“In reality the truth ethic differs widely around the world; and, for an American observer, nowhere are the differences more startling or consequential than in East Asia.”
Eamonn Fingleton, In the Jaws of the Dragon
Commentary & Analysis
The Case for Chinese Reform and Challenge to US dollar Reserve Status
Yesterday, I laid out the case for a Chinese real estate crisis. Lest I be accused of biased thinking (guilty as charged many times over I am sure), today I am sharing the case for Chinese reform and a relatively smooth transition to a more balanced economy. I agree with GaveKal on this issue (and utilized much of their brilliant research in this piece)—reform in China is required if the leadership’s goal (and we know it is) is to surpass the US economy, challenge the US dollar’s reserve status, and create a solid platform for geopolitical dominance. I shared this essay with Black Swan subscribers last week.
China slows but succeeds in its reform process. China has already made progress even though growth is decelerating. In fact, the bullish argument doesn’t argue growth is slowing in China; they agree it will likely slow even more (slowing growth is in fact one indication of reform; a surge in growth is likely the result of another blanket liquidity injection leading to more overcapacity, bad loans, and higher speculation that will only make it harder to avoid a financial crisis).
The economic research firm GaveKal is quite optimistic about the future of China and the leaderships’ ability to reform. They say both the bulls and bears have it all wrong. Yes, China may be entering a difficult transition period, but they will be able to pull it off and spoil the bear party once again. But same token, don’t expect a return to the past in the form of 8-10% growth rates and demand for commodities soaring again.
According to GaveKal, “the old idea that Chinese economic growth is a simple creature of government-directed infrastructure investment” was never correct in the first place. “A better way to understand China today is that it has begun a painful shift from the capital mobilization stage of development to the capital efficiency phase,” they say. So what does that mean?
Instead of relying on what GaveKal coins the efficiencies from “Ricardian” style growth, i.e. the massive dividend from workers moving from their farms to the cities, China must move to “Schumpeterian” style growth, i.e. creative advances and innovation from entrepreneurs in the age of the knowledge revolution.
China’s growth, under the old model, was driven by the inefficient use of massive resources at its disposal: low cost labor and capital and natural resources, the game has changed. Chinese wages are rising fast and China is losing its low cost advantage. Capital is neither free nor abundant thanks to the game changing impact of the credit crunch. And natural resources have been polluted to dramatic proportion.
“If China wants to continue growing, it really only has two options: after labor, corporate structures, land, and commodities, China will need to embrace the new frontier, i.e. the deregulation of capital,” says GaveKal. “The only way to sustain growth is to go for more efficiency, especially through financial sector reform.”
Why will China succeed with reform: “Because China’s leaders wake up every morning pondering how to return China to being the world’s number one economy and geopolitical superpower in its own right,” says GaveKal. That is a powerful motivator. Progress is being made already toward this goal, even if it is a bit stealth-like in nature, i.e. two major changes are already taking place beneath the surface which few are talking about.
One is the fact an increasing share of Chinese exports is going to emerging markets. And these exports are the usual consumer trinkets we tend to think about. These products are high added-value machines emerging markets are employing to build their own infrastructure. Heavy machinery and machine tools at prices which crush developed world competitors – Caterpillar could be in serious trouble.
This is an excerpt of a study from UHY (independent network of accounting and consulting firms):
Gone are the days when foreign companies operating from China predominated in its export market. Now, home-bred Chinese firms are taking the upper hand.
Gone are the days, too, when China was reliant on Western markets for its exported products. Now, Chinese-built markets in emerging markets of the developing world are taking the lead in China's export trade. So much so, that competition from this superpower-in-the-making will look very different in the coming decade.
Ten years from now, Chinese brands will be commonplace in the global commercial landscape, particularly in the world’s increasingly important emerging markets where business opportunities for growth will be the most prevalent.
Already, non-OECD (Organisation for Economic Cooperation and Development) countries account for 36% of the world's imports (2010 figures) — a share that has risen from 25% in 2001. Capital goods, rather than consumer goods, are leading the way.
In the past, competition from China in low-end exports, such as toys and games, helped to produce a disinflationary effect on importing countries. Now that China’s higher-end exports are seeing success in emerging markets, Chinese companies are able to produce such goods relatively cheaply as well. In turn, competitive prices from China force rival global manufacturers to look constantly for ways to add value and stay ahead of the curve.
Some economic analysts say that, despite rapid progress on the technology front, Chinese companies have 'gone to ground' before catching up with the West: under the veneer of a seemingly unstoppable Chinese manufacturing machine, it is suggested, lies a frail foundation.
However, the influential Economist Intelligence Unit forecasts that, as Chinese wages rise and technology progresses, Chinese exporters will move up the value chain and increasingly compete in the core product markets of developed countries.
China is competing and winning as it moves up the value chain.
This suggests the belief China will continue to suffer as consumers in the developed world remained mired in secular deleveraging may be an overplayed mantra. But this growth in exports from China to emerging markets contains another very interesting element few are talking about. This leads us to the second reason GaveKal is confident China’s reform will succeed.
China’s independence and power will be enhanced dramatically with the rapid internationalization of its currency, the renminbi. “The internationalization of the Chinese currency is “potentially one of the most important financial developments. Yet no-one seems to care,” says GaveKal.
China realized after the credit crunch, as dollar credit drained from the globe, just how dependent its trade survival was on the US dollar. This is because most trade is invoiced in dollars. And because China’s exports are going increasingly to emerging markets (the countries that have the hardest time accumulating dollars when global liquidity is in decline), the dollar impact is even more severe. Thus, China has been quietly offering its emerging market clients a convenient way to shift their trade from the dollar to the renminbi: direct lending of renminbi from the Bank of China and use of China’s deep capital market located in Hong Kong—the dim sum bond market.
Thus, countries and companies can utilize the dim sum market to either borrow renminbi or lend their excess reserves. And as you can see in the chart above, the dim sum market is growing fast despite the rather tepid global trade market over the past few years.
This is a huge strategic advantage for China going forward as it allows them more closely tie its most important customer to them (offering easy trade terms), and become independent of the actions of the US Fed.
In the year to date, companies have raised $10.8bn in offshore renminbi bonds – including both Hong Kong and Taiwan issued debt – more than double the amount during the same period last year, according to Dealogic. April alone saw $2.5bn of new issuance, in spite of the currency weakness, according to the Financial Times. This suggests the dim sum market is becoming increasingly credible as a place for trade finance and less a speculative market simply to bet on the rise and fall of the Chinese currency.
Needless to say, as emerging markets move from financing trade in dollars to financing trade in renminbi, the US loses clout and influence, while China gains.
This isn’t to say the US dollar will lose its reserve status overnight; but it is to say China’s could gain a considerable trade advantage among the fastest growing segment of the global economy while it continues to progress further up the value added chain.
So, there is trouble on the growth front for China in the immediate future. But the optimist say we need to separate the cyclical stuff (growth pressures brought on by the global economy) from the structural stuff (real reform generating internal growth and increased independence) to get a better assessment of how China transitions during this tough time; they are confident China will avoid a financial crisis. And once this period passes, China’s competitive advantage will only continue to grow.
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