By now everyone should be familiar with the argument against China.
We’re talking gaping spare capacity, a real-estate bubble, an import slowdown, short-term dollar shortage, horrible manufacturing stats, commodities over-exposure and well, just see this interview with Jim Chanos for more on how nobody in China earns their cost of capital.
But what if…
… none of that matters?
In December last year our colleague John McDermott posted findings from a paper by Carmen M. Reinhart and M. Belen Sbrancia entitled The Liquidation of Government Debt which introduced, we think, a very important development in the crisis. The growing role and importance of financial repression.
It all comes down to how economies reduce debt-to-GDP ratios, with Reinhart and Sbranica identifying five key possibilities:
1. Boosting economic growth;
3. Default, or restructuring of public/private debt;
4. “A sudden surprise burst in inflation”; or
5. “A steady dosage of financial repression that is accompanied by an equally steady dosage of inflation”.
Lacking economic growth, no will for austerity, fear of default stigma and no prospect for a sudden burst of inflation, the onus increasingly falls on option 5, financial repression, to get us out of the crisis.
As John highlighted:
“‘Financial Repression’, means limits on interest rates and the direction of lending to the government by a captive domestic audience, say the authors. This can be the result of subtle (e.g. through ceilings imposed by the central bank on commercial bank lending rates) or less subtle (e.g. state ownership of banks) policies. For example, the authors cite Regulation Q, which capped interest rates on savings deposits, and the “forced home bias” regulations on portfolios under the Bretton Woods arrangements.
Anything, really, that uses a domestic audience to keep nominal rates lower than they otherwise would be in order to erode the real value of government debt. (Hence why it’s most potent with a burst of inflation.) When real interest rates are negative this equates to a transfer from savers/creditors to borrowers, which in the authors’ case is the government.
Keep that in mind as we now reconsider the situation in China.
Here follow extracts from an absolutely fascinating note from Australian analyst James White at Colonial First State, which argues extremely convincingly that none of the usual economic arguments apply to a country that has transcended the conventional role of capital. In short, nobody does financial repression like the Chinese.
As White explains in the introduction (our emphasis):
China’s rise confounds economic history, but not necessarily economic theory. At the heart of growth is a focus on capital investment in infrastructure, designed to create more productive lives, funded by a government which may bear losses but is capable of capturing the still positive side-effects (externalities) from rising tax revenues. In addition, the government is more removed from activity in the consumer sector where it promotes a competitive industrial landscape designed to lower the cost of living for households. These foundations seem brittle to western investors used to judging the health of an economy through the returns on capital. But the Chinese are comfortable with low capital returns if the pay-off is a stronger economy. This has been the case.
As he goes on:
The Chinese don’t play chess. They play wei qi. Wei qi is a game of strategy played on a larger board with black and white pieces each of equal value. The Chinese government views the economy as though it’s wei qi. Each piece has its own role in the economy, but each is no more important than another.
This is an important observation. In the developed world, the economy is generally seen through the prism of capital; the stronger the outcome for capital, traditionally, the stronger the perception of the entire economy. Falling or negative returns on capital are a sure sign of economic weakness reflecting the end of a period of over-investment, which is naturally followed by a period of under-investment. This is the business cycle.
In China, capital is just one piece on the board where the aim is to raise living standards of all households. As a result, capital is used and treated remarkably differently, often to the consternation of external observers and investors. It is not a matter of aggregating up the investment decisions of individual firms and households to predict macro-economic outcomes, as was done by some economists prior to the sub-prime crisis in the US. The government’s role is paramount. Despite claims of dramatic imbalances (investment spending has made up to 45% of GDP in recent years, compared to below 15% in some developed economies), investment is driving sustainably higher economic growth. This high investment economy has led to some important outcomes that support the economy’s growth model.
At a macro-level, the higher allocation of capital in China has led to falling profit growth and lower returns for capital. Compared to its BRIC (the Brazilian share market, Russia, India and China) counterparts the Shanghai Composite has been staggeringly bad. Since 2004 Brazil is up 167%, Russia 176%, India 197% but China is up just 46%, despite higher growth rates. Beyond the stock market, 2011 has been punctuated with stories of large capital losses across the economy, including losses by local government financing vehicles established in the Great Stimulus of 2009, property developers and informal lenders based in the coastal cities of Eastern China.
And here’s the crucial point:
At a micro-level, capital is often very well protected in Western markets, relative to the other pieces on the board. Property rights are an important part of capitalism. While property rights are evolving in China, there seems less desire to protect intellectual property rights in areas where it may discourage competition. China views competition as an important means of raising living standards by lowering the cost of goods and services. This encouragement of a hyper-competitive industry structure drives innovation through the threat of failure; there is no carrot for innovation. Investors understand that achieving scale and productivity growth is the only way to sustain a profitable business model. By not using capital returns as a scorecard for economic progress, China improves the allocation of capital in its economy and raises living standards. Effectively, China takes a broader perspective to the value of capital in an economy. Such an approach seems fraught with danger but there’s more protection than global markets seem to understand.
And why capital losses just don’t matter:
First, and most obviously, the government has the ability to fund losses on individual capital projects through the accumulated financial reserves, totalling at least $3.2 trillion. Second, and most importantly, the Chinese government, as ultimate capital allocator, can recoup returns from projects by capturing the positive externalities from projects in the form of higher tax revenues created by higher levels of activity. Third, the failure of individual projects does not discourage investment elsewhere if other projects can still add value to the economy as a whole.
The Chinese government can continue to invest through the business cycle. This has been a crucial driver of stable economic growth despite a number of asset price cycles. As the chart below shows, government tax revenues have risen as a share of nominal GDP; 11% in 1992 to 20% in 2011. This is not to say China can’t or shouldn’t expect returns from individual projects. Undoubtedly, if it had its time again, the Great Stimulus would have been smaller and, probably, better regulated. But similarly, the investment of the past decade will provide dividends for years to come and act as a foundation for the next stage of growth. The result is an economy that has achieved an unparalleled balance of growth and low inflation. As chart 4 shows, China’s economic performance in the last 20 years has been remarkable; very strong growth and low inflation. This is particularly the case when compared with other developed, BRIC and Asian nations. Even current levels of inflation offer much better growth to inflation trade-offs than seen in other BRICs and most developed economies.
And we guess that’s what the string of China bulls who acknowledge the country’s problems but choose to remain upbeat are on about. None of the problems matter. How can they? There is no stigma associated with default nor concern about ‘capital’ relocation.
The Chinese in that respect are like a competitive version of the Doozers in Fraggle Rock. We in the west are more like the individualistic Fraggles.
As White concludes:
China through the prism of financial markets is not a welcoming economy for capital. Capital returns are low because of competition, a closed capital account that makes capital abundant and companies that have more than just financial motives in mind when they invest. It takes some skill to identify those opportunities in China that can offer a sustainable long- term return above the cost of capital. But this frosty welcome is positive for the broader economy. The aggressive use of capital is lowering the cost of living by raising the productivity of firms and individuals and cutting the prices households pay for the goods and services they need and want. The government, as the largest capital allocator, can both manage losses from individual projects and capture the benefits of loss-making projects through its taxcollecting authorities. As has been the case for some time now, capital returns based on China’s growth have been highest in areas where the asset cannot be replicated. Industrial commodities are a classic example.
All of which has definitely got us thinking.
For the full note, see here.
“Financial repression” part II: a critique – FT Alphaville
The negative fear bubble – FT Alphaville
Beyond scarcity – FT Alphaville
A tale of two Chinas – FT Alphaville