China Collision Course

“But man, proud man,

 Dressed in a little brief authority…

Plays such fantastic tricks before high heaven

As makes the angels weep.” – Shakespeare’s Measure for Measure

The strident demands from the US that China should immediately revalue it’s currency, or face unilaterally imposed trade tariffs is a vast international policy error. It may or may not play well in domestic politics, but it is hard to see why this should trump it’s consequences on the crucial economic relationship between China and the US, on which world economic growth depends so much.

First of all, it is internationally illegal. The sovereignty provisions of the IMF clearly state that it is the sovereign right of any nation to implement whatever currency arrangement it chooses. No other country has the right to decide what is right for another country, so the US demand breaks this provision.

The second part of the US demand, which is the threat of charging 27.5% tariffs on Chinese goods is also illegal under WTO rules concerning the unilateral imposition of tariffs. The US claim that the Chinese are manipulating the exchange rate is absurd given that we have not heard this before and the exchange rate has now been fixed for the past 10 years!

Even if the US policy demand was legal would it be good advice? Sadly, no. It is highly destabilizing, both economically and politically, dreadful diplomacy, and in the end poor advice too. To understand why we need to examine China much more closely.

Do we even know that much about China? Sadly, in the west, we all too quickly jump to conclusions about what is happening and what “needs to be done” about other countries. We like to think we know as we look through our own cultural lens from thousands of miles away. I quickly realized how far off the mark western conventional wisdom was (and it still is) on China when I met Joan Zheng in Hong Kong in 1997. Joan had grown up in Beijing and had become an economist at the Central Bank of China, before becoming J.P.Morgan’s China analyst. Within a few minutes I quickly realized how little I knew. Unless you use real information from people with experience inside China, most of what is common knowledge in the west, is likely to be misleading at best. Since then I have taken great care about my information sources to get a better understanding.

For sure, China has a strange brand of economic development that is quite unique to western eyes, and its incredible growth has already changed the way the world economy works.  You can complain about it, or try to change it if you really think that will get you anywhere. Alternatively, you can come to terms with it, understand how it operates and be realistic about what it means. Only then can you hope to find solutions that are achievable and optimal for both sides. The latter approach would be so much more productive.

China’s crazy state sponsored capitalism

Spend some time in Shanghai and you will soon become amazed at the prices you will find yourself paying for just about anything. You can buy lighters and working counterfeit watches for 12 to 24 cents. Take a 20 minute cab? That will be $1.50. But think about that. The gas alone costs $1.10, and then there is the driver’s time, and wear and tear on the cab. How can he make any profit? Most of what you can find in Shanghai is selling at or even below cost. We’ve all heard that labour costs are cheap in China, but there is something else is going on here in addition to cheap wages.

Next visit some Chinese companies and you may continue to be amazed. You will probably find that they are leveraged to the hilt with far more debt than equity. Strangely when you ask them how they will ever repay their debts they all have the same reply. The loans were from state owned banks at low interest rates and renewable in perpetuity, and the banks did not expect them to be repaid until the companies become profitable. One executive got around this by keeping two sets of books, one always showing low profits or a loss for the “benefit” of his bank.

What we find, therefore, is that the Chinese government through the banks is subsidizing every level of the economy on a massive scale, from pensioners, to taxi drivers, to major corporations. No wonder the economy is booming. Apparently unlimited credit is freely provided by the government to one and all!

Great! So if you are in China here’s what you should do. You first of all get a loan you don’t have to pay back. Then you sell your product at or below cost to generate cash flow. You then show a loss so you don’t have to repay your loan or pay any taxes. Meanwhile you siphon off some of the cash flow to buy some property or put it in a new bank account in Hong Kong where the banks are much more likely to be solvent.

No wonder you have a miracle economy. In this environment prices remain permanently low as capacity explodes and no-one really needs to make a genuine profit from higher prices. Growth is so strong because it is so attractive to be in business, and China can produce goods that no one anywhere else in the world can compete with, given its size, low labour costs and free cost of capital. What a great deal!

