Warren Buffett had it right, “Only when the tide goes out do you discover who’s been swimming naked.” Peer through the fog of commentary on recent share price gyrations and you can see the unclothed figures of Chinese president Xi Jinping and his fellow managers of the Chinese economy, the very one that in recent years has been providing about half of global economic growth even though it accounts for only about 15% of world output. The rulers of the world’s second largest economy first attempted to shore up their collapsing stock markets by intervening – no short sales, limited ability to sell shares, massive purchases by government entities -- then managed a devaluation of the renmimbi that went about twice as far as they intended, and finally directed the central bank to cut interest rates and ramp up liquidity in an effort to maintain a 7% growth rate. Which succeeded, if you believe Chinese government statistics, which no one does, not even premier Li Keqiang, who years ago said that his country’s GDP figures are “man-made … for reference only”. Many analysts, among them economists at Capital Economics Ltd., reckon that the Chinese economy is growing at around 5% rather than the officially reported 7%. Not bad, but the aggregate figure conceals a structural shift.
The Chinese economy has relied on export-led growth, fueled by massive government borrowing and lending to state-owned enterprises in the heavy-industry sector, resulting in a banking system loaded with uncollectable IOUs. But rising wages and increased competition have driven China’s exports down by 8.3% in July compared with last year, while construction starts have fallen 16.8% so far this year. In a market economy, capital would flow out of those industries into the consumer goods sector. Some of that is happening, but not much, and slowly. Xi knows that abandonment of the export-led, debt-fueled, heavy-industry model will have a negative effect on job creation, at least until any transition to a more market-driven allocation of capital is complete. According to Hong Kong-based China Labour Bulletin, there were three times as many strikes and worker protests in the fourth quarter of 2014 as in that same period in 2013, and the number rose by an additional 14% in the first quarter of this year. With no democratic outlet for unhappiness, these are a good indicator of troubles to come for the regime if unemployment ratchets up.
So, Xi finds himself in the position of King Faisal in the film, “Lawrence of Arabia.” Faced with the choice of annihilation of his army or placing it under European command, Faisal mused, “I must do it…. But I fear to do it. Upon my soul I do.” Xi has no desire to become the Mikhail Gorbachev of China, liberalizing the economy but unable to maintain one-party rule. Job-creating construction of cities that will never be occupied and production of goods that will only be sold at a loss just might be more attractive to the regime than following communist parties in the Soviet Union and other centrally controlled Eastern European economies into the dustbin of history. Except that it is unsustainable, even for a country possessed of China’s massive foreign currency reserves.
From the point of view of America, and indeed of Western market economies, China’s current difficulties have three consequences more enduring than a volatile stock market. The first is the re-establishment of the superiority of the democratic capitalist market model as a creator of widely distributed material well-being. That model has often faced challenges from other forms of economic organization: in the 1930s by Mussolini’s fascism that made the trains run on time, Hitler’s national socialism that produced a (rearmament-based) economic recovery, and Stalin’s communism that the US National Security Council described as having a "proven ability to carry backward countries speedily through the crisis of modernization and industrialization". After WWII, Japan’s managed economy, with MITI doing the managing, was the new ideal, deemed likely to surpass America’s when Japanese investors bought Rockefeller Center -- shortly before their country entered the “lost decade” of economic stagnation from which it has yet fully to recover. With China’s rulers having shown that a combination of omnipotence and incompetence is not a reliable substitute for reliance on market forces to allocate capital, the Chinese model is, at minimum, tarnished.
The second consequence of China’s flailing economy is a policy dilemma for the Fed’s monetary policy committee. Until the securities markets went on their recent rollercoaster ride, Janet Yellen had pretty much persuaded her colleagues on the committee to begin raising interest rates in September, or so rumor had it. Along came the wipe-out of a few trillion in global wealth, and the influential head of the New York Federal Reserve Bank, Bill Dudley, found a rate increase “less compelling” than only a few weeks ago. Just 24 hours later, the government revised its second quarter GDP growth estimate of 2.3% to a robust 3.7%, which might return an interest-rate increase to the “compelling” category. But life is not easy for central bankers: a new study lowers the unemployment rate that is consistent with an absence of inflation, meaning inflation hawks can relax even as the unemployment rate falls further, obviating the need for an interest-rate rise.
The third consequence of China’s problems has been to create winners and losers. US exports to China account for less than 1% of our GDP and, according to Goldman Sachs, only 2% of the revenues and 0.5% of the profits of the 500 companies in Standard & Poor’s index are directly attributable to China. Still, GM gets 35% of its sales revenue from China, construction machine makers such as Caterpillar are watching sales in China (and elsewhere) fall and its lay-offs rise, and New York hoteliers and retailers are worrying whether Chinese tourists will continue to spend upwards of the $1.4 billion they spent in the Big Apple last year, or whether the relative decline in their presence in hotels and shops, from Tiffany to Macy’s, is a passing or permanent thing.
So far, China’s consumer goods and services sectors are holding up. Only 6% of Chinese “citizens” own shares, so most were not directly hurt by the price collapse. Consumers still save about 30% of their disposable incomes (we stash away about 5%), so they have money to spend, although not on conspicuous consumption items that might lead to charges of corruption, a show trial and jail. Which is why Apple reports rising sales of iPhones, and Boeing is predicting enormous demand for new aircraft to ferry Chinese tourists around the world. It is largely up to Xi, presiding over the most repressive regime since Mao, to decide whether to allow a transition to markets and consumer control at the risk of surrendering one-party control of China. He fears that he can’t take one from column A and one from column B, but must make a choice. Little wonder that he fears to do it. Upon his soul he does.