The second largest economy in the world has enjoyed a stock market boom, with stock indices in the country typically up some 44 per cent or more over the last 14 months. There is more good news, policy makers have been following advice, and they have done what the IMF advised them to and moved towards a system of a freely trading currency. They are also trying to do one more, devilishly difficult thing, and change the way the economy is structured. Such a move is bold indeed, but it is no more than what the great and good of the economic world have been advising it to do. Here is the odd thing, according to the headlines, this apparent example of a poster book economy is in crisis; a crisis so bad that it threatens to drag the global economy down with it. How can this be?
I refer, of course, to China. In the last few weeks shares have crashed. Take for an example the Shanghai Shenzhen CSI 300 Index. This index fell from 5,500 odd in mid-June of this year to close to the 3,000 level during the last few days of August. It was a similar story for the Shanghai Composite index. It too suffered a precipitous drop indeed. It is just that at one point in June 2014, the CSI 300 stood at just over 2,100. You could say the index has enjoyed a remarkably good run, or you could say it has put in an awful performance. It depends on what time frame you want to look at.
Then, there is China’s currency, the Yuan or Renminbi. For the last decade or longer, the likes of the IMF have been urging China to let its currency trade freely. Politicians on Capitol Hill have been screaming at China to adopt a more market friendly approach to its currency. In August 2015, China duly obliged, and allowed its currency to devalue, as a part of a policy it described as moving towards a freely trading currency. The IMF welcomed the development. Yet, a queue of critics formed. Those critics were so numerous in their number that if felt as if the queue could have stretched from Beijing to China’s western border. All China did was pick the optimal moment to move towards the IMF’s recommended position.
A superficial problem is that no one believes the data coming out of China. The Chinese government says the economy is growing at 7.5 per cent of GDP – if that were so, it would mean that the country would still be the biggest contributor to growth in global GDP. It is just that John Sawers, the former boss at MI6, has said that China’s growth rate is more like 3 per cent a year. Other studies looking at data which is harder to fudge, such as electricity output and freight transport, suggest China is growing at around 5 per cent a year. That may sound worrying, but according to the China Activity Index produced by Capital Economics, the worst of China’s slowdown is behind us and the economy is now picking up.
Look deeper, two problems emerge. For one thing, China has become too reliant on exports and investment. As the world’s second largest economy, China is simply too big to carry on growing at 10 per cent a year or more off the back of exports – the global economy is too small to fund all the required imports from China.
As for investment, there is lots of evidence that too much of this investment has become wasteful. Investment is a good thing, but like everything else in life, you can have too much of a good thing. As Martin Wolf pointed out in the FT, in 2014 fixed investment in China accounted for 44 per cent of GDP, but, if the economy only grew at 5 per cent, as economists suspect, then that would suggest negative marginal returns on investment. Look at China’s brand spanking new roads, alas bereft of traffic, or gleaming shopping centres with just a handful of shoppers and such a conclusion becomes easy to believe.
The second problem relates to debt. According to Capital Economics, during a ten year period before all emerging market banking crises that we know about, private sector debt to GDP rose by an average of 40 percentage points. There has never been an occasion when private sector debt to GDP rose by more than 30 percentage points and a banking crisis didn’t follow. Yet, in China over the last ten years, private sector debt to GDP has risen by 70 percentage points.
This all sounds serious, but bear in mind that China has massive foreign currency reserves, right now it has the resources to fund a banking bailout if necessary. Sure, China is too reliant on exports and investment, but this is precisely what the Chinese government is trying to change. The slowdown in the economy is a direct consequence of China’s government trying to make the necessary reforms. Better to do that now, than in a decade or so time, when the economy is more mature and change is harder to implement.
The China crisis is not new, experts have been warning of trouble for years ahead. What is new, is that China is trying to grapple with the challenges and it is this that has caused the market panic. Maybe instead, we should be celebrating.
Courtesy Clever Adviser