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Is the Bloom Off the Rose of China’s Economic Miracle?

A ChinaFile Conversation

On Monday, August 24, the Shanghai Composite Index dropped 8.5 percent, its second such steep fall since late July, and its worst since 2007. On Tuesday, stocks fell an additional 7.6 percent. The steep slide translates into more than $4 trillion in losses on China’s leading bourse since its June peak. Analysts watching a resulting global sell-off are debating whether it is a long-overdue correction in an overheated market or a sign that a longer-lasting economic slowdown is on the horizon. —The Editors

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China’s normally competent policymakers have had a rough time recently. First, against a backdrop of inexorably slowing economic growth, they encouraged ordinary Chinese to buy into a short-lived stock-market bubble. When the bubble burst, they organized a massive $400 billion program to support stock prices. Two months later, they abandoned this program, and since last Thursday the Shanghai index has fallen by 22 percent, the steepest four-day drop since 1996.

Second, the People’s Bank of China on August 11 abruptly announced a 1.9 percent devaluation of the renminbi (yuan), and declared that henceforth the currency’s daily rate would be set mainly by the market, rather than arbitrarily by the PBOC as in the past. The move was applauded by the IMF, which has long pushed China to make its exchange rate more flexible (and which requires this flexibility as a condition for the renminbi’s entry into its artificial reserve currency, the special drawing right (SDR), later this year). But after economists and analysts around the world denounced China for deliberately depreciating its currency to boost exports, the PBOC reversed course. It has spent an estimated U.S.$200 billion in currency markets to defend the renminbi at about the rate it set on August 11. In theory, it remains committed to a “market-driven” yuan, but in practice it is pulling out all the stops to prevent the market from pushing the currency down.

Many commentators have taken this confusion as a sign that China’s economy is in worse shape than its headline 7 percent growth figure suggests, and that officials are desperately clutching at any means to prop it up. There is some truth to this, but we should not exaggerate. China is in the midst of a long and painful transition from an economy driven by capital spending and heavy industry to one driven by services and consumer spending. The regions most dependent on resources and heavy industry have been badly hit, a fact already evident in official data. The three northeast provinces are reporting negative nominal GDP growth, and two other provinces are close to zero. In other words, parts of China are already in recession. Other provinces, however, are adapting better and still report solid, though slowing, growth. The most likely trajectory is that China’s economy will continue to slow for the next two years, but avoid the collapse predicted by some pessimists.

Yet the outlook is clouded by a basic uncertainty: are China’s leaders committed to economic reform, or not? In the first three decades after Deng Xiaoping inaugurated “reform and opening,” this was rarely in question. Through all sorts of ups and downs, the general direction has been towards more markets and less state. More important, at a series of crucial turning points the Communist Party surrendered control over economic levers, gambling that a bit less control would lead to a lot more growth. They did this in the 1980s by freeing farmers to grow their own crops and start small businesses; in the 1990s by eliminating most price controls, opening the door to foreign investment, and reforming state enterprises; and in the 2000s by encouraging private entrepreneurs and freeing the nation’s markets through entry into the World Trade Organization.

The Third Plenum reform roadmap unveiled by president Xi Jinping in 2013 seemed at first to offer a similar trade-off, with its promise that markets would gain a “decisive role” in resource allocation. But that document also affirmed that the state sector would maintain its “dominant role” in the economy. In the subsequent two years, that obvious contradiction appears to be resolving in favor of the state. Market reforms have proceeded in fitful increments. Reforms to the state-owned enterprises—which embody most of China’s economic problems—have failed to materialize. Meanwhile, Xi’s efforts to centralize political authority in his hands, and build up China’s prestige as an international power, have continued without pause.

Xi’s bargain is more state control now, in return for a vague hope that it will eventually be used for beneficial ends. This is exactly the opposite of the recipe his predecessors used to conjure up 35 years of extraordinary growth. The result is the mish-mash we saw this summer, when celebration of “market forces” turned instantly to massive intervention when markets delivered results not to Beijing’s liking. If growth is to revive, a convincing and consistent embrace of market mechanisms—whatever their short term outcomes—will be required.

