A Chinese Puzzle- something has to give…

While the state of the relationship between the US and the PRC, is undoubtedly the single most important bilateral relationship in the world, and the subject of much heated rhetoric about trade balances, currency manipulation and protectionism, even if the recent meeting between their respective leaders avoided such controversy, it is worth bearing in mind that the Middle Kingdom’s geopolitical stance and economic health matter far more broadly.

In this post, we shall focus on economics and finance. To say that the signals are “mixed” is an understatement.

On the one hand, firms such as Morgan Stanley have recently argued that the PRC will escape the notorious “middle income trap” to join the likes of South Korea and Japan as a high income economy. On the other, concerns exist that a combination of trade protectionism and demographics will thwart a necessary shift from an export-led to a domestic consumption-based economy if the PRC is to continue to increase its GDP at anything remotely resembling current levels. Add in the fact that economic statistics on the PRC’s economy and the health of its financial system are somewhat “opaque”, to be polite, and one has the makings of an unexpected systemic shock which would undoubtedly transmit to the wider global economy and financial system.

However, the FT’s Martin Wolf (“Chinese finance is storing up trouble for the rest of the world”) has recently made the case that the current emphasis on trade is missing the point. Rather than worrying so much about current account deficits or surpluses and trade flows, one should pay attention to the PRC’s capital account and the pressures building within the domestic financial system. While the precise levels disclosed may be “fudged”, there seems to be little doubt that the level of debt (at least 250% of GDP) and its above-trend rate of growth, when coupled with uncertainty about the quality of assets and a potential “Ponzi scheme” within the “wealth management products” sector of an unstable and poorly-controlled shadow banking system are factors that point to real fragility.

Yet, because the PRC still imposes capital controls (and has recently attempted to tighten them) in the face of a domestic savings rate that far outpaces the domestic economy’s ability to absorb it, there is a real imbalance within its economy in terms of capital being allocated into productive investments, versus being “wasted”, and constant pressure to export capital somehow.

So, the question arises as to how the PRC’s government (which is notoriously sensitive about maintaining “stability”, and whose legitimacy depends upon delivering ever-rising living standards) will handle the rising internal pressures to invest outside the country in ways that are not masked and distorted by the current need to circumvent exchange controls, or obtain bureaucratic approvals. The fall in reported foreign exchange reserves by USD 1TN (sic) between mid-2014 and early 2017 is a signal of such tensions.

In reality, the PRC’s government faces a dilemma, because if it continues to impose capital controls, while trying to curb excessive credit, it risks its much-vaunted ability to “manage” growth potentially being compromised, with all the adverse political consequences that entails; whereas, if it relaxes those controls it risks destabilizing its already fragile financial system, while also transmitting that fragility (because of its scale) to the wider global financial system. In short, failing to integrate risks internal stability, while allowing more integration not only risks internal stability, but also that of the wider world.

Such issues require careful and calibrated management, not soundbites or rhetoric “for domestic consumption”- whether in the PRC or the US.

At Awbury, we believe that, while there are significant opportunities in carefully-selected risks in the PRC and Asia as a whole, accepting them without understanding the wider context and the real macroeconomic and geopolitical factors that have longer term consequences is simply foolish.

The Awbury Team

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