China’s long road ahead

Christophe Bernard (pictured) is chief strategist at Vontobel.

“One country, two systems”, a famous phrase coined by the late Chinese leader Deng Xiaoping, has served China well: letting Hong Kong’s western-style economy co-exist alongside a state-controlled system has helped fuel spectacular growth rates in the past decades.

Chinese officials were able to take credit for that. However, belief in the leadership’s economic savvy has waned amid sagging growth and heavy-handed government interventions in the country’s equity markets.

There is little doubt that China has achieved a lot since it opened up to the world under Deng Xiaoping in the late 1970s: GDP growth rates have been stellar and the improvement in the standard of living impressive.

However, this success has been increasingly credit-driven and overly dependent on investment in areas such as real estate and heavy industry.

At the third plenum of the central committee of China’s Communist party in November 2013, the country’s leadership recognised the need to rebalance the economy towards consumption and services, outlining an ambitious long-term plan to allow market forces to play a larger role.

This is easier said than done: the slowdown of the economy has turned out to be sharper than expected.

In addition, economic and monetary policies have lacked coherence to the point that a crisis of confidence has emerged. This can be seen from the massive drop in Chinese foreign-exchange reserves over the past 18 months.

Yawning gap between stated intention and action

It seems that the government is trying to pursue objectives that are mutually exclusive.

For instance, fighting a depreciation of the Chinese yuan by selling foreign-exchange reserves is preventing the Peoples’ Bank of China (PBoC) from easing monetary policy at a time when it is sorely needed.

By the same token, the authorities have identified massive overcapacity in industries such as steel, cement or coal, but balk at addressing this issue for fear of a surge in unemployment – a development that could threaten social stability.

Likewise, the authorities correctly assume that a higher degree of freedom for economic agents is necessary for climbing up the GDP-per-capita ladder; but they resort to intervention when markets behave “badly” – i.e. when they do not follow the leadership’s script.

The Chinese government’s massive and recurrent tampering with local bourses since the summer of 2015 bears witness to this policy incoherence.

The core issue in China is that there is no easy way of doing away with the mountain of debt that has piled up over the years from massive investments in areas with sharply declining profitability.

The result is a downward trend in economic profits at a time when disinflation has become pervasive, making debt sustainability a major challenge.

As a rule, countries facing such imbalances experience a full-blown crisis with a sharp drop in their currencies and economic output, eventually setting the stage for a sustainable recovery.

Given plentiful foreign-exchange reserves, a positive trade balance and the ability to control the yuan, China has the capacity to delay or smoothen such a downward adjustment. However, it cannot defy gravity forever.

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