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The Question China Has To Answer Fast to Save Its Economy

Dan Denning wrote on Monday in his article on the Australian share market that there is a brutal one-two punch combo coming towards the average portfolio this year. The first swing is the European credit crisis affecting the Australian banks. The second bit of biffo is the Australian resources sector falling because of China’s economy.

We’ll take it for granted you’ve had your fill of the European debacle. It’s been a constant story for weeks. So today we’d like to follow up on the idea of a China punch coming our way. To do that, we’re going to call upon your regular Daily Reckoning editor Greg Canavan.

But first! It might sound strange to even question the Chinese growth story at all. Although a recent Chinese manufacturing survey revealed a decline for the eighth month in a row, HSBC chief economist Hongbin Qu said positively (as probably only an economist can):

 ‘It is all about growth and employment. As external demand has weakened and domestic demand hasn’t shown a meaningful improvement in response to earlier easing measures, growth is likely to be on track for further slowdown, hence weighing on the jobs market. But as inflation eases sharply, Beijing has plenty of room and policy ammunition to avoid a hard landing. We expect more decisive easing efforts to come through in the coming months.

That’s economist-speak to say the economy isn’t going so flash, but the government will pump some more money in to ramp it back up again, so it’s all good. Underlying this is the idea that the government can manipulate the whole shebang. But there doesn’t seem to be much evidence that the last massive economic stimulus produced any benefit.

In fact, it’s probably completely the opposite. As the Financial Times reported a few days ago:

The flood of liquidity and the building boom it unleashed then led to countless inefficient investments across the country, particularly in residential real estate and grand infrastructure projects that are now weighing on local government finances and the balance sheets of state banks.

So, it appears that China’s economy has dug a hole for itself. The question is, can it get out?

To try to answer that question, we sat down with Sound Money. Sound Investments editor Greg Canavan. He has been researching the Chinese economy deeply over the last year. In October 2011, he warned his subscribers about the coming China slowdown, and recommended avoiding the resource sector.

CN: In your last report on China, back in March, you mentioned how the Chinese Communist Party puts ‘people before profits’. What did you mean by this?

GC: China’s economic growth is politically motivated. The Communist Party’s mantra is social stability. It’s this stability that allows them to retain their grip on power. It’s what allows them to live a very privileged existence. To maintain stability, ‘The Party’ must provide jobs. An employed and well-fed populace won’t take to the streets demanding change.

So employment is the main focus for China’s leadership…even if employment comes at the expense of profits. And this is exactly what is happening in China’s economy now. They’re pumping billions of dollars into uneconomic projects purely to maintain short term stability, but it’s causing major long term distortions. Much of China’s growth is fake. They’re practising a retarded form of capitalism. Putting people before profits only works in the short run. In the long run, it catches up with you. The long run has arrived in China.

CN: Economists and Western media expect China to increase their stimulus efforts…and that this will avoid a hard landing. Do you think this is possible?

GC: China’s trying to rebalance its economy from investment to consumption. More stimulus will not help with this transition. It will only exacerbate the imbalances. So lower interest rates or reserve requirements or whatever might help in the short term, but they won’t help China to make the transition that China desperately wants to make. They know ever greater imbalances will only foment social instability down the track…which is a threat to their grip on power. They know the old growth model is dead. They’re just not sure how to make the transition.

And if you look at the long term performance of the Shanghai Stock Exchange, you’ll see that investors are not holding out too much hope for stimulus to be very effective. The index is in an obvious downtrend. This chart goes a long way toward explaining why the Aussie market has performed so poorly in recent years.

Shanghai Stock Exchange Ten Year Chart

Shanghai Stock Exchange Ten Year Chart

Source: StockCharts

In short, I think China can delay a hard landing by firing more monetary ‘ammunition’, but they’ll be shooting blanks. The transition period, or rebalancing of the Chinese economy, won’t be pretty.

CN: But won’t lower interest rates stimulate consumer spending and help with the transition?

GC: No. China’s financial system is not like the West. Due to capital controls and the lack of a social safety net, the Chinese save a decent proportion of their wage. These savings flow into the banking system. Lowering the rate of interest actually lowers the return on their savings. So instead of stimulating spending it may actually discourage it.

The other point to take into account is that these savings actually finance all the loans made by banks for dodgy infrastructure spending. Encouraging consumption explicitly encourages the withdrawal of these savings. A rapid removal of even a portion of these savings would lead to the collapse of China’s economy.

There’s no easy way out for China. The transition from commodity intensive, infrastructure led growth to more focus on domestic demand will be very difficult to achieve. And because we’re relying on bureaucrats and politicians to pull it off, I’m not particularly hopeful.

CN: So you’re saying there’s nothing that China can do to make this inevitable transition smoother for itself, and by implication, Australia?

GC: Pretty much, yes. Although I think there is one thing China can do…and more importantly is doing…to mitigate some of the fallout. It’s very involved, so I won’t go into the details here, but it’s all about attempting to maintain social stability…so the Communist party can hold onto power.

