China – rebalancing and the risks to world growth


Macro Letter – No 8 – 28-03-2014

China – rebalancing and the risks to world growth

  • China’s exports collapsed last month – is this a trend or will the rebalancing be less painful?
  • Will a slowdown in Chinese growth tip its major trading partners into recession?
  • What would 4% Chinese GDP growth mean for developed markets?

After a period of double digit GDP growth during the last decade, China has slowed to a still respectable 7 to 8% range. Behind the scenes, however, the new administration is attempting to steer the world’s second largest economy away from export led expansion towards a more balanced mix of production and consumption. China embarked on economic reform in 1978. After several decades of mercantilist policies the adjustment process will inevitably be beset by squalls and stormy weather.


Back in 1992 Hyman Minsky published a paper entitled The Financial Instability Hypothesisit discusses the three stages of credit expansion during an economic cycle: –

Hedge Finance – where borrowers have sufficient cash-flows to meet repayment obligations

Speculative Finance – where borrowers can repay interest but not principal

Ponzi Finance – where borrowers have insufficient cash-flows to meet interest or principal obligations

By a number of conventional measures China has reached the Ponzi stage. Total debt has increased from $9trln in 2008 to $23trln in 2013 (250% of GDP). Private sector debt has increased from 115% of GDP in 2007 to 193% in 2013. Measures of the multiplier effect of debt to GDP suggest it now takes 4 RMB of debt to create 1 RMB of GDP growth. The Chinese authorities attemptes to slow bank lending have led to a significant expansion of shadow bank credit. Much of this lending is to sub-prime borrowers.

Recent action by the PBOC suggests they are now targeting the illusive shadow banking sector. Last week they drained 50 bln RMB via reverse-repos. Below is a chart of Chinese loans; after strong growth in 2013 the PBOC may be inadvertently engineering a “Minsky Moment” – when asset prices collapse – but the Third Plenum focus on market based reform would suggest this is not the intention: –

Chinese loans


Whilst the shadow bank loans have been reigned in, credit formation is still progressing. This is consistent with target M2 growth of around 13%.

There are signs of official policy beginning to bite. In January a coal mining company (Zhengfu Energy) was saved from defaulting on loans by a government engineered bailout, however, in sea-change, China witnessed its first corporate bond default this month (Shanghai Chaori Solar) and a real estate developer (Zhejiang Xingrun Real Estate Company ) was allowed to default on $567 mln of debt to a consortium of 15 banks.

This week the HSBC PMI index recorded 48.1 the fifth month of decline. Meanwhile domestic consumption is growing but the rate of retail sales growth has been easing: –

China retail sales 2010 - 2014


China’s transition towards domestic consumption is still remarkable. It is testament to the ability of the state to direct policy.

Reform Agenda

The new administration under President Xi has a clear agenda as this article from the China – United States Exchange Foundation explains:-

First and foremost, Xi’s economic reform agenda wisely addresses some of the country’s most serious economic problems. The new leadership unambiguously aims to tackle them in a forceful manner. 

Second, Xi not only took control of all the supreme institutions in the party, state, and military during the latest political succession, but he also now chairs the newly established National Security Committee and the Central Leading Group on Comprehensive Deepening of Economic Reform. The lower levels of the Chinese government have also established leading groups on economic reform headed by party secretaries and governors or mayors. All of these provide institutional mechanisms through which Xi and his team can more effectively implement reform policies.  

Third, Xi has been supported not only by experienced economic reformers in the top leadership but also by a group of world-class financial technocrats, including Harvard graduate Liu He and Stanford-trained Fang Xinghai. Recently, Ma Jun, Deuteche Bank’s former chief economist on greater China, was appointed as chief economist of the People’s Bank of China. Huang Yiping, former chief economist of emerging Asia for Barclays, also joined the advisory team to the top leadership.  

Finally, the timetable for the bold reform agenda reflects President Xi’s political calculations to stabilize the Chinese economy before the fall of 2017, when the party leadership will experience another major turnover (because of age limits, 5 out of 7 members of the Politburo Standing Committee will retire that year). Xi needs to consolidate power for his second term by unequivocally succeeding in implementing his economic reform agenda. 

If the aim is to rebalance the Chinese economy by 2017 draconian action is required in the near-term. The US economy is stronger than it has been since the crisis of 2008/2009. The Eurozone whilst vulnerable is in better shape than it was in 2011/2012. From a global perspective the developed economies are better placed to absorb the shock of a China slowdown.

