Eyes on the Prize
Signs of economic slowing are not bad news. The credit bubble that started forming in 2008 has distorted resource allocation in a major way and created wasteful GDP. Correcting it will lead to a statistical GDP slowdown. It is inevitable and welcome news. China has a widespread labor shortage. A slowing economy will not have a significant social impact.
A labor shortage and saturation of the export market leave only productivity growth as the main source of growth. The current economic model is based on quantity expansion – more construction and manufacturing of the same things. Putting growth above reform without changing the model first holds the economy back and multiplies the cost of eventual and inevitable reform.
The first, necessary and inevitable step in reform is to accept the bursting of the giant bubble of land, local government debt and the shadow banking system. The available policy tools are, first, clarifying the central government position on bailout policy regarding the local government debt; and, second, eliminating the expectation of yuan's slow but predictable appreciation.
The pickup in the economy in 2013 centered around local government spending and property speculation, and was financed by the shadow banking system. A slowdown in 2014 is inevitable. The interest rate on the funds from the shadow banking system is too high to sustain a property bubble for long. The slowdown in the first two months of 2014, as reflected in weakening PMI, mainly reflects this dynamic.
Further slowing is likely. The unwinding of the yuan's predictable appreciation will be a big source of economic deceleration. The funding source in the shadow banking system was quite dependent on the yuan carry trade. The higher onshore interest rate and steady yuan appreciation sucked in large amount of hot money. The inflow increased foreign exchange reserves, which validated expectations the yuan would appreciate.
The recent volatility in the yuan exchange rate has the potential to break the bubble in the currency's expectation. If it occurs, hundreds of billions in hot money could flow out. It will push up the interest rate in the shadow banking system further, which may accelerate the decline of land prices already unfolding in many cities. Of course, falling land prices would decrease local government revenue and borrowing capacity, adding to the economic slowdown.
Finally, when the artificial credit support is pulled, overcapacity will have to be shed. It involves retrenchment of many industries. The associated bad loans will have to be accounted for. The combination would be the final step in unwinding the bubble due to the erroneous stimulus policy after 2008.
Bad News Is Good News
China is uniquely well-positioned for an economic downturn and, therefore, economic reform. The working age population is shrinking. The labor shortage is apparent everywhere. The old mantra that the country must grow to create millions of jobs to maintain social stability is not relevant anymore. When China embarked on painful structural reforms in 1998, the economy did experience a huge labor surplus. Still, the government braved on and laid the foundation for the rapid growth of the following decade.
In 1998, China had a small foreign exchange reserve and small export base. The opposite are true today. Hence, the risk of a systemic crisis is low. The central government has plenty room to handle any financial fallout from economic restructuring.
In the absence of employment pressure or systemic crisis, there is only upside to economic reform. And, no real and meaningful reform could occur without letting the existing bubble go, which of course involves ending wasteful economic activities. The resulting economic weakness as shown in GDP or PMI is inevitable.
Cutting out bad GDP has to be good news. When an economy pumps credit into building more and more ghost towns, the GDP does rise. But, debt rises faster. The longer the process continues, the bigger the debt overhang. Of course, when the process stops, the GDP comes down too. Is this bad news?
Parts of the country's economy resemble the above dynamic: many ghost towns are being built, more capacity is being added to industries already dealing with overcapacity and white elephant projects are visible in virtually every city. When such wasteful projects stop, GDP looks weak. Again, as the labor market suffers a shortage, displaced workers can quickly find alternative employment. Hence, weak economic data must be good news for the future.
Many wasteful projects are driven by kick-back opportunities. As the government wages a strong anti-corruption campaign, new projects are not being added like before. Of course, good projects can stand on their own. Hence, the anti-graft effort should not affect them. The weakening pace of new project starts should be viewed as good news. Less waste today means a better economy tomorrow.
In the coming months, some opinion leaders, both at home and abroad, and financial markets may scream about weakening economic data. We should not worry about them. Financial markets are usually oriented toward the short term. True economic reforms are usually not welcomed by financial markets right away. In 1998, for example, few investors were willing to touch very cheap Chinese stocks. But, at the peak of the bubble in 1997 and 2010, swarms came to buy overvalued stocks. This pattern will repeat itself.
China makes a living by being the factory of the world. The reforms of the late 1990s laid the foundation for that. But, since 2004, inflation from excessive monetary growth has played a major role in income and wealth distribution. Excessive monetary growth fosters speculation in land, stocks, funds, PEs, trusts, puer tea, lilac, paintings, etc. It essentially attaches a casino to a factory. When the factory's workers are paid, they are incentivized by the monetary environment to roll the dice in the casino. Since 2008, the casino has become so big that the factory workers are increasingly abandoning work for full-time gambling. The irony is that, as speculation becomes the main show, the policy has to support it out of fear of an economic downfall should speculators go bust.
China's main economic problems – excessive and wasteful investment, and low consumption – are due to the economic distortions from speculation supported by excessive monetary growth. Breaking this vicious cycle will correct most of the distortions on the demand side.
One major driver for correcting the imbalance in demand is an increase in real wages. The labor shortage has been driving a nominal wage increase. But, as money supply grows as fast as land prices to support the speculative bubble and investment demand, inflation erodes the real value of wage increases. When the speculation cools, the demand for money will also slow. Land prices will decline, and general inflation will cool. Real wages will rise faster, which shifts aggregate demand toward household consumption.
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