Ichiro Suzuki
China’s stimulus package temporarily boosted optimism toward the end of September. But enthusiasm has cooled down as soon as investors came back from a holiday week at the start of October. The stimulus package was widely received as insufficient. It was even called “the largest band-aid ever”. Band-aids don’t solve the problems that require a surgical operation.
President Xi Jinping’ thinking was explained on the Financial Times by Arthur Kroeber, founding partner of Gavekal Dragonomics:
“Xi’s strategic aim has not changed. He wants to shift capital from the property sector into tech-sensitive manufacturing, which he sees as the basis of China’s future prosperity and power.
The program is cogent as a national strategy but unfriendly to financial investors. The emphasis on investment means supply will always run ahead of demand, leading to a deflationary pressure, which is bad for corporate profits. Even the high-tech sector face immense competition that will erode margins. China’s vision is unchanged: technology and self-sufficiency matter more than growth and profits.”
The above statement is correct, and the vision is full of flaws. To begin with, profits matter immensely. Though Xi Jinping intervened in the market with a stimulus package in the hope of lifting the stock market, he doesn’t yet understand why persistently low stock prices must not be tolerated. Attractive investment opportunities draw private capital that seeks high returns. That’s how projects are financed, needless to say. Higher stock prices require greater profits and higher valuation. Xi stresses technology without understanding investors who risk their money for new projects. Does the Chinese government/ the Communist Party keep financing everything indefinitely? He has never thought about it. He has already scared investors, in and outside of China, by shaming tech entrepreneurs and destroying their wealth in a rather spectacular fashion. No one in a right mind would risk their money for tech startups in China. AI, EVs or renewable energy, the industries that are thriving today were funded prior to 2021. Going forward, China would find it harder to bring out new, new things that we can’t imagine. AI is a case in point. It has emerged all of a sudden in the U.S., not China.
While the future path for innovation in China might not be as smooth as President Xi thinks, vibrancy in the technology and manufacturing sectors alone is not going to carry the Chinese economy. Consumption accounts for a touch less than 40% of the economy. While this is significantly lower than the standards of developed countries, where consumption is 60% or higher portion of the economy, it is still the largest component of the Chinese economy. Lackluster performances from this sector would keep the overall Chinese economy under pressure, however brilliantly tech and manufacturing do. Chinese consumers have been sidelined for decades by the Communist Party’s focus on infrastructure investments. Though hundreds of millions of Chinese people were lifted out of poverty by breakneck growth, the household sector should have done better, especially outside of the largest cities. As the Chinese economy is beginning to perceive detrimental effects of the aging population, the economy is facing difficulties in making Chinese households richer.
The struggling real estate sector is exerting intense downward pressure on Chinese consumers, since investments in houses represent the largest portion of household sector assets. Their largest assets have been under pressure. Worse, many of them are suffering from negative equity in their houses since market value of their houses have fallen below the amount of money they owe to banks. Even worse, construction of many condos are halted due to the developers’ severe cash shortage while some men have already paid for it. The plight of the real estate sector undermines consumer sentiment, at a time when the job market is weak.
Developers, banks and local governments need to be bailed out even if doing so is morally objectionable. The U.S. economy bounced back relatively quickly from the 2007-09 Great Recession by accepting moral hazard. It gave the economy a chance of a fresh start. Subprime borrowers, who took in debts that were beyond their means, declared bankruptcy and returned the key. Then they became off the hook. Lenders wrote off the defaulted loans quickly, and had their balance sheets recapitalized with the funds supplied by TARP (Troubled Asset Relief Program). The vast majority of the banks repaid TARP funds with high interests, and the U.S. government made money out of TARP. In most other countries, retail borrowers remained tied to the money they borrowed, and banks kept carrying such low return assets for a very long time, to the detriment of the economy. China is on course to this stringent path of working bad debts or non-performing loans (NPLs). Accepting moral hazard may be against Confucius virtue. The Communist Party, however, at one point in the future would be still forced to do something radically on massive NPLs with taxpayers’ money, There is effectively no other way out of the doldrums. The longer the CCP hesitates, the larger the cost becomes. Allowing deflation to persist creates new NPLs that are not associated with real estate, since weak economic conditions put many struggling businesses under harsh difficulties. In recent decades in the developed world, banking crises on a real estate bust were estimated to have cost 20 to 25% of GDP. Costs on China could exceed this range as the CCP hesitates to take decisive actions.
In addition, China is too big to pursue a strategy of ‘beggar thy neighbor’ even if China’s tech and manufacturing sectors dazzle. Much smaller countries might do this but the Chinese economy is the second largest, and a few times larger than the third largest. Xi Jinping thinks that manufacturing is virtue while consumption is frivolous, and may see American consumers as profligate idiots. China, however, would have to beg such stupid consumers overseas to buy Chinese goods for the country to prosper. Buyers can’t absorb all Chinese goods they want to sell, since the seller is a behemoth, however good the products might be. At a time of stalled global trade, exports from China is growing at 10% lately. In response to China’s hard drive of exports, the U.S. and EU are trying to raise the barrier to imports form China in the form of tariffs. China’s export drive is especially strong to the developing world. Global South countries have not openly expressed disaffection with China, due to the power balance between China and else. Nonetheless, this is not how to win the hearts of the countries that China considers as allies, or the Communist Party may be looking them down. China’s relentless push for exports might cause a rift in the Global South. Mercantilism has its limits.
About the author: Mr. Suzuki is a retired banker based in Tokyo, Japan.
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