China dreaming...

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"Where is the wisdom we have lost in knowledge? Where is the knowledge we have lost in information?"

                                                                T.S. Eliot

Commentary & Analysis

China dreaming…

Churchill is credited with saying: "I cannot forecast to you the action of Russia. It is a riddle, wrapped in a mystery, inside an enigma; but perhaps there is a key. That key is Russian national interest."  Apt as that was at the time, I think the quote is now most applicable to China.  With every twist and turn bears dream of crisis, while the bulls vision hegemony.  China’s national interests are considerably complex. But given the considerable control at the center, and the resources available to wield that control, it seems the odds of a Western-style financial crisis are limited.

If there is a grave yard for forecasters—the bodies would be piled high and wide when it comes to past dissection of China’s economic prowess.  Over the years I have made more than one call for doom and gloom; only to be thwarted by reality.  No doubt it is a dangerous time for China’s development, which now can be characterized as an attempted transition from the old capital investment model to a more balanced economic approach whereby consumption becomes a great share of gross domestic product. 

There is blowback from powerful vested interests inside China reluctant to change; thus the serial suicides among key officials.  The global economy is saddled with an ever increasing mountain of debt—it means maneuvering room is tight; any policy mistakes will be magnified—as we see with the Chinese handling of stock market circuit breakers. 

Howls of condemnation, as you know, are flowing from many Western enlightened investment analysts’ about the “unfairness” of it all; China shouldn’t be allowed to so blatantly manipulate its markets. Funny how such howls relating to the quality of “fairness” are rarely heard when markets are going up; even more funny given Western markets are far from anything defined as “free and fair.” 

So, though I am now AWOL from the doom and gloom army, which seems to be rapidly growing in size and intensity, it doesn’t mean I don’t recognize some of the problems China faces.  But interestingly, China’s problems are not unique. One of the biggest is extricating itself financial repression—a game they have diligently and effectively played.  But evidenced by zero or near-zero interest rates for the last several years throughout the Western world, proves policymakers here have a deep reservoir of repression skills. 

What is financial repression?  Wikipedia defines it:

Financial repression refers to "policies that result in savers earning returns below the rate of inflation" in order to allow banks to "provide cheap loans to companies and governments, reducing the burden of repayments". It can be particularly effective at liquidating government debt denominated in domestic currency. It can also lead to a large expansions in debt "to levels evoking comparisons with the excesses that generated Japan’s lost decade and the Asian financial crisis" in 1997.

The term was introduced in 1973 by Stanford economists Edward S. Shaw and Ronald I. McKinnon in order to "disparage growth-inhibiting policies in emerging markets". 

“…in order to allow banks to ‘provide cheap loans to companies and governments, reducing the burden of repayments’…Thus, financial repression is the crème de la crème of the capital investment model.  But as one might expect, actions create consequences.  And when it comes to manipulating money and credit the unintended consequences can be vast and usually aren’t good. 

China’s version of extreme financial repression has turned vicious since the export-cum-investment dependence model started to breakdown when the world’s consumers decided to leave the building thanks to the credit crunch. 

Granted, since the crisis progress has been made on consumer deleveraging; but the bet China made just after the credit crunch, to ramp up production in an effort to grab more global share, proved a very bad one. On an absolute scale it seems the bet was history’s grandest of capital misallocations, which is depicted in a prominent place in the flow diagram we created below:

At the expense of repressing local consumer demand, China expected the rest of the world’s demand to recover quickly (exports are effectively taking demand from the importer).  With the gift of hindsight we now know demand has failed to recover to those credit-free pre-crisis heydays.  We are witnessing the consequences of China’s doubling-down on an investment model unfit for prime time.   

The new commitment to supply side reforms expressed recently by China’s leaders is a good start—I wish Western policy makers would fully commit to the same (instead of the worn-out, broken down, intellectually vacuous neo-Keynesian stimulus model).  The problem is even good structural reform takes time. And time is of the essence for China given jobs tethered so tightly to industrious with such gaping overcapacity (see the social unrest box in the diagram above).  Thus, the decision by China to let its currency actively trade on its own merits against the US dollar (or be manipulated lower depending on your perspective) is simply part and parcel to this transition (they will no longer will have to load up on Treasury paper to stabilize the yuan).

China’s is receiving considerable amounts of criticism about its recent actions on its currency.  But few have given China credit for the fact China held its currency stable throughout the credit crunch, and provided massive stimulus during that period (unlike Germany which rode on the back of the US and China during the crisis), while the yuan has been appreciating right alongside the US dollar against the rest of the world’s currencies and key trading competitors (German and Japan):      

Japan on the other hand has weakened its currency explicitly as part of policy—Prime Minister Abe’s three arrow strategy (no Zen archer he, as said arrows seem to have missed the target given Japan’s current prospects).  Yet, I am not hearing cat calls of “Japanese currency manipulation” flowing from the feted feckless frauds residing in Washington D.C. 

So besides the fact being short the Chinese yuan against the Japanese yen looks like a good bet for 2016, China’s attempts to transition from the financial repression box doesn’t necessarily lead to crisis.  But if China’s leaders are serious about this transition, and given the ongoing morbidity of the Western consumer it is clearly the best path for China, we can expect many years of declining growth ahead—or muddling through—from China. 

If my guess it right on China, we should expect a few more years at least of slow (below capacity) inflation/deflationary growth at best across the OECD.  But then again by its very nature, a Black Swan event cannot be part of a forecast.

Jack Crooks

President, Black Swan Capital

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