Like looking in a funhouse distorted mirror, China reflects back at you what you want to see—and it always has.

Sometimes it has been the relentlessly positive view of the land of ever expanding markets the Lancashire mill owner dreamed of in the 19th century when mentally adding an inch to every Chinese shirttail, or the land of ubiquitous penetration today’s smartphone analysts extrapolate on a straight line from today’s 40 percent. Sometimes it has been the unremittingly negative view of a Yellow Peril washing over the earth as in the 19th century, or a cascade of falling dominos spreading Communism in the 1960s.

We’re just coming off a period when it was, by near unanimous acclimation, China’s century. Posh Western families gave their children Chinese nannies to sing them Mandarin lullabies to better prepare them for a Goldman Sachs intern competition 20 years hence; hipsters moved from Brooklyn to Beijing’s Sanlitun to notch their belt with cool experiences; banks, brokerages, private equity houses, consultancies and media companies bulked up their Beijing and Shanghai offices to harvest the seemingly inevitable riches.

But how much of the investment and planning was ever based on hard analysis versus emotion and momentum?

One need only read back a bit in the archives to see some people making decisions based on Chinese economic data, then writing long screeds decrying the value and accuracy of said statistics, then panicking when those self-same statistics looked bad, then criticizing those statistics again, and finally—as we saw this week—saying the current market carnage would only stop when Chinese statistics took a turn for the better!

Much of this is China’s own fault for making its system and workings so opaque. That opacity and lack of transparency is precisely what has created romance and stirred the emotions.

Emotional investments, however, revert to the mean in the same way financial investments do.

That reversion is precisely what we are seeing when an anchor for a major American news network claims he’s never heard the name of the president of the world’s most populous nation and its second largest economy. That’s what we see when a leading U.S. presidential candidate claims the Chinese president only deserves a fast food hamburger instead of a state dinner. And that’s what we’ll see when—and you can count on it—board room after board room will demand papers on whether “our China investment is worth it.”

One need only look to Japan for the model (much as Beijing’s leaders might hate that comparison, particularly as “Victory Day” approaches on September 3). In the 1980s, Japan was “Number One”; its wise bureaucrats could do no wrong in working with industry to steer the economy; the stock market moved ever upwards. Inevitably, U.S. students flocked to introductory Japanese courses; financial institutions and media companies bulked up their Tokyo presences; and all was rosy and bloomy—until it wasn’t. Today, though Japan is still the world’s third largest economy, the romance is off and few global companies give it an equivalent share of attention and investment.

China has many real things going for it. Its huge population surely will produce more, consume more, and build more. Its cities will grow in number and size, as will its infrastructure needs and dreams. Both its currency and diplomacy will take on greater roles in the world. But what can’t be manufactured is the romance; what can’t be forced is the dream.

The future reapers of all that China has to offer will be the realists, not the dreamers. And that, while a painful transition, will probably be a good thing.

The rout in China's stock markets has sent shockwaves across the world, dragging global equities, currencies, bonds and commodities into the worst tailspin since 2008. Both domestic and international investors seemed to have lost faith in China's once fabled ability to manage its economy, hence the deepening gloom and spreading panic everywhere. While there are very valid concerns about China's economy and financial system, market reactions are vastly exaggerated.

To start with, China's falling domestic equities do not necessarily herald a sharp contraction in its broader economy. Historically the country's immature and extremely volatile stock market has been a poor predictor of GDP growth. With retail trading dominating the market place, share prices are mostly driven by short-term sentiments, not by any rational expectations of economic fundamentals.

Since mid 2014 the Chinese equity market was gripped by sudden spikes of speculative frenzies, in part fanned by the official Party media, and started a stunning rally. As valuation quickly soared to astronomical levels, a sharp correction, and even a spectacular crash, just seemed inevitable. That is exactly what has happened over the past few months. With Shanghai now down by more than 42 percent from its peak, the current stock valuation has factored in most of the bad news—manufacturing malaise, weakening exports and capital outflows. Chinese equities are now traded at a discount to major emerging market peers that face far worse macroeconomic conditions. The risks of further sharp decline in China equities appear to be limited.

