmark shares, which gained 57 percent this year, are in “deep bubble territory,” according to former Morgan Stanley Asia economist Andy Xie.
The China Banking Regulatory Commission will take “effective” steps to prevent bank loans from being diverted to the stock and property markets, the China Securities Journal reported today, citing Wang Huaqing, the regulator’s discipline chief. Banks that fake loans and earnings reports will also face harsher punishments, the report cited Wang as saying.
What we are seeing is that the Chinese appear to have learnt the lessons of the economic crisis, and are seeking to avoid lending being diverted into asset price bubbles, though it is quite possible that the action is too late. I was in China in 2007, at the time of another surge in the Chinese stock market, and witnessed the mentality of investors first hand. Many people I met were playing the stock market, and were being amazed at how much money they could make. They congratulated themselves on how smart they were, without realising that a monkey could have picked stocks and still seen them rise.
Likewise, with property, it was possible to see huge numbers of brand new apartment buildings, but at night there would be no lights on in the building. What was happening was that individuals were investing in property, and leaving the apartments empty in the expectation of sale at a later profit (in China, once an apartment has been lived in, the value falls). Large numbers of shopping malls were being built, but whether there was sufficient demand for the expansion was questionable.
In this case, I am reporting what was taking place in 2007, and it is not clear that the situation is the same this time. However, I suspect that the situation is very similar, and that there are problems on the horizon, in particular now that China is taking its foot off the credit accelerator. Recent volatility in the Chinese stock market may only be the start, as the degree of irrationality of Chinese investors makes even Western investors appear rational. This, in conjunction with the opacity of information, makes the Chinese stock market a genuine casino.
Despite the surge in interest in China, problems remain in having a clear understanding of China, such as the opacity of the information of what is actually happening in the country. Figures are massaged and manipulated, governance is hidden behind a wall. Even when there is an announcement of import, it is often made by a proxy for the government, such that the government can float an idea whilst still being able to deny it as policy. It is hard to be certain of what is, and is not, happening in the Chinese economy.
A good starting point for consideration of the underlying Chinese economy is the level of activity within the economy. The official figures for this are widely viewed with suspicion, such that it has now become commonplace for electricity usage figures to be used as a proxy for the level of activity. This is a report from August by AFP:
Power consumption in China rose for a second successive month in July, official data showed Friday, giving more hope that the world's third biggest economy is recovering from the global slump.
The six percent year on year increase, released by the National Development and Reform Commission, followed a 3.8 percent lift the previous month.
Before June demand had been falling continuously since October, according to previous media reports citing government data.
Despite the rise, electricity use in the first seven months was down 0.9 percent from the same period a year earlier, the commission, the nation's top economic planning agency, said in a statement.
The commission gave no reason for the recent increase but it came at the same time as a rebound in the industrial sector, which consumes more than 70 percent of the power in China.
Industrial output -- a main gauge of activity in plants across China -- rose 10.8 percent in July from a year earlier, the National Bureau of Statistics said this week, on top of a 10.7-percent hike in June.
Such figures do suggest a major perking up of activity within the Chinese economy. The question is how much of the activity is built upon the government's stimulus to the economy, and high risk credit expansion?
In the meantime, Chinese exports, the driver of Chinese growth are starting to stabilise after the major contraction that followed the commencement of the economic crisis:
Chinese exports fell less sharply in August from year-earlier levels than the 23 percent drop seen in July, as the overall outlook for overseas shipments improved, a top customs official said on Monday.
Li Kenong, vice head of the General Administration of Customs, also told Reuters that exports grew in August on a month-on-month basis. He declined to give specific figures.
"From the recent months' figures we can say that China's exports will definitely become better and better over time, but it is still difficult to judge when it will turn to positive growth," Li said on the sidelines of a news conference.
The comments underpin optimism that, even though net exports will probably exert a negative pull on gross domestic product growth this year, the extent of the decline is easing as demand stabilises in Western countries.
So where does all of this leave the underlying state of the Chinese economy? The first point is that, unlike countries like the UK and US, China can afford the fiscal stimulus, and there are projects that can actually be funded with some purpose. China does still need more infrastructure, and the country has the savings and resource to fund this. With regards to property and the stock market, these do present risks on the horizon. However, having said this, if China can stabilise and recommence growth in exports, this would limit the problems that might arise.
