2011 has been a year of worry. So much so that investors couldn’t make up their minds what to worry about most: the US, Europe or China.
In the last couple of weeks, China seems to be nudging into the lead. There’s been a barrage of headlines about a bursting property bubble, a hard landing and impending disaster.
I think these stories are overdone, mistaking a slowdown for a depression. Yet they’re less misguided than some of the counter-arguments about why China is safe.
So this week, I’m going to look at three myths about why China is safe. Ultimately the real problem isn’t that they are true or false, but that they simply aren’t enough…
Huge FX reserves make you invulnerable
China’s foreign currency reserves – currently around $3.2trn – are the source of many misunderstandings.
One mistaken belief is that they ultimately give Beijing the upper hand in trade disputes, because they have a nuclear option: they can stop funding America’s borrowings and cause a US debt crisis. Another view is that FX reserves form as a kind of savings account, which can be dipped into to fund emergency spending if needed, without any side-effects.
Neither idea reflects what the reserves really are. The bulk are held in US dollars. So if China wanted to invest the proceeds in non-US assets, or to spend them, it would need to sell down these dollar-denominated holdings first.
However, China’s holdings are so large that selling a significant amount would shake the market. It would immediately depress the price of the US dollar assets it sold, while pushing up the price of any non-US dollar assets it buys even more (since there’s no other currency with asset markets deep and liquid enough to absorb all these extra savings).
Like it or not, China is stuck with keeping most reserves in US dollars as long as the dollar is the global reserve currency. Trying to sell too many would mean taking large losses on the rest of its holdings.
What if China didn’t care about this? What if it just decided to sell, accepting that it would take a large haircut, to employ the money at home?
China can’t benefit from ditching dollars, even if it wanted to.
Apart from the general chaos this would cause in global financial markets, the problem is that it’s self-defeating. There’s no gain from acting this way. To see why, you need to understand how China acquires its FX reserves.
The reserves come from China’s trade surplus and capital inflows into the country. Inflows into China should naturally push up the renminbi, but policymakers have been keen to prevent it rising too fast against the dollar and losing export competitiveness. So they intervene to sell renminbi and purchase foreign currency.
Selling newly-created renminbi increases the money supply within China. Or it would do – but obviously policymakers have also been concerned about this pushing up inflation. So China tries to mop up this renminbi liquidity, by ordering banks to hold higher reserves with the People’s Bank of China (PBoC) (the central bank) and to buy sterilisation bonds issued by the PBoC. By doing so, it ends up with domestic liabilities offsetting its foreign assets.
If the value of these foreign assets falls substantially in renminbi terms, the central bank is taking losses relative to the renminbi liabilities it holds against them. Also, if it hands some of the FX reserves to a government department or company to spend, it’s given away the asset but still has the liability. Either way – via aggressive selling or moving the reserves elsewhere into the government coffers – there’s a bit of a hole in the balance sheet.
In one sense, this isn’t a problem for a central bank that controls its own currency. If it ultimately ends up with only RMB70-worth of foreign assets outstanding for each RMB100 of liabilities, it can create the extra RMB30 needed to make good on its liabilities. But obviously, this involves ‘printing money’, which increases the base money supply – which is what the sterilisation process was intended to avoid in the first place. In short, a government can’t do much with its FX reserves without it sooner or later having to create more domestic currency.
So there’s nothing magical about using FX reserves that can’t be achieved by having the central bank buy newly-issued government bonds. Maybe there’s a bit more smoke and mirrors as to how the money ended up in the system, but it doesn’t make possible anything that isn’t already possible if you control your own currency.
Where FX reserves are important is in protecting a country’s external position. They allow you to support your currency if you need to and provide foreign currency to pay for imports or service debt in a balance of payments crisis.
That’s a genuine strength if you’re an emerging market and China (and most of Asia) is fortunate to be in this position. But that’s as far as the benefits go.
The Chinese government has almost no debt
The second myth is much simpler. You’ll often hear that China has very little government debt – only around 20% of GDP.
That’s only true in a very narrow sense. Central government debt is low. But there is an awful lot of spending in China that is not in the central government budget or on its balance sheet that is nonetheless effectively underwritten by the state.
Realistically, you should include local government debt, off-balance sheet spending by opaque bodies like the Ministry of Railways, lending by policy banks, bad loans in the banking system and so on.