So how will China reform? This short article from AJISS – Analysis of the Third Plenary Session and the Outlook for the Future – suggests a number of areas for focus but highlights the areas where doubts exist about the administrations ability to deliver, they conclude on an optimistic note: –

As noted above, expectations are low that the Xi Jinping administration will undertake radical reforms, but a more careful examination of the Decision reveals a number of praiseworthy policies: private capital will be permitted to participate in state-financed investment projects, the percentage of money paid into the public treasury from state-run company earnings will be boosted in order to step up social security funding, and the system of land ownership will be further reformed to increase individuals’ share of capital gains from land. As long as a growth rate of about 7% can be sustained, the combination of these partial reforms should be reasonably effective in extending the lives of the current political and economic systems. The most likely scenario for the near future is that the Communist government will maintain the present political and economic systems by seeking out compromises with rising economic elites, rooting out corruption and implementing income redistribution policies to partly alleviate popular discontent.

All these reform policies are relatively long-term in nature, but if financial markets begin to meltdown, it should be remembered that China is a command economy and can implement bail-outs more swiftly than in most democracies.

Last month the China-United States Exchange Foundation published the following article – Coming Out of the Shadows: Why China Needs a Lehman Moment – which goes to the heart of the dilemma facing the Xi government:-

If we agree that the Chinese state has the financial means to restructure the shadow banking system (which has assets equivalent to 60 percent of GDP), then the challenge is to design a market-based approach that will liquidate zombie borrowers quickly (Zhengfu Energy is a classical zombie borrower).  Investors (mostly wealthy private individuals in the case of shadow banking) must pay a steep price for their failure to perform due diligence (so far, no private individual has lost money investing in products channeled through the shadow banking system).   Granted, the widespread practice of cross-collateralization (borrowers guaranteeing each other’s debt) is likely to trigger chain defaults if one zombie borrower goes under.  But this is an unavoidable price to pay.  Beijing would be far better off in the long run if it opts for intense short-term pain. 

This week, in response to the recent publication of the Work Report, the China- United States Exchange Foundation – The Second Arrow of Likonomicsdescribed the process of Likonomics:-

1. A cautious manner to economic stimulus measures.

2. The deleveraging of financial sectors.

3. Structural reforms of the Chinese economy.

Essentially this process begins by allowing the market to gain prominence but this is only the first arrow: –

Likonomics is different from laissez-faire economics, and it is not a stress test for the Chinese economy. The Chinese government does not alternatively choose between small and big government ideas, but leaves market issues to the market, and government responsibilities to the government. It re-clarifies the role of the market and the role of government in economic and social development. 

If increasing the role of the market and reducing administrative interventions is the first arrow of Likonomics, then the second arrow is clearing lines of responsibility and the role of government in reform, as explained in the new government work report. 

First of all, the Chinese government will become the active regulator of reform, to ensure that the Chinese economy avoids upheavals. The report clearly states that the reasonable range for the Chinese economy in the future will be a GDP annual growth rate of around 7.5%, M2 growth of 13%, and CPI at 3.5%. These indicators are consistent with those of 2013, but the expectations of growth and inflation were lower than 2011. It means the Chinese government has abandoned hard targets on economic growth and inflation, allowed some of the indicators to cross the line, and accepted the fact that China’s economic growth started to slow down. However, the emphasis of the reasonable range means that the Chinese government will carefully assess the situation of the economy and provide crisis intervention if necessary. The clarity of the reasonable range will help stabilize the outlook and enhance market confidence in the Chinese economy. 

Most market commentators are beginning to predict slower growth for China in 2014 and beyond. I think this expectation is mainly based on past experience of Chinese stimulus. The new administration is adopting a different approach. Whilst the economy may stall in the near-term I believe the government can and will intervene aggressively to avoid a widespread crisis.

For a wonderfully argued contrary view Micheal Pettis – The impact of reform on growthsums up what should happen in a genuine reform process.

I believe that a large part of the objective of this economic reform is political in nature. President Xi has already shown himself to be a more centralist leader than China has witnessed in many years. The imbalance of the Chinese economy presents an opportunity to return power to the center. This article from Jamestown Foundation – Xi invokes Mao’s image to Boost his own Authority helps to put the Third Plenum economic policies in a wider context:-

Xi’s carefully calibrated rhetoric is thus geared toward appeasing Chinese who want a continuation of economic reforms as well as conservative elements within the Party who agree with Deng’s judgment that “if we abandon the standard of Mao Thought, we are in fact negating the party’s illustrious history” (People’s Daily, March 24, 2010).  Indeed, in his now-famous internal talk last December on drawing the right lessons from the collapse of the Communist Party of the Soviet Union (CPSU), Xi noted that the CPSU made a fatal error in denigrating Lenin and Stalin. As a result of forsaking their founding fathers, Xi pointed out, “[latter-day Soviet party members] were wallowing in historical nihilism.” “Their thoughts became confused, and different levels of party organizations became useless,” he said. (Radio Free Asia, May 24; Deutche Welle Chinese Service, January 25, 2013).