So why not join in and start a business in China? Before you do, read “Mr. China” by Tim Clissold. Then you will find out how successful you might be with $400m to invest and 17 years of trying. Even learning to speak Mandarin did not do the trick. Chinese state bureaucracy is ever present and there are countless problems you will encounter, not the least of which is “nei jin wai song” – cracking down at home while pretending to foreigners to be wide open. Agreements don’t count for a great deal and as for patents or piracy protection - well, good luck!

So what do you do with China? It’s tough to invest in China either directly, or in its very underdeveloped untrustworthy markets, and you cannot compete with it. You can trade with China as it needs raw materials and certain products, and you can sell its incredibly cheap exports all around the world a bit like Walmart. But that’s about it.

Whatever you make of this it works right now for China. The state regards civil stability as key and overall this dramatic growth is keeping its vast population busy and happy. However, nothing is perfect and there are two main problems.

First of all for China the domestic economy is highly unstable in the medium term. The financial system has no discipline or integrity, and you cannot trust any accounts. State owned banks lack skilled staff and have yet to gain management control of their branches. The banks have enormous bad loans portfolios that are increasing all the time and the government has to continually bail them out to keep the process going. Furthermore, capital is very poorly allocated. With so little financial discipline, much of the investment ends up being wasted.

Everyone agrees that reform of the financial system is a good objective in the long term, but how realistic is this? At best it would take years to implement, and these reforms would challenge the free credit engine that is delivering so much growth. So don’t hold your breath. China is committed to removing capital controls and making the currency fully convertible as a precursor to the possibility of some exchange rate flexibility, but this will be done cautiously over time. From China’s perspective it is broadly accepted that widespread reforms are needed, but the timetable is very much in the longer term.

The second main problem is that China now has a huge impact on the rest of the world economy. Industrial capacity has exploded, while prices remain remarkably low, and to the extent that production is switched to China, growth is taken away from elsewhere as it is virtually impossible to compete with China. So while China experiences remarkable growth, it transfers massive deflationary forces on the rest of the world.

It is no wonder that the recent industrial powerhouses of Germany and Japan, in particular, are experiencing considerable deflationary forces, with record low government bond yields. So how does the world cope with this impact and what can really be done about China? Also how likely is it that China would even listen to these concerns, even assuming something could be done in the short term?

The China Perspective

In 1934, during the last major deflationary period, China did revalue it’s currency under international pressure and with disastrous consequences. It set off a recession which led to the fall of the then Nationalist government and further chaos in China. Today’s leadership all grew up through the cultural revolution, under Mao Zedong, which followed decades of civil war. After such a long period of political turmoil China is particularly concerned about economic and civil stability. While it does not have a perfect record, by any means, it is greatly concerned with an orderly society. The relative stability it has achieved in recent years has provided the platform for growth, and the growth has helped with stability. Any dramatic changes that could damage this apparent virtuous circle are therefore regarded with great caution.

China has more recently regulated the speed of its own development, wisely ignoring the rush to privatization advised by the “Washington Consensus” in the 1990s, as described by Joe Stiglitz (author of “Globalization and its discontents”), who uniquely had direct access to Chinese policy makers. So China is big enough and has a good enough track record not to feel obliged to accept any other country’s view about how it should develop. Also for historical reasons it has become highly unconvinced about the value of foreign advice.

This perspective of self determination is now deeply ingrained in the Chinese perspective. China feels that it has been persistently invaded, and taken advantage of, over the last hundred years or so. From the opium wars of the mid 1800s and the ceding of Hong Kong, to the 80 year period of continuous civil war, with foreign interference, to the Japanese invasion and the terrible Nanking Massacre, which still runs deep in Chinese memory. Even after World War II, America unilaterally signed away some islands, that China disputed, to Japan. Then there is the remaining issue of Taiwan, which split from the mainland at the end of the civil war. 

