China’s Great Rebalancing Act

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China’s Great Rebalancing Act

The government is at last showing signs of resolve, but the road ahead will be testing.

The rebalancing of China’s economy could well be one of the most profound stories of the early 21st century. If the rebalancing efforts fail, the significance will be much greater. After years of false starts, it appears that this epic process may finally be getting underway in earnest. At the very least, China’s leaders are making the right noises.

In China’s context, rebalancing implies the complicated and difficult process of lowering investment levels, increasing household consumption, reducing the role of the state sector, and significantly altering the way credit is allocated. Complicating this mission is an environmental crisis, the weak global economic backdrop, serious inequality within the population, widespread corruption, a tough real estate market, and the growing mountain of debt in China’s sprawling, distorted financial system. Despite these challenges, the rebalancing process must be undertaken soon if China is to achieve sustainable growth in the future, allowing it to continue its re-emergence onto the global stage and deliver on the ever-increasing economic expectations of its people.

Two key factors jump out as one considers how this process must proceed. First and foremost, strong political resolve will be vital for successful rebalancing. Moreover, there will be unexpected negative consequences that will cause various players to adjust their expectations and behavior in reaction to the changes that emerge. Knowing when to counteract these negative shocks and when to let them run their course will be an unenviable and delicate balancing act unto itself.

Recent events have illustrated potential and inevitable difficulties in this ongoing process. A cash crunch in China’s interbank markets caused a mild panic as well as several failed debt auctions (including by the Ministry of Finance and the Agricultural Development Bank of China). Growth rates and other data are worsening, prompting downgrades to growth forecasts and even a sovereign debt downgrade by Fitchearlier this year.

Although growth has moderated from the double-digit highs of the previous decade, even maintaining more comfortable high single-digit GDP figures is proving increasingly tough, despite credit growth spiraling at more than 30 percent per year since the global financial crisis. As the limits of over-investment and overcapacity are reached, a rebalancing is ever more urgent. The alternative is a larger debt crisis and collapse in growth down the line.

In order to rebalance away from inefficient and increasingly wealth destroying investment-driven growth, China’s consumption rates must grow faster than GDP for many years, as has long been argued by Peking University’s Michael Pettis. The difficulty is that China’s economic and financial system is heavily skewed towards supporting production and investment at the expense of consumption and household income.

This distortion is based on the provision of subsidized credit to often-inefficient firms through financial repression, an undervalued currency that helps exporters at the expense of everyone else, the transfer of wealth from households to companies through inadequately compensated land seizures (the source of much unrest at the local level), and wage growth significantly lagging productivity levels.

Rebalancing all this will not be easy.

Why? First consider the issue through the prism of “political resolve.” Subsidies, be they implicit or explicit, as well as ever increasing amounts of easy credit, have been addictive. What’s more, they have been allowed to continue for so long that “addict” sectors and industries (particularly state-owned enterprises with better credit access) have grown out of proportion—both in terms of their importance to the economy and their influence in China’s political patronage system. Examples are numerous, but shipbuilding, steel, aluminum and the solar industry are most often cited.

This resolve has been found wanting in the past. Former Premier Wen Jiabao talked many times about tackling China’s “unbalanced, uncoordinated, and unsustainable” economy and the associated real estate bubble, but ultimately, Wen’s government was unable to deliver. Increasing consumption was included as a goal in the last five year plan, and had been discussed by various leaders for years. Again, changes thus far have not been sufficient, and consumption remains relatively weak.

Part of the reason was that the comfortable external environment which had been absorbing much of China’s overproduction collapsed in 2008, just as consensus for change in China was building. The post-crisis stimulus unleashed yet more credit and investment, principally aimed at avoiding the biggest fear of China’s leaders – a growth slowdown and unemployment – rather than at putting the economy on a more sustainable, balanced path. Rescuing growth meant a big step backward in nascent financial sector reform. Since 2009, every time measures were introduced to tighten and restrict normal or “shadow” credit, to control the property sector or to rein in local government debt, the subsequent falls in growth rates and feared employment effects prompted U-turns and delays in proposed policies. The resulting piecemeal measures prevented China from rebalancing, and indeed runaway credit growth has continued. Now, time is running out.