As many readers will be aware, China now has somewhere in the region of $US 2 trillion of reserves, with a third of the reserves held in US treasuries. What we are now seeing is that China has the power to make or break markets. It was apparent that this would be the case some time ago, and I wrote the following in a post a long while ago:
The key difference that arises from such scale is that China has the potential to massively impact upon any market with which it is involved. The sheer size of their reserves means that they can swing any market up or down according to their actions. Aside from this difference, which requires a circumspect approach from China, I would probably find myself having made the same recommendation that I made to individuals nearly a year ago. This was that gold was the best prospect and an asset that might survive the turmoil (though I offered many caveats to this advice, as I am not an investment advisor).
We are now seeing that effect actually playing out in the gold market. This consideration from a report in the Telegraph, from a Chinese individual who is described as a roving Chinese economic ambassador:
“Gold is definitely an alternative, but when we buy, the price goes up. We have to do it carefully so as not stimulate the market,” he said.
In other words, China is buying the dips, and will continue to do so as a systematic policy. His comment captures exactly what observation of gold price action suggests is happening. Every time it looks as if the bullion market is going to buckle, some big force steps in from the unknown.
The massive holdings of treasuries have been a topic that I have discussed at some length in many posts in the blog. In one post, I speculated that China would seek to quietly offload its store of treasuries, doing so whilst not alarming the market and destroying the value of all of their $US holdings. In order to do so, I suggested that they would shift their holdings into other assets, and seek to embark on a shopping spree:
I mentioned at the start of the post that gold represented a good opportunity for China, but there are limits to how far China might take such a policy. The same might be said for other precious metals. However, it does seem quite likely that precious metals will play a larger part in China's overall mix of assets. This still leaves the central problem of what else China might move into, if it moved out (is moving out of?) of US treasuries? The same analyst who points out that China can not shift into gold, also argues more broadly that there are no credible alternatives to US treasuries.
However, the analyst makes a basic error in thinking that China would have to take an all or nothing approach. He does not consider that China might spread their reserves over a wide range of assets, and this is my best guess for the direction of China's policy. If they follow this strategy, and implement it with care, China has the potential to rapidly jump towards becoming the world's most powerful economy.
The first step is to manage the sale of US treasuries with the greatest of care, such that they gain as much value of the sales as possible before the $US collapses. As they move out of $US they would likely buy as many precious metals as possible without driving the price too high, as well as buying into emerging market, European and Japanese bonds. In doing so, they will be taking risks but with the benefit that they will be positioning the RMB as the next reserve currency. Furthermore, it is no secret that China has been trying to buy into various commodity companies (or natural resource companies), such as the ongoing saga of the Chinalco purchase of Rio Tinto or their wider expansion of investments in this sector.
If you have time, I might suggest that you read the post in full. Since writing the post, much of what was then speculation has become reality. The only missing element is the collapse of the $US and, as I have detailed in previous articles, the $US is looking ever more unstable. My expectation is that, as the $US collapses, China will go on a shopping spree in which, in the economic chaos, they will seek to purchase key companies at bargain basement prices. In doing so they will leap frog up the technology hierarchy.
Another element of the consideration of China's economic ambitions has been an ongoing subject of the blog. This is the ambition of China to replace the $US as the world's reserve currency, a suggestion that was widely considered to be impossible at the time that I started writing about it. In a series of articles, I have followed the tentative moves towards this goal. In July of this year, I pulled together many of the points made in previous posts, and provided an update on the progress of China towards their reserve currency goal. Once again, you may wish to read the post in full, as I will just quote a couple of sections here:
I have long argued that China is using the idea of an SDR reserve currency as a stalking horse. In positioning the SDR as the replacement for the $US, China can engage the support of other countries like Russia, India and Brazil, who might blanch at the prospect of the RMB as the reserve currency (e.g. see here for discussion of support for the SDR in relation to India and Russia).
The underlying reality behind the challenge for reserve supremacy is that China is increasingly the linchpin in the global financial system. Whatever China does with its massive reserves quite literally shapes the world financial system. China quite literally has the power to make or break any asset or any market, as can be seen in the attention paid to every utterance from China regarding the $US. When a country has such economic firepower, it is puzzling that anyone might suggest that it is not ready to take on the role of a reserve currency. I can only assume that many analysts are taking the SDR stalking horse seriously, and are not considering the vacuum that will be left when the $US finally collapses under the weight of quantitative easing and fiscal profligacy.
The only question marks that remains over the RMB as a reserve currency are largely to do with whether China can continue the present economic momentum, and the timing and nature of the collapse of the $US. When I first wrote about China for the blog in July 2008, I highlighted the risks for China, but concluded that on balance I favoured the view that China would emerge in the ascendant in the economic crisis. Whilst still issuing a note of caution, the developments since that time are even more favourable for China. With regards to the collapse of the $US, it is quite astounding that it has defied gravity this long.
