China's best hope is that Trump, Wall Street, and the whole world are willing to play pretend
- China's economy is showing signs of extreme stress, and not just because of President Donald Trump's trade war.
- Economic data is showing that China's debt problems are gobbling up cash faster than more Chinese people can become consumers.
- To change this narrative and calm markets, China will have to make a deal with Trump by March 1.
- The deal will likely be a sham.
- But the best outcome for China is that Trump pretends it's good so that he can declare victory, and Wall Street and the rest of the world can pretend China's economy has a catalyst for recovery.
China's best hope for stabilizing its economy is a massive, coordinated, global game of pretend.
Here's what that would look like: On March 1, Trump's administration emerges victorious from its trade talks with Beijing. It strikes some sort of deal that fundamentally changes what China's leaders have been planning for and investing in their their economy for years, and helps US companies with issues like Chinese intellectual-property theft and forced joint ventures.
Then, Wall Street deems it safe to go back into China's waters and foreign investment starts pouring in while domestic money stops heading out.
After that we can all pretend the Chinese economy doesn't have dangerous structural issues that threaten to pull parts of the world into recession - at least for a while.
This is the best we can do.
For the last week or so - since Apple warned about weakness in the Chinese economy affecting its revenue going forward - Wall Street and Washington have been debating whether or not China's economic troubles are mostly being caused by Trump's trade war.
They are not. That is why all we have left is pretend.
Bank of America
It's the foundation
Let's go back to what China has been saying it was going to do with its economy for years now, which is switch it from one based on investment to one based on consumption. That would make China's economy more like the US - more able to support its own growth on the back of consumer buying power.
It's not there yet. Not by a long shot.
That means for the economy to keep growing, it still very much needs outside investment and consumption. Or it needs to keep handing out credit and letting debt build up. The latter is dangerous. The more debt that builds up in the system, the more money is spent paying it rather than doing more productive things.
The more debt that builds up, the slower the economy goes until it grinds down to stall speed.
And so a few years ago,Chinese leaders said they were going to slow credit creation and clamp down on shadow banking. Last year was supposed to be the year we saw the fruits of that labor. But it wasn't, the economy started sputtering in June. And according to Leland Miller, the founder of survey firm China Beige Book, only private firms ever slowed their borrowing, and not for long.
"Halfway through 2017 private firms were already dialing back their hiring, borrowing, and investing, but not SOEs [state owned enterprises], they kept their pedal to the metal all the way into 2018," he told Business Insider. "So a 2018 slowdown was inevitable regardless of what was happening around the globe, or with Trump trade."
If you pay attention to Chinese media, this is something entrepreneurs have been angry about. Many feel that they've had to take on all the burden of China's credit reforms even though state-owned enterprises hold most of the debt. According to the Chinese credit-rating agency Chengxin, 83% of the companies that have defaulted on debt payment since 2014 are private. They're the ones dealing with all the moral hazard.
And so billionaire tycoons like Chen Hongtian, founder of Cheung Kei Group, are predicting "the difficulties will be larger than expected" going forward. That's what he told a gathering of The Harmony Club, a Shenzen-based group of 150 of China's richest businessmen.
"The winter will be very cold," he said according to the South China Morning Post. "I would like to remind again … it's hard to predict and all that I can say is that difficulties [for private enterprises] are much bigger than people expected."
So in China we have more and more good money chasing a growing pile of bad money. Policymakers have tried to enact measures targeted at private and smaller businesses to free up more good cash. Tax cuts, for example. But they haven't done anything to turn the economy around. Most recently, policymakers announced a cut in Chinese banks' reserve ratio requirement, but Miller says a lack of access to credit has never been the problem, so it won't be the solution.
All Trump's trade war has done is make this even worse. For one thing, it has added a measure of uncertainty that has scared off China's much-needed foreign investors. Foreign direct investment plummeted to $25.2 billion in Q3 from $52.7 billion in Q2, and Citigroup estimates that about $26.2 billion left China over the same period.
"The current weakness is not due primarily to the trade war," Miller said. "It's a major pressure point, certainly, but much of the weakness we picked up this year - particularly in manufacturing - predates the imposition of large scale tariffs.
"A March 1st US-China trade agreement would relieve a great deal of uncertainty from the rest of 2019, but it would only keep things from getting worse, not necessarily help the economy get better."
Come play with us
So China's best near-term hope is that this trade war ends, and that -true or not- China bulls on Wall Street can sound the all clear to get back in the water.
To achieve this, policymakers have three options:
- Cave to Trump's demands and significantly and transparently change the course of its economy. This would be a massive admission of defeat.
- Pretend to cave to Trump's demands and risk a return to war in the future if their game is found out.
- Kick the can down the road and wait for another, kinder administration in the US. This risks freaking out financial markets as investors get doubtful of, or impatient with progress. In the meantime, the Chinese economy will suffer.
It's not hard to see that pretending, if China can pull it off, is the best solution for the time being. So trade negotiators will be looking out for loopholes and hollow wins. The head of Trump's trade delegation, Robert Lighthizer, seems adamant that the president will not accept those as total victory.
But Trump loves (at least to claim) victory, so maybe he'll decide to play along with China.
And maybe, since Wall Street loves fast cash and stability, it'll take "the trade war is over" narrative and run with it, pouring much needed investment back into the country.
That's the absolute best case here, and it's vapor.
Remarkable graphic showing that even though China rebalancing has made some progress, it is light years away and structurally a country mile from its developed and emerging peers. 1/n pic.twitter.com/rJQ4H4wbOS- George Magnus (@georgemagnus1) January 6, 2019
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