The most important idea holding China's economy together is being tested like never before
- China's leaders have spent years convincing the world that they're ready to handle a slower growing, more volatile economy.
- But President Donald Trump's trade war against the country is adding an unexpected, so-far uncontrollable level of difficulty for policymakers and uncertainty to the global financial community.
- That may set China's economy up for the worst kind of crisis it could ever face - a crisis of faith.
With every day that passes it seems more likely the US and China will not be able to avert a full-scale trade war.
On the US side, President Donald Trump recently announced his willingness to put tariffs on all of China's exports to the United States by January. Meanwhile, in Beijing, The South China Morning Post reports that think tanks are struggling to have honest conversations with legislators about how to proceed with trade negotiations, afraid that criticism of the Chinese economic model or the government's handling of trade talks thus far may get them in trouble.Frank communication, as things stand now, seem to be in short supply all around. One day, Chinese President Xi Jinping and Trump seem to be hashing it out; the next, the market is sliding again.
This year was already turning into a difficult one for Chinese economic policymakers. After a steady start to 2018 the country's economy started slowing dramatically in the second half of the year - a long expected result of China's financial-system reform, an attempt to ween itself off of the debt gorge that kept its economy growing through the Great Financial Crisis.
Analysts expected that particular kind of hiccup. Beijing has been preparing the world for a more volatile, slower growing Chinese economy for years now, and by and large they've convinced the world that they can handle that.
What they did not expect, however, was how the added pressure of a trade war - the drama of continued failed negotiations - would exacerbate the situation.
"For China, signs of a further slide in growth and threats of expanded tariffs from the U.S. are an unfortunate combination," noted Bloomberg chief economist Tom Orlik. "So far, Beijing has managed to find policies that combine targeted stimulus with steps toward reform. If demand continues to deteriorate, threading that needle will get harder to do."
Now China's currency, the yuan, is falling to its lowest level against the dollar in a decade, and Beijing is pledging to fight to keep it afloat. China's property market, the engine of its economy, is flailing as housing sales fell 3.6% in September, and property investment - half of the country's overall investment - is likely to follow. The stock market is crashing - the Shanghai Composite is down over 21% year to date - and warning signs in sectors like automobiles and manufacturing are flashing.This is a test for the brains behind China's economy. Not since the late 1990s/early 2000s has it been this weak in the face of a potential disaster. How policymakers handle this could change the way the entire global financial community thinks about their ability to deal with crisis.
This could turn into a crisis of faith, challenging the most important idea holding China's economy together - I call it, the "they've got this," theory of Chinese economics.
Chill, they've got this
The "they've got this" theory of Chinese economics goes like this: While democratic capitalism is nice, authoritarian state planning has its benefits - and one of those benefits is that the smartest people with all the answers are running China's economy. They get to guide it as they please, and so far they have had the correct policy mix in place to avert all of the little disasters that have emanated from the economy since things started getting really hairy in 2015.
And so in the event that something major happens don't worry y'all, "they've got this."
You hear this thesis in academic circles and at hedge fund conferences and among the thinkers at certain think tanks. Even famed investor Ray Dalio, founder of the world's largest hedge fund Bridgewater Associates, is a proponent of this notion. While in China last February, he preferred to avoid direct questions about the economy, according to The Wall Street Journal, saying only that he was "very bullish" on China and that the issue wasn't the challenges but the way they were handled.
And Beijing has the best handlers in the business, so the theory goes.
On the other hand - and this post is very much about the other hand - what if they don't? This "they've got this" type thinking, after all, was the reasoning behind why the USSR was such an economic success until it very much wasn't. So it may be for China.Now that an incredibly disruptive trade war has been thrown into the mix with an already complicated reform agenda, the prospect that Chinese policymakers lose the "they've got this" benefit of the doubt is very much in play.
Over at the Center for Strategic and International Studies, authors Logan Wright and Daniel Rosen examined the slow creation (and potential destruction) of China's "they've got this" narrative in a paper called "Credit and Credibility; Risks to China's Resilience."
They explain it like this:
"...traditional explanations of China's financial stability underestimate the vital importance of Beijing's credibility in providing a sufficient government response to any financial stress. Credibility has been a powerful political asset reinforcing financial stability, but it is not intrinsic to China's system.