The Chinese stock market remains a sideshow as far as China's Main Street is concerned.

Unfortunately, the Chinese authorities' market interventions have done more harm than good. Far from stabilizing the markets, massive stock buying by state-owned institutions such as China Securities Finance Corp and Central Huijin Investment Ltd. have distorted the functioning of the stock market, caused widespread confusion and aggravated the risk of moral hazard, further undermining investor confidence at home and abroad.

The unprecedented stock market interventions, many pundits speculate, must have revealed the Chinese government's deep worries about the rapid deterioration of the underlying economy. Yet the Chinese stock market, though second only to the U.S. by market capitalization, remains a sideshow as far as China's Main Street is concerned.

So what has happened to China's economy? Accustomed to growing at the double digit pace, it is now struggling to reach the official target growth rate of 7 percent. But the GDP growth slowdown has been both gradual and moderate, far from being the disaster that has so spooked global investors. Even at 5 percent, China would generate more growth than any other country.

Partly to address the longstanding concern about China's over dependence on investment and export led growth and its impact on global imbalances, the Chinese leadership has vowed to transform China into a more consumer centric and innovation-led economy. Recent data clearly show such a shift has been well underway, with consumption accounting for over 50 percent of overall growth in 2014 and 60 percent in the first half of 2015. True, headline GDP growth has been trending down, but growth is now broader-based, more balanced, higher quality and possibly more environmentally friendly -- if only judging by the increasing count of blue sky days in Beijing. (Hu’s full comment can be read at World Post, where it was first published.)

My view of both Chinese economic policy-making and the quality of our assessments of it is harsher than David’s and, certainly, Arthur’s. First a disclaimer: I don’t think the equities drama is important. Another stock bubble inflating and popping is not how to judge Chinese decision-making or our record as observers. These should be evaluated against the much larger backdrop of economic performance.

Arthur praises 35 years of what he sees as pro-market reform but questions whether the Xi government will consistently hold to this path. This may now be a common view.

In fact, the pro-market reform period was closer to 25 years. China began the movement away from pro-market reform at the 2003 third plenum, when Hu Jintao’s then-new government indicated it sought technological upgrading and less “disorderly” competition. Actions that followed introduced the investment-consumption imbalance—it did not exist in 2002—where investment was largely directed by the public sector. The gap between GDP growth and personal income growth widened, standard for a command economy.

Implementation of WTO concessions made by Hu’s predecessor masked the new policy direction but, by 2008, the switch to a new model emphasizing growth over productivity was clear. In 2009, China was even praised for this, with its enormous loan stimulus via state banks called “the gold standard” of global responses to the financial crisis. Instead, the stimulus reintroduced and greatly intensified debt problems, which had been slowly easing.

Many observers welcomed the Xi government because they had already consigned Hu and company to the failed, statist dustbin. The 2013 third plenum was lauded for re-embracing market reform.

I agree with Arthur that the 2013 plenum, while an improvement over stated Hu-era policies, was not an especially convincing program. But China’s policy missteps are certainly not two years old, they are at least six and arguably as much as twelve. The immediate implication is there is a much deeper hole to dig out from than most observers have been willing to recognize, at least to now. This may be why Premier Li Keqiang keeps emphasizing how painful reform will be.

It also raises David’s point—why did most people miss this? One reason is the world’s, not just China’s, obsession with GDP. Investment-consumption imbalances, merely moderate personal income growth, higher income inequality, environmental destruction—all were treated as secondary for years because China reported fast GDP. Not only was this a strange priority at the time, the flaws in the development model guaranteed fast GDP growth itself would fade.

Related but distinct is the emphasis of outcomes over the factors driving them. The China story was taken to be, not reforms granting private property rights and permitting some competition, but the numbers they generated. As long as the numbers were being reported (by what is effectively an arm of the ruling party), there was little concern about what was behind them. David calls this emotionalism, I call it bad economics.