It is therefore dangerous to underestimate the sense that China has that it wants to restore the integrity of its sovereignty and also how reluctant it may be to be persuaded by advice from foreign powers, whoever they may be.

US relationship with China

Given China’s perspective, the increasingly strident demand that China should immediately revalue its currency, which has been fixed for a decade, or else face tariffs must seem extraordinary. Not only is this remarkably undiplomatic, but it also makes it a face losing exercise. This aggressive stance may play well in some minority constituencies in the US, but this is poor and simplistic policy advice, which completely ignores the issues of the internal workings of the Chinese economy as well as historical precedent.

It also raises the issue of what should be done about China’s enormous dollar reserves. A revaluation of 10% would cause a loss of around $40 billion in the value of China’s reserves. Although, China could handle this it would be a severe blow that it would want to minimize, possibly with some reserve management adjustments, which again would take time to implement prior to any revaluation.  Selling hundreds of billions of dollar assets may not be to the advantage of the US.

The most remarkable part about the US demands is that there is so little to be gained by the US even if the Chinese were to revalue. Almost everyone, Greenspan included, believes this will make no difference to the US current account deficit. Even if China does revalue the US Trade deficit is unlikely to narrow, as the cost advantages of producing goods in China is vastly greater that any conceivable amount of revaluation. Production would either stay in China at greater cost to the US, or be switched to another low cost country.

Not only does the US prescription lower the quality of the policy dialogue, but to threaten a trade war if China does not immediately comply, is absurd as it will back fire so badly on the US itself. Somehow, the US is forcing itself into position in which it is demanding changes that will produce little or no benefit to the US and possibly some harm, or else it will impose a trade war which will almost certainly do itself some great damage, as well as the rest of the world economy.

While China does need to continue to reform its economy and better balance it’s growth with the rest of the world, this is a delicate mechanism that will take a great deal of time. Time the rest of world may no longer have politically. So far China has managed its reform with some success, partly because it has moved at its own pace. The world needs coordinated policy changes if it is to successfully rebalance itself and cooperation is the best way to optimally achieve this. More than likely these demands stem from impatience and possibly a poor understanding of how China’s economy really works, and the speed at which reforms can really be implemented.  

Summary

China may well ignore US demands for an immediate revaluation of its currency. China would be justified in doing so both from a legal standpoint, and in terms of its own preference for cautious policy development. A hurried currency revaluation right now makes little sense to China for so many reasons and China’s history has shown time and again it is better off being very careful about foreign advice.

China could choose to make a small adjustment as a political palliative but this may not satisfy the US, and might still destabilize its currency policy as it would clearly undermine its commitment to its fixed exchange rate. It may prefer to let the US decide what protectionist policies it really wants to impose. This may not be as widely popular as US politicians currently seem to think, as it will harm many multinational corporations, reduce world growth, and possibly raise prices in the US. It may be a better tactic for the Chinese, to assume that the US will not be able to follow through on its threats.

Whatever the final outcome, it is very hard to understand why the US decided to take such a great policy gamble for very little if any gain, and in the process damage its relationship with China, and the co-operative environment needed to address worldwide economic issues.

The world economy is now facing growing economic imbalances with significant deflationary risks. Now would be a good time for policy makers to demonstrate some vision and leadership. The US policy initiative demanding an immediate revaluation of the Chinese currency falls a long way short of what we need. Hopefully, in time, the US will come to a better understanding and a more co-operative approach, and stand down from its strident demands. 

 

 

 

Notice

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. Chris Belchamber (the author) may or may not have investments or positions in any assets or derivatives cited above.

Communications from the author are intended solely for informational purposes. Statements made by various authors, advertisers, sponsors, and other contributors do not necessarily reflect the opinions of the author, and should not be construed as an endorsement by the author, either expressed or implied. The author is not responsible for typographic errors or other inaccuracies in the content. We believe the information contained herein to be accurate and reliable. However, errors may occasionally occur. Therefore, all information and materials are provided “AS IS” without any warranty of any kind. Past results are not indicative of future results.