For a different, but complimentary, view of the current political shift within China, this article from The Diplomat – Why Chinese Study the Warring States Period – provides a fascinating perspective: –

The Chinese leadership is working toward achieving three main goals:  The leadership wants to prevent the emergence and mitigate the existence of the conditions that plagued the political arena of the Warring States era. Specifically it wants to maintain stability, foster unity and reduce the risk of division, as well as mitigate competition. The leadership also wants to continue developing a more prosperous economy and a strong military. And the military must remain committed to supporting the leadership’s agenda, namely bolstering the ruling regime’s legitimacy, protecting sovereignty, defending territorial integrity, and ensuring the state’s overall survival. Finally, unlike the Qin leaders who emphasized the rule of law, the current leadership most likely will continue promoting a code of behavior to cultivate obedience and order. If these trends continue along the current trajectory – in other words, there are no internal and/or external disruptions to the existing trajectory – the Chinese leadership should be able to create a relatively stable and more prosperous and unified state system supported by a strong military capable of ensuring the survival of the current Chinese state system.

The Warring States Era took place between 475 and 221 BC. It was a period regional power struggles which ended with unification under the Qin dynasty. From a military perspective China has already become the regional hegemon in Asia-Pacific. A united country is essential if it is to build on this position.

Chinese Imports

But what about the near-term impact of a China slowdown on financial markets? For the remainder of 2014 and probably the first half of next year China’s economic activity will be difficult to forecast, but it is reasonable to anticipate further signs of weakness. This will impact its major trading partners. Countries which rely on Chinese imports may begin to experience shortages or higher prices – although these may be offset by a weakening in the RMB. The chart below illustrates this, however, it is a new trend and the first sign of RMB weakness for many years.

USD-CNY 2009-2014

Source: Yahoo Finance

Countries which export to China are likely to find the environment more challenging, especially those which supply commodities and basic materials.

Here is a table of China’s principal trading partners from 2011.

Region            Exports         Imports                Trade balance

EU                          356.0              211.2                     +144.8

USA                       324.5               122.2                    +202.3

ASEAN                  170.1               192.8                    -22.7

Japan                    148.3               194.6                    -46.3

S.Korea                 82.9                 162.7                    -79.8

Brazil                    31.8                  52.4                      -20.6

India                      50.5                 23.4                     +27.1

Russia                   38.9                 40.3                     -1.4

Taiwan                  35.1                  124.9                   -89.8

Source: National Bureau of Statistics of China

Exporters in Taiwan, South Korea and Japan are clearly vulnerable to a Chinese slowdown but there are other export countries which have significant exposure.

Here is a selection of countries for whom China is a substantial export market:-

Region                              Percentage

Vietnam                                25.8%

Japan                                    21.3%

United States                       19.0%

Australia                               18.4%

New Zealand                        16.4%

South Korea                         15.6% (2012 est.)

Russia                                    15.5%

Brazil                                     15.3%

Indonesia                              15.3%

Malaysia                               15.1%

South Africa                         14.4%

Saudi Arabia                        13.5%

India                                      10.7%

Source: CIA Factbook

The fall-out from a China slowdown is likely to be broad-based. For these countries it will temper inflationary forces and support lower interest rates. Whilst the initial impact on stocks may be negative, the expectation of lower domestic interest rates will be positive. Slower growth in China will reduce growth globally, prompting developed nation central banks to adopt stimulative monetary policies in order to avoid recession. This in turn will support equity markets both in developed countries and, through international investment flows, emerging markets.


Chinese growth may slow further in 2014/2015 from current levels of 7.5% towards 4% but I believe the government will then intervene aggressively to reverse the decline once it has achieved its political agenda. China’s main trading partners will not escape the impact of this slowdown unscathed, although it will affect countries which export to China more directly.

Within China sectors such as health care, retail and IT will benefit from the great rebalancing. Commodity export countries such as Australia will continue to find the environment challenging. The Chinese administration will use the slowdown to assert its authority in regional disputes around the South and East China Sea. In the process it will once again test the resolve of any US military response.

For developed markets slower Chinese growth will temper inflationary concerns. Once this spills over into slower developed country growth I expect further quantitative easing – this will support asset prices for stocks, bonds and real estate both domestically and internationally.

2 thoughts on “China – rebalancing and the risks to world growth

  1. Col,

    I look forward to reading your thoughts on the impact of the Ukrainian crisis on market prospects.

    Best, Peter.

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