Published on May 20th, 2014 | by Michael Drury, Chief Economist, McVean Trading & Investments, LLC


What’s Ahead for China?

The global economy is dealing with another episode of summer disappointment. It seems every year in the post Lehman period we start the year with unbounded optimism that this is going to be the big breakout, the return to a normal post-war expansion, only to see growth remain lackluster as the spring turns to summer. It was the PIGs in 2010, Japan in 2011, Italy and Spain in 2012, US tax hikes in 2013. This year the disappointment emanates from China. We see four basic reasons for this ongoing malaise: 1) a global lack of strong fiscal stimulus due to concerns about debt; 2) a lack of effective monetary policy due to the zero interest rate bound; 3) a decline in global trade, which stymies currency adjustments and increases the need for domestic stimulus; and 4) a lack of policy coordination among countries resulting in a rolling recession – US, then Europe, now China — which saps the strength from other nations’ budding recoveries.

As the locomotive for growth in the post-Lehman cycle cools, it is becoming increasingly clear that China will follow a policy of tough love – much like Angela Merkel’s stance in Germany – rather than opting for a dose of stimulus. Like Germany, China can afford this policy. They are still the fastest growing major economy on the planet. They maintain a trade surplus even as world trade ebbs. They have the world’s deepest reserves of foreign exchange. Their debt is entirely funded domestically. Most importantly, their new leaders have eight years in which to carry out their vision for China. This week, President Xi Jinping warned that there was a new normal in China and that all should remain cool-minded as they economy adjusts. Premier Li Keqiang, on tour drumming up new markets in Africa, indicated growing exchange reserves were a burden and China would seek to narrow its trade gap. Bottom line, China has set long term goals and will accept a moderation in growth as it realigns.

Like Germany, this may be no problem for the Middle Kingdom, but the repercussions of a moderating China on its trade partners will be far more significant. Many do not have trade surplus or large forex reserves, and many have large external debt even if financed in their home currency. Nor do they have economic alternatives like China. As the commodities super cycle ends, many are faced with retrenchment – as Greece was when the credit was cut off. The beneficiary is China, as some commodities are now cheaper and exporters more willing to sell domestic assets – in currencies which have devalued relative to the yuan.

As Li has suggested, now may be the opportune time for China to end its growth in forex reserves. To absorb dollars generated by their trade surplus (and to control their currency) China printed yuan and forced holders to sell dollars to the state which then bought Treasuries. To end this inherently inflationary process – which boosts yuan liquidity and fosters real estate development — a narrower trade deficit would be one solution. Clearly China wants to buy more imported clean energy, as well as energy intensive products, in order to reduce pollution. Russia and others are ready to sell. Indeed, China is a beneficiary of the Ukraine situation in that everyone who sold to Russia is looking for new trade partners – especially the commodity rich Stans on China’s western border. Another alternative would be to let earners of foreign currency (often SOEs) reinvest overseas, generating much better returns than Treasuries. This was the strategy of the US after WWII, which built a substantial flow of repatriated profits to offset a declining trade surplus.

The preponderance of Chinese data points to a more bracing slowdown than authorities are willing to confirm. A wide range of indictors including industrial production, credit growth, electricity use, freight traffic, purchasing managers indexes, and ISI’s weekly China indicator all show the cooling has continued into April and May. Rather than new temporary stimulus, China is focused on consolidating longer term growth with new trade opportunities on a continental scale.

  1. The new free trade zone in Shanghai will lie at the extreme east of a wider development zone containing Shanghai, Suzhou and Zhejiang province. In turn, this region will lie at the head of an extended Yangtze River economic belt that starts in Chongqing, has a mid-point at Wuhan and ends at Shanghai.
  2. The integration of the Beijing-Tianjin-Hebei economic area will include nearby parts of Inner Mongolia, Liaoning and Shandong as well as the capital seeks to reduce pollution and the excess in industrial capacity.
  3. Ongoing development of more advanced industries in Guangdong and the Pearl River Delta, with a new free trade zone in Qinghai near Hong Kong.
  4. A new Silk Road, connecting the western provinces with Europe, the Indian Ocean, and the Arabian Sea by rail is designed to give China a west coast and shorten delivery times.

These are long term projects with little benefit in 2014, but unlike western leaders Xi and Li have years to produce results. This is in contrast to Hu and Wen, who were trying to preserve a legacy of strong growth when they over-stimulated in 2009.

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