Credibility is a byproduct of a track record of successful and meaningful interventions defending investors' interests, and this same credibility will be tested as China reforms its financial system and steps back from widespread implicit and explicit guarantees on assets, companies, and banks...
Credibility has helped Beijing to manage the typical consequences of rapid credit expansions, but this credibility is transient and will be taxed in the near future as financial reform proceeds."
Stop, you're doing too much
Now enter the trade war.
Current, unexpected, circumstances are pushing policymakers to return to what got them in this situation and hurts their credibility - loosening credit conditions.
On the one hand, Chinese news outlets are reassuring investors that the economy is still on the path to reform and that they're going to stick to their guns despite what looks like a dreadful situation.
On the other hand, there are signs that policy could be moving in the opposite direction. In a note to clients earlier this month, analysts at Societe Generale acknowledged that the country experienced a surge in local government bonds in August and September. Earlier this week the People's Bank of China released more guidance on boosting infrastructure investment. Around the same time, The China Banking and Insurance Regulatory Commission asked banks to boost their lending of unsecured or uncolateralized loans to private enterprises.Now to be fair, private enterprises in China are not in the same debt trouble as its massive state-owned enterprises (SOEs). And policymakers are saying that the stimulus efforts they've made so far (like a recent tax cut) are targeted at private enterprises and households. Therefore, they're not a return to old habits, and they're not going to fortify "zombie" companies - profitless SOEs that need credit to survive.
China takes a "whole of society" view of national interest in all capacities, and has shown a commitment to marshaling any and all of the resources in its economy in the face of this debt crisis. For example, the government has urged healthy private companies to take ownership stakes in struggling SOEs in the past.
Either way, recent data from private surveyor China Beige Book contradicts the government line that only private enterprises are getting credit help.
"...corporate borrowing isn't sliding - it exploded in Q3 to the highest level we've seen since 2013," the company said in its latest quarterly report.
"A rise in borrowing by small and medium-sized enterprises could have been expected, with the PBOC urging as much seemingly every week. But this quarter everyone borrowed more. Large firms saw borrowing rocket skyward. By sector, manufacturers borrowed at a frenzied pace, while property firms borrowed at a 5-year high."
Perhaps this is why in a recent note, analysts at Societe Generale noted a "puzzling strength in manufacturing investment" despite the fact that manufacturing output slowed from 6.7% in 2Q to 6.0% in 3Q and continues to be in a downtrend. It also seemed strange to them that real estate investment was still resilient despite declining property values.
"They're back to their old formula... it's not 2009, 2010 but it's remarkable to hear the narrative - which is that conditions are tight and corporates can't get credit. They're investing a lot more than what people say. Official data is more negative than what we saw in China Beige Book Q3."
A downturn, with Chinese characteristics
Obviously, whatever the government is doing hasn't been enough to beat back China's economic slump, suggesting that introducing new credit to the economy is becoming a less and less effective jolt as debt builds up.
But what else is there to do? A lot could go wrong before the US and China come to any sort of agreement at Xi and Trump's meeting at the G20 at the end of this month.
For example, China's September export numbers looked good, in part, because exporters were front loading orders to the US ahead of more trade war action. That is to say we haven't even seen the full impact of Trump's trade war measure in the data yet.
Meanwhile, we're seeing personal consumption - something Chinese authorities have been trying so hard to build up in order to modernize the economy - take a hit already.
From Societe Generale:"...the 3Q data suggest that domestic demand - primarily consumer demand - became less supportive of growth over the quarter, more than offsetting the improvement in net trade.
The year-to-date contribution from consumption (including both households and government) to headline GDP growth slipped from 5.34pp to 5.23pp, while the input from net trade inched up from -0.67pp to -0.66pp."
This is especially disconcerting data for China this week. On Monday, Xi kicked off a six-day expo in Shanghai meant to showcase the country as a buyer of international goods. Unfortunately, according to the New York Times, the event was poorly attended. Big trading countries like Germany, Japan, and the US didn't show. One attendee, the President of Kenya, complained that his country's trading relationship with Beijing was "heavily skewed in favor of China."
Now, more than ever, China needs friends -even more specifically, friends who still believe "they've got this."