As the current situation stands, the RMB is looking very much like the new reserve currency, and it is not going to become the reserve currency in ten or twenty years time, but in the near future. It may be that SDRs will be implemented as a reserve on a temporary basis during the transition, for long enough for China to satisfy the aspirations of the other supporters of the SDR. However, unless China's ascent is halted (e.g. through civil unrest), it is almost certainly going to succeed in the ambitions for the RMB.
The latest news appears to confirm China's ambitions. This is a recent report from the New York Times:
The Chinese Ministry of Finance said Tuesday that it would issue 6 billion yuan worth of government bonds in Hong Kong, a major step to internationalize its currency at a time of concern about the dollar.
The yuan bond issue, the equivalent of $879 million, will “promote the yuan in neighboring countries and improve the yuan’s international status,” the ministry said on its Web site.
“The first step toward internationalization is regionalization,” Shi Lei, a currency analyst at Bank of China in Beijing, said during an interview. “China wants to develop the offshore market in Hong Kong.”
What appeared to many analysts as an impossibility, the replacement of the $US by the RMB, is fast moving towards a real possibility. One interesting speculation is that the move by China to accumulate gold might be the first steps towards a gold standard RMB, but I would reemphaise that this is nothing more than wild speculation at this stage. However, in the coming currency chaos, such a move would absolutely secure the status of the RMB.
The last element in the consideration of China is the mercantilism that is the centre of Chinese economic policy. I have detailed the many mercantilist practices of China, and have railed against the acquiescence of the West to such policies. Their manipulation of the RMB, various trade barriers, and disregard for intellectual property have been common themes. I will not re-state the points made in previous posts, but simply point out that China has been playing to its own rules, and those rules have been mercantilist in approach.
I have covered some considerable ground in this long post. Even so, bearing in mind the complexity of the situation in China and the role of China in the world economy, the post has only brushed over the subject. It has also not considered the ongoing risks for China, which have been detailed in many previous posts. In particular, there is a risk that, if the Chinese economy does at some stage suffer a severe contraction, there are significant risks of major unrest within China. Whilst I have emphasised this in previous discussions, I am now less convinced of the risks. Yes, there are question marks about what might happen with any further collapse in exports, if consumption in the West contracts further. Yes, there are potential problems when the stimulus recedes and lending is tightened.
However, the record of China to date suggests that they have the potential to ride the coming storms.
Having followed the progress of Chinese policy, it has become ever more apparent that they have been playing the 'great game' to win, and that they have played their hand beautifully. It is impossible in one post to convey how they have achieved their current position as the preeminent actor in the world economy. I find myself with a grudging admiration for the way in which they have positioned themselves, and find a measure of contempt for the politicians in the West who have allowed China to play the game so effectively. As the current situation stands, we are witnessing the shift of economic power from the West to the East, with China emerging as the world economic super power.
At this stage, such a rise by China is still not guaranteed, but as each month passes by, the probability of their success appears to be growing. It looks like the 21st century will be the century of China, and that the 'great divergence' described by Pomeranz is coming to an end (note 2). China is returning to its place as the centre of the world.
Note 1: I have listed below links to some previous posts on China. As you follow the posts, it may be apparent why it is that I have become increasingly confident that China will be so central to the world economy in the future. Within the posts it will be apparent why I have so much confidence in the success of China.
- July 2008, China - What Future?
- August 2008, China Propping up the $US
- January 2009, Free Trade 'Yes' - Mercantilism 'No' - Why China Should be Shut Out
- January 2009, The Myth of the Eternal Status of the $US as 'the' Reserve Currency
- February 2009, China's Pivotal Role in the Next Step for the World Economy
- Fenruary 2009, China and the US - Fighting on the Edge of a Cliff
- March 2009, Economics and Power, the Loss of US Power
- March 2009, China, Gold and the $US
- April 2009, China as the World Economic Power?
- April 2009, The RMB as the Reserve Currency
- May 2009, China, the RMB and the $US
- July 2009, The RMB as the Reserve Currency - an Update
Note 2: I am not convinced in all respects about the arguments put forward by Pomeranz in his book on the 'Great Divergence'. However, he is correct in identifying China as having a consistent history as an economic powerhouse, and that the divergence from this role with the rise of the West was an exceptional event (or series of events).
Note 3: I was provided with many links to assist me with this article, when I proposed writing it. I am very grateful for these, and one of particular interest is the prospect of China defaulting on derivatives contracts. I wanted to use the article, but simply ran out of time/space. I would, however, suggest it as an interesting read. It is rather puzzling.