Once you do that, you probably come to a figure that is closer to 70-80% of GDP. That sounds a lot more alarming. However, it needs to be kept in context.
It would be a mistake to compare that with similar debt levels in Western governments and conclude that China’s finances are as bad as the US, the UK and Europe. Governments everywhere have undeclared liabilities and you can add plenty more off-balance sheet debts to all those countries if you wish.
Importantly, China’s borrowings are almost entirely in renminbi. And while currency controls remain in place, domestic investment options remain limited and the banks remain state-controlled, the government is not going to have problems borrowing at relatively low interest rates.
This is not necessarily a good thing. Low interest rates effectively represent a subsidy from Chinese savers for the state and state-owned companies that can borrow cheaply at similar rates. It’s also why you end up with excess investment in property – given ten-year bonds yielding 3.5% and an immature stock market, real estate may look the best deal.
But as a result, it’s hard to see how China could suffer any kind of government debt crisis in the near future. The government can fund itself from a captive bond market (and in an extreme situation could monetise debt with the central bank).
And as long as the government can fund itself, it’s also hard to see how there could be a severe banking system crisis, because the banks are just an arm of the state. Their bad loans will be covered by the state, if needed. So while there could well be problems in China’s banks, they can be managed (although private shareholders in listed banks would probably take a hit, through rights issues and lower profits).
Yet at the same time you shouldn’t assume that China’s finances will be rock solid ten years from now. The underlying fundamentals are not quite as good as they seem and some changes will ultimately be needed.
The economy can always be managed to grow smoothly
The third myth is that because China is still a state-directed economy to significant extent, it can be managed to prevent any serious slowdown. This simply isn’t true.
The Chinese economy has experienced plenty of ups and downs since reforms began. While long-term growth has been extremely impressive, there were major slowdowns in 1981, 1986, 1989, 1998, and 2008. The causes were different each time, but in all cases GDP growth fell substantially – often by more than the statistics suggested.
Even where the numbers weren’t fudged (nobody believes the economy grew at 8% in 1998), year-over-year GDP figures can disguise the extent of sharp but short-lived slumps. In 2008, real GDP apparently grew at over 9% – but in the fourth quarter, the annualised rate could have been close to zero.
So when more pessimistic analysts such as Jim Walker of Asianomics say that Chinese growth will fall below 5% in 2012, that wouldn’t surprise me at all. And it could be a very good thing. Regular slowdowns and recessions help shake out marginal businesses, prevent excesses building up, pop bubbles and keep the economy healthier.
But investors seem to fear any interruption to Chinese growth, assuming that if it slows at all, it will go off the rails altogether. Yet economic development has always been associated with frequent booms, bubbles, busts, recessions and crises.
Take a look at the US in the 19th century. There were the ‘panics’ of 1819, 1837 and 1857, plus the Long Depression. Depending on your viewpoint, the latter was either a two-decade depression from 1873-1896, or at least three separate crises (1873, 1884 and 1893). Then, of course, there was also a civil war and various international crises that didn’t begin in the US, but still affected it.
Clearly, the world’s leading economy went through some pretty turbulent times back in the days when it was an emerging market. It’s unreasonable to expect China’s path to be any smoother.
The risks we can’t predict are the biggest ones
What concerns me about China is not a recession, banking system problems, or even a fiscal crisis. Developing economies can get through these and emerge in better shape. Rather, it’s the wildcard of severe civil unrest or major policy mistakes that can completely knock a country off track.
For examples of this, think of Argentina and Russia. In the 19th and early 20th centuries, these countries were viewed as great development prospects alongside the US – yet obviously neither turned out well, for very different reasons.
One of our biggest psychological problems as investors is overconfidence. We overestimate our knowledge and are too confident that we understand how hugely complex and unpredictable situations will play out.
So the real problem with the idea that FX reserves or low debt or being a managed economy makes China invulnerable isn’t simply that they wrong – but these facts are just a tiny part of a huge picture. How do you weigh China’s ability to recapitalise its banks in a crisis against the political risks you can see in events like the high-profile protests in Wukan?
You obviously can’t – yet it may be issues like the latter that matter more in the long run. While I am highly optimistic about China’s eventual prospects, history tells us that we can’t be certain of anything.
It’s only prudent to assume that the China story could go wrong and invest accordingly (ie be diversified and don’t bet everything on one country or theme). That, not taking comfort in FX reserves and government debt, is how you can avoid worry in these difficult times.