To sum up, China’s old growth model is dead. That’s bad news for Australia, because we benefited from it handsomely over the past decade. The transition won’t be pretty, but there is a flicker of light at the end of the tunnel. Stay tuned for more on that in the coming days.

Regards,

Callum Newman

for The Daily Reckoning Australia 

From the Archives…

The Biggest Fraud in Economics
2012-06-29 – Bill Bonner

Why India is Buying Gold
2012-06-28 – Greg Canavan

Is the Silver Price Finally Bottoming Out?
2012-06-27 – Tim Staermose

A Giant Game of Currency Chess
2012-06-26 – Dan Denning

An Open Letter to the Fed: What’s Your Number Ben Bernanke?
2012-06-25 – Keith Fitz-Gerald

4 Comments

  1. Ross says:

    Callum grounds his theory with the naive view that there are market economies and that such markets with inherent flexibilities have acted to safeguard malinvestment in the modern era.

    Poppycock mate. Such theories haven’t been evidenced in practice since the New Deal, if ever.

    The Chinese learnt everything they know from the western corporatists and are playing that same game using the cards given them.

    Whether it’s Kennedy era unfunded liabilities, Volcker exporting the Brown belt and having brand owning mates importing deflationary mercantile goods at higher profits to offset his massive public deficit growth, Japanese real estate asset bubbles, or Rubin-Summers funny money, and the all pervasive inflation printing and carry trade exporting of USDs to maintain debt fueled consumption in white western homes while creating and milking asset bubbles in emerging and resource economies.

    China is a taker and not a maker of all those positions above. It took the industrial growth given to it by cowardly US grubs that wouldn’t face the need to improve education or productivity among their blue collar working class and the blue bloods wouldn’t accept the fall of profits or decline of their military industrial estate and hence imperial hegemony. China recycled the phony USD paper and paid a tax upon it in the form of higher USD input/commodity prices. They kept their capital controls because they, like “recalcitrant Mahatir” fully knew the consequences of allowing carry trade induced asset inflation and what it would do to their people’s savings.

    And yes some of what you say is correct. So what? In terms of consequences it is one bunch of corporatists playing among a field of them. In this game however, when the music stops and the finger pointing starts there will be a war like never before. Right now everyone, including the Chinese are trying to kick that can down the road without having a clue on how to reintroduce free market economics because they all know the consequences of the liquidation of their b/s positions.

  2. Kalabairava says:

    Ross,

    If you live by keynesian economics, you will have to take what it gives. I agree that while it may be true that flexible economies may not be able to adjust malinvestments, I do not understand the logic behind your allegation of naivity and proof.

    Keynesian economics, assumes certain premise and predicts certain outcome. There is no use in now fighiting over whether keynes was right or wrong.

    As callum has correctly pointed out, the transition from production oriented to consumption oriented economy is a very gradual process as it involves change in mindset of individuals. A increase in credit alone cannot convert an economy into a consumption oriented one.

    The converse is also similar, Australia simply cannot live without exports of uranium and coal. It is difficult now to change the nature of the australian economy as an import oriented economy.

    But i do agree with you on one thing, china can kick the can the farthest with its 3 trillion bucks in reserve (if it is worth that much).

  3. Wingnut says:

    “But first! It might sound”

    But first, learn sentence structure. :)

  4. Ross says:

    @Kalabairava,

    Nice to make your acquaintance. I believe the point of contention arises from your use of the words “flexible economies” to describe western economies that I contend have been only been flexible on one side of their ledger and hence Keynesian theory (kicking the can down the road and pump priming). In every one of the turning points from the 1960 recession and the beginning of the US’s unfunded liabilities onwards there has always been someone there with a Greenspan put trick. He didn’t invent that responsive course. He followed a well established tradition.

    On “A increase in credit alone cannot convert an economy into a consumption oriented one.”

    I agree. In China’s case the issue is personal savings. They enjoy consumer goods at the rate moderated by that issue. Debt is oriented toward enterprise in China (for good and bad). Germany and Japan didn’t change their savings culture despite being whacked.

    On “It is difficult now to change the nature of the australian economy as an import oriented economy.”

    You must be reading this article from afar. Australia is an import oriented economy in all except the resources industries. It is incredible that we are now even a net importer of food.

    What Australia cannot live without is a flood of badly risk rated funny money carry trade sourced debt that sustains its asset price bubble and services/consumption driven economy.

    Perhaps to restate my opinion, I too believe in the ideal of the market economy, but the western hegemony have long refused to play by those rules. As long as the USD stands as the defacto global reserve currency then no emerging economy can either.

    Until such a time that is, as Paul Kennedy says in The Rise and Fall of Great Powers, and unless the Western regimes are overthrown from within due to the income disparities, they will certainly fall if they lose the balance of power in their mobilised potential (their economic/production capacity).

    I do fear what wingnut would make of my text!

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