Excepting perhaps the glare flaring from the sweat-soaked foreheads of party leaders, few would deny that the September 3 military parade in Beijing, held to celebrate the 70th anniversary of Japan’s defeat in World War II, was anything but an exemplary display of human clockwork and deadly weaponry.
But neither would many deny those leaders’ recent loss of face from a botched rescue of China’s collapsing stock market and muddled rollout of a new currency fixing regime. Where domestic and global investors were once content to give Beijing the benefit of the doubt – even sometimes conferring on it a level of omnipotence – the markets’ reaction to these missteps has suggested they now have far less faith in Beijing.
“I think those two things together really hurt perceptions among international investors of Chinese policymakers’ ability to keep things under control,” said Julian Evans-Pritchard, China economist at Capital Economics. The market rescue attempt in particular, while not hugely damaging to the real economy, has raised the question of whether the Xi Jinping administration is committed to economic reforms. Those concerns were compounded when some observers initially concluded a subsequent devaluation of the yuan against the dollar was a desperate measure to boost exports.
But while the damage to Chinese officials’ previously sterling reputation is real enough, Evans-Pritchard and others point out that there’s little evidence that top leaders have abandoned rebalancing altogether, and recent months have witnessed real reforms – like lifting a ceiling on interest rates for long-term deposits – alongside easing measures. Rather than justified apprehension, the current instability may be the result of misplaced market expectations that align less and less with reality as China moves forward with its economic transition away from credit and toward greater reliance on consumption.
“I think there was a sense that China might ride to the rescue again as the dependable growth engine,” said Damien Ma, a fellow at the Paulson Institute. “But the moves over the summer, plus a string of bad data, spooked markets even more that the Chinese growth engine was sputtering more than once thought.”
Still on the job
The ramifications of these changed perceptions will play out atop the bedrock of China’s real economy—the sectors outside of finance, where real goods and services get bought and sold. Employment provides one of multiple cross-checks against the ongoing tumult in equities and exchange rates, provided one ignores the headline figure produced by China’s National Bureau of Statistics.
Official unemployment rates in China are notoriously low and stable, holding steady at around 4%. In December a joint report (pdf) by the International Monetary Fund and the Economist Intelligence Unit estimated unemployment during 2014 of around 6.3% and projected it would fall to 6.0% in 2015. Another alternative unemployment rate can be gleaned from a 31-city survey compiled for internal use by policymakers which is occasionally made public. In June state media reported said figure had fallen to 5.06% after rising to 5.19% in March, with a net 7.18 million new jobs generated in urban areas during the first half of the year.
“Judging labor market conditions isn’t easy,” Evans-Pritchard said, “but we certainly aren’t seeing the sort of strain in the labor market that one would expect if things were really as bad as many people are suggesting.” Such resilience in line with the conclusions of a July working paper (pdf) from the International Monetary Fund that found China’s labor market appeared to be holding up well despite slowing growth.
Researchers credited expansion in China’s services sector with picking up the slack for manufacturing. Frances Cheung, head of China-Hong Kong strategy for the brokerage CLSA, agreed, adding that the market still likes to look at industrial indicators, which have become less stable.
“One thing that people aren’t looking at is the service sector. That’s still plugging along. It’s the biggest part of the economy, it’s creating jobs, and so far it’s holding up okay,” Cheung said. That dichotomy – inherent to China’s economic transition – is reflected in recent readings (pdf) from the Caixin/Markit Purchasing Managers’ Index series, which gauges sentiment among executives from hundreds of Chinese firms. Where recent months saw contraction in manufacturing activity, services continued to grow, albeit more slowly.
The IMF paper’s authors also allowed that urban employment’s apparent endurance might have stemmed in part from unemployed rural migrant workers returning home to the countryside, or from the practice of labor-hoarding by state-owned enterprises whose chief duty is often policy rather than profit growth.
These may keep unemployment down in the short-term, but the IMF study’s authors cautioned that failure to reform China’s restrictions on internal migration and its largely immobile pension system would prevent better allocation of labor where it is needed (i.e. employment). They also warned that SOEs holding on to excess labor delays the de-escalation of overcapacity sectors, concluding both short-term buffers could ultimately be a detriment to the national labor market in the medium-term.
Addiction to growth
Cutting such Gordian knots through swift policy action is supposed to be a hallmark of Chinese officials’ pragmatic approach to governance. But meeting GDP growth targets has now served by party mandate as the top indicator of China’s economic performance for so long that failing to deliver could unsettle markets further.
That could hold true even as critics of China’s national GDP figures multiply. A Bloomberg survey of eleven economists yielded a median estimate of 6.3% growth in the year’s first six months, well lower than the official rate of 7%. Looking forward, Goldman Sachs has even cut its 2016 GDP forecast to 6.4%. But here, too, there remains a fixati
on on headline growth that was first encouraged by Beijing. That may be delaying international investors’ adjustment to a China that is no longer a driver of demand in the same sectors as before.
“I think the obsession with growth targets is really what’s driven all this debt growth, and maybe a lack of understanding of what’s driving that growth,” Cheung said. With less emphasis on rapid growth backed by overpriced property valuations, debt growth may finally ease up. Even Wang Jianlin, head of property-focused conglomerate Dalian Wanda and China’s richest man, told South China Morning Post that China should drop high-growth rate targets and “just accept 6%, 7%, or even 5%.”
That realization may take a while to sink in among investors still pining for the old status quo. Evans-Pritchard said the failed equities rescue had also put more pressure on policymakers to engineer an economic rebound, targeting flagging sectors with more stimulus to restore faith in their ability to at least shore up China’s economy, if not its more feral financial market.
Yet while reforms that don’t help boost the headline figure may now be on the back burner, none of those interviewed expected policymakers to completely abandon reforms aimed at rebalancing away from credit and toward consumption. “I wouldn’t say they’ve given up on those goals, just that suddenly the short-run downsides have come to the fore,” Evans-Pritchard said.
Nor are officials without recourse when struggling to meet an increasingly arbitrary target of their own making. Monday’s surprise GDP revision, which lowered the 2014 figure from 7.4% to 7.3%, also lowers the basis of comparison for growth this year. That might make achieving 7% growth in 2015 a little easier.
Balancing the books
Taking the long view on policy may help calm investors’ market-battered nerves. As banks and brokerages pump money into the stock market and China’s central bank sells off holdings to maintain the RMB’s peg, however, those focused on the here and now are raising questions over whether China’s balance sheet can handle the weight.
In February, the McKinsey Global Institute published a report suggesting China’s overall debt ratio appeared manageable, “although it is now higher in proportion to GDP than that of the United States, Germany, or Canada.” Of an estimated US$28.2 trillion owed, the report estimated that 40-45% of loans were linked to real estate while about 30% were from the shadow banking sector; the true extent of local government debt is tangled up in the business of both by dint of economic history.
Local governments were banned from borrowing directly from 1993 until 2014. Instead, shell companies called local government financing vehicles used government land as collateral for loans to fund infrastructure projects. Local governments also generated revenue by selling public land to developers that built projects on it to be sold for profit (often themselves using borrowed money).
Thus the debt burden of the 2008 stimulus fell mostly on local governments, whose only collateral and most valuable commodity evaporated when mainland property markets entered a correction last year.
“It’s human nature,” Cheung said. People “keep doing what they’ve been doing because it’s been successful. Until they can’t. And in 2014 they couldn’t because of the property correction, and that forced a change.” Regulations have been overhauled to allow localities to issue bonds directly, but few buyers are willing, and the total new debt allowed for the year’s remainder was recently capped at just RMB600 billion.
Cheung said that he wasn’t too concerned about China coming up short based on his research into the assets Beijing had on hand for dealing with such liabilities, which will be published in an upcoming report. While China’s debt is a serious issue, he believes the country “has a very strong balance sheet to offset it, probably stronger than most countries in the world.”
Yet there are serious lessons that need to be learned from the central government’s attempted market rescue and confusing new currency regime. Beijing especially needs to realize how such moves might reverberate through both domestic and global economies that can bounce the effects of policy decisions right back into policymakers’ faces.
“China is no longer a country which only needs to deal with its internal issues,” said Dan Luo, an assistant professor of economics and finance at the University of Nottingham’s School of Contemporary Chinese Studies. That will make policy communication key, she said, if officials want to prevent senators in Washington from seizing on future policy adjustments for political gain.
In the case of the yuan’s devaluation, she said, China’s central bank had not expected markets to interpret the move as a desperate bid to boost exports for lack of a better option. The resulting tumble caught regulators off-guard, forcing them to combat more severe devaluation with market-based measures like selling off US Treasuries.
That last part is key, as it indicates that the new mechanism for determining the yuan’s trading midpoint is a real step toward a fully floated currency and away from fixing by fiat. It also means that such support can’t go on forever: The yuan will eventually have to find its own floor when the central bank can’t afford to sell off any more foreign exchange reserves.
Dan also said regulators had overestimated the maturity of mainland stock exchanges as a tool for direct financing that could provide an efficient alternative to bank-based credit allocation. She cited mainland-listed firms’ “extremely low dividend payout rate” as one key source of volatility: Since the only value to be made for investors comes from share prices, they have no reason to hold onto a stock if share prices drop.
Since a functional stock market is impossible until share prices are finally allowed to find a floor, Dan suggested there was little chance that China’s current bank-dominated financial system would be supplanted in the near future. Thus, she added, “policies need to be proposed to encourage the healthy development of other non-conventional financial institutions,” lest the funding needs of smaller firms that help drive economic growth go unmet.
Ma, at the Paulson Institute, shared other observers’ lack of concern over recent developments and skepticism that devaluation was meant to boost exports. Instead he was looking to the party’s fifth plenum, supposedly scheduled for mid-October. “It is ostensibly focused on the 13th five year plan,” he said, “but I think if they come out of that meeting with a strong and clear message of doubling down on
reforms, that’ll boost confidence pretty significantly.”
In the near term such a message, especially if poorly communicated, may lead to more of the economic shocks seen in recent weeks. That could nudge down headline growth even further, and may not play well among international investors who focus solely on growth as a stand-in for economic health. But restructuring China’s economy was never going to be easy.
“Markets seem to like the idea of a successfully reformed Chinese economy,” Ma said, “but they don’t like the actual process of getting there.” ♦
Author: Hudson Lockett (@KangHexin)