The result: One of the biggest questions currently facing the global economy is whether or not the new government of Premier Li Keqiang and President Xi Jinping in Beijing has the necessary political capital (or confidence) to push through the painful rebalancing against entrenched interests and inertia in local governments, state owned enterprises, the export sector and indeed the financial system itself.

On the latter target, the People’s Bank of China (PBOC) appeared to show a great deal of resolve when it recently refused to come to the aid of China’s interbank and money markets as rates spiked and pressures grew. Since then, its stance has apparently moderated slightly but as the potential significance of the new less-supportivereality set in, China’s stock market investors panicked, sending the country’s main indices tumbling.

Yet, here is an example of the second factor affecting China’s rebalancing: As the economy adjusts, the reactions and behavior of various players will have unexpected consequences that could exacerbate any slowdown or increase instability. For example, the recent fall in China’s stock markets effectively delayed the plans of many medium sized Chinese banks to list shares in Hong Kong. At the time of writing, current valuations would breach rules that forbid them listing at low price-to-book ratios. The knock-on effects on their capital raising, and thus business, are significant. This situation may reverse, but it is still illustrative of the kind of unexpected consequences that can ripple out from any attempts to rebalance the economy.

Equally, as the China “high-growth story” ends, forecasts are downgraded, and headlines turn negative, it would not be surprising for both foreign and domestic players to reduce their investment and expansion plans for China. Reduced investment, while a desirable part of rebalancing, must also reduce GDP growth (absent an offsetting increase in consumption, exports or government spending). This is one of the reasons why China must slow. Yet such a “feedback” loop could push things too far and result in investment collapsing rather than reducing in an orderly, easy-to-manage fashion. Indeed, some genuinely productive investment could disappear alongside the waste as expectations about the country’s outlook change and pessimism replaces the previous euphoria.

The long journey of rebalancing on which China must embark contains numerous potential negative feedback loops, all of which will challenge political resolve. Nowhere is the potential for disruption as high as in the country’s distorted and opaque financial system.

The PBOC’s aforementioned panic-inducing squeeze on the interbank markets was aimed at parts of the shadow banking system enabling irresponsible lending, specifically wealth management products (WMPs), and the use of reverse repurchase agreements (reverse repos) to avoid regulatory risk controls. Credit (especially the shadow kind) is being used to roll-over non-performing loans. Any crackdown will seriously hit both corporate and financial sector balance sheets. Even if no bank is allowed to collapse, recapitalizing them (again) will hit existing shareholders. Recent bank share price drops are entirely justified.

Another area of financial concern is China’s domestic bond market, which has still not seen a “real default” in which bondholders have been forced to take significant losses. This process is a necessary step if China is to achieve its goal of improving the bond market’s ability to price risk, raise funds, and allocate them to worthy borrowers. However, when the first such cases occur, they will shift the risk-benefit calculations of all bondholders. Again, the results could be as hard to manage as they are unpredictable.

Yet another potential area where unexpected consequences or feedback loops could hit is the property sector. Closely connected to the financial system, efforts to control the property market always cause concern. Indeed this fear is probably responsible for the persistent failure of the government to effectively tackle the runaway real estate market, despite several policies and numerous statements signaling an intent to do so. Whether the local bubbles pop or are gradually deflated, the construction sector affects not only its associated industries and employment, but also the value of the land which local governments have used to capitalize their financing platforms.

A tremendous amount of political resolve is necessary to stay the course through slowing growth, numerous potential mini-panics, and employment shocks. However, the alternative would prove genuinely disastrous. Although put off for many years, it seems China’s difficult rebalancing process may finally be underway.