Monday 18 November 2013

More Thoughts about China.

Reaction to the third plenum has been overwhelmingly positive. Market reaction, social and economic commentary, as well as the sentiment in the mainstream media have all hailed Xi's first step towards a pretty aggresive reform agenda.

There have been a few detractors however. Most are skeptical about the implementation process or the seemingly contradictory nature of some of the key points; like strengthening SOE's while pushing for market liberalization, or the target completition date of 2020.

I think this is a fair recognition of how complex these reforms are, and I'd take that any day over overly simplistic targets that can't realistically be met (as we see in most western democratic elections). As a supporter of a weak efficient market hypothesis world view I tend to believe that increasing the market discipline can, and probably will, create strong SOE's. The time lag gives the CPC plenty of time to implement, test, and alter these reforms to produce positive results. Another policy path that has served China well. Giving the CPC the benefit of the doubt is the least we can do after their 30 year track record of reform and growth.

In the following article from Forbes by James Gruber, a few items are specifically outlined. I'll run through my thoughts on them (a few of which we hear regularly from China skeptics). Namely, the disproportionate weight of SOE's, the unknown debt levels, and the slowdown in growth.

China's Bold Reforms Are Bad News For Markets (Forbes)

While outlining the many positive impacts of the reform package, the author outlines three key areas that he believes may well result in a net negative market impact for these reforms:
There are a few simple reasons why I think these bold reforms will be negative for markets. First, it’s obvious that this will be net-negative for the majority of China-listed companies. Investment firm, Eastspring Investments, estimates 64% of profit from the Chinese stock market comes from sectors which have benefited from regulated pricing – such as banks and utilities. These sectors will get pummeled by the proposed reforms and consequently so will profits for the majority of Chinese-listed firms. That’s bad for the local stock market. 
More broadly, I don’t think this reform agenda will reduce concerns about China’s growing debt bubble. These concerns may actually grow. The bubble is a real problem which needs concrete, immediate solutions that this agenda doesn’t provide. 
Long-term, if the agenda’s reforms are implemented in full, there’s a greater chance of China growing in a more sustainable manner. That’s undoubtedly a good thing for China. However, the switch to a more consumption-led economy will almost certainly mean much slower GDP growth. Over the past decade, investment growth has averaged close to 15%, while consumption growth has averaged about 9%. If you’re committed to significantly slowing investment growth, then consumption has to make up some of the difference. And it’s very unlikely too given it’s already coming from a high base. Therefