China is not col­laps­ing

Financial Mirror (Cyprus) - - FRONT PAGE -

China cer­tainly ex­pe­ri­enced a tur­bu­lent sum­mer, ow­ing to three fac­tors: eco­nomic weak­ness, fi­nan­cial panic, and the pol­icy re­sponse to these prob­lems. While none on its own would have threat­ened the world econ­omy, the dan­ger stemmed from a sel­f­re­in­forc­ing in­ter­ac­tion among them: weak eco­nomic data leads to fi­nan­cial tur­moil, which in­duces pol­icy blun­ders that in turn fuel more fi­nan­cial panic, eco­nomic weak­ness, and pol­icy mis­takes.

Such self-re­in­forc­ing fi­nan­cial feed­back is much more pow­er­ful in trans­mit­ting global eco­nomic con­ta­gion than or­di­nary com­mer­cial or trade ex­po­sures, as the world learned in 2008-2009. The ques­tion now is whether the vi­cious cir­cle that be­gan in China over the sum­mer will con­tinue.

A sen­si­ble an­swer must dis­tin­guish be­tween fi­nan­cial per­cep­tions and eco­nomic re­al­ity. China’s growth slow­down is not in it­self sur­pris­ing or alarm­ing. As the IMF noted, China’s growth rate has been de­clin­ing steadily for five years – from 10.6% in 2010 to a pro­jected rate of 6.8% this year and 6.3% in 2016.

This de­cel­er­a­tion was in­evitable as China ad­vanced from ex­treme poverty and tech­no­log­i­cal back­ward­ness to be­come a mid­dle-in­come econ­omy pow­ered by ex­ter­nal trade and con­sumer spend­ing. It was also de­sir­able, be­cause rapid growth was hit­ting en­vi­ron­men­tal lim­its.

Even as the pace of growth slows, China is con­tribut­ing more to the world econ­omy than ever be­fore, be­cause its GDP to­day is $10.3 trln, up from just $2.3 trln in 2005. Sim­ple arith­metic shows that $10.3 trln grow­ing at 6% or 7% pro­duces much big­ger num­bers than 10% growth start­ing from a base that is al­most five times smaller. This base ef­fect also means that China will con­tinue to ab­sorb more nat­u­ral re­sources than ever be­fore, de­spite its di­min­ish­ing growth prospects.

Yet China is caus­ing high anx­i­ety, es­pe­cially in emerg­ing coun­tries, largely be­cause fi­nan­cial mar­kets have con­vinced them­selves that its econ­omy is not only slow­ing, but fall­ing off a cliff. Many Western an­a­lysts, es­pe­cially in fi­nan­cial in­sti­tu­tions, treat China’s of­fi­cial GDP growth of around 7% as a po­lit­i­cal fab­ri­ca­tion – and the IMF’s latest con­fir­ma­tion of its 6.8% es­ti­mate is un­likely to con­vince them. They point to steel, coal, and con­struc­tion sta­tis­tics, which re­ally are col­laps­ing in sev­eral Chi­nese re­gions, and to ex­ports, which are grow­ing much less than in the past.

But why do the skep­tics ac­cept the truth of dis­mal gov­ern­ment fig­ures for con­struc­tion and steel out­put – down 15% and 4%, re­spec­tively, in the year to Au­gust – and then dis­miss of­fi­cial data show­ing 10.8% re­tail-sales growth?

One rea­son can be found in the fi­nancier Ge­orge Soros’s con­cept of “re­flex­iv­ity.” Soros has ar­gued for years that fi­nan­cial mar­kets can cre­ate in­ac­cu­rate ex­pec­ta­tions and then change re­al­ity to ac­cord with them. This is the op­po­site of the process de­scribed in text­books and built into eco­nomic mod­els, which al­ways as­sume that fi­nan­cial ex­pec­ta­tions adapt to way round.

In a clas­sic ex­am­ple of re­flex­iv­ity, when China’s stock-mar­ket boom turned into July’s bust, the gov­ern­ment re­sponded with a $200 bln at­tempt to sup­port prices, closely fol­lowed by a small de­val­u­a­tion of the pre­vi­ously sta­ble ren­minbi. Fi­nan­cial an­a­lysts al­most uni­ver­sally ridiculed these poli­cies and cas­ti­gated Chi­nese lead­ers for aban­don­ing their ear­lier pre­tenses of mar­ke­to­ri­ented re­forms. The gov­ern­ment’s ap­par­ent des­per­a­tion was seen as ev­i­dence that China was in far greater trou­ble than pre­vi­ously re­vealed.

This belief quickly shaped re­al­ity, as mar­ket an­a­lysts blurred the dis­tinc­tion be­tween a growth slow­down and eco­nomic col­lapse. In mid-Septem­ber, for ex­am­ple, when the pri­vate-sec­tor Pur­chas­ing Man­agers’ In­dex (PMI) came out at 47.0, the re­sult was gen­er­ally re­ported along these lines: “The in­dex has now in­di­cated con­trac­tion in the [man­u­fac­tur­ing] sec­tor for seven con­sec­u­tive months.”

In fact, Chi­nese man­u­fac­tur­ing was grow­ing by 5-7% through­out that pe­riod. The sup­posed ev­i­dence was wrong be­cause 50 is the PMI’s di­vid­ing line not be­tween growth and re­ces­sion, but be­tween ac­cel­er­at­ing and slow­ing growth. In­deed, for 19 out of the PMI’s 36 months of ex­is­tence, the value has been be­low 50, while Chi­nese man­u­fac­tur­ing growth has av­er­aged 7.5%.

Ex­ag­ger­a­tions of this kind have un­der­mined con­fi­dence in Chi­nese pol­icy at a par­tic­u­larly dan­ger­ous time. China is now nav­i­gat­ing a com­plex eco­nomic tran­si­tion that in­volves three some­times-con­flict­ing ob­jec­tives: cre­at­ing a mar­ket-based con­sumer econ­omy; re­form­ing the fi­nan­cial sys­tem; and en­sur­ing an or­derly slow­down that avoids the eco­nomic col­lapse of­ten ac­com­pa­ny­ing in­dus­trial restruc­tur­ing and fi­nan­cial lib­er­al­i­sa­tion.

Man­ag­ing this tri­fecta re­quire skill­ful jug­gling of

re­al­ity, not the other suc­cess­fully will pri­or­i­ties – and that will be­come much more dif­fi­cult if Chi­nese pol­i­cy­mak­ers lose in­ter­na­tional in­vestors’ trust or, more im­por­tant, that of China’s own cit­i­zens and busi­nesses.

Vi­cious cir­cles of eco­nomic in­sta­bil­ity, de­val­u­a­tion, and cap­i­tal flight have brought down seem­ingly un­break­able regimes through­out history. This prob­a­bly ex­plains the whiff of panic that fol­lowed China’s tiny, but to­tally un­ex­pected, de­val­u­a­tion of the ren­minbi.

The ren­minbi, how­ever, has re­cently sta­bi­lized, and cap­i­tal flight has dwin­dled, as ev­i­denced by the bet­ter-than-ex­pected re­serve fig­ures re­leased by the Peo­ple’s Bank of China on Oc­to­ber 7. This sug­gests that the gov­ern­ment’s pol­icy of shift­ing grad­u­ally to a mar­ket-based ex­change rate may have been bet­ter ex­e­cuted than gen­er­ally be­lieved; even the mea­sures to sup­port the stock mar­ket now look less fu­tile than they did in July.

In short, Chi­nese eco­nomic man­age­ment seems less in­com­pe­tent than it did a few months ago. In­deed, China can prob­a­bly avoid the fi­nan­cial melt­down widely feared in the sum­mer. If so, other emerg­ing economies tied to per­cep­tions about China’s eco­nomic health should also sta­bi­lize.

The world has learned since 2008 how dan­ger­ously fi­nan­cial ex­pec­ta­tions can in­ter­act with pol­icy blun­ders, turn­ing mod­est eco­nomic prob­lems into ma­jor catas­tro­phes, first in the US and then in the eu­ro­zone. It would be ironic if China’s Com­mu­nist lead­ers turned out to have a bet­ter un­der­stand­ing of cap­i­tal­ism’s re­flex­ive in­ter­ac­tions among fi­nance, the real econ­omy, and gov­ern­ment than Western devo­tees of free mar­kets.

One ques­tion has dom­i­nated the In­ter­na­tional Mon­e­tary Fund’s an­nual meet­ing this year in Peru: Will China’s eco­nomic down­turn trig­ger a new fi­nan­cial cri­sis just as the world is putting the last one to bed? But the as­sump­tion un­der­ly­ing that ques­tion – that China is now the global econ­omy’s weak­est link – is highly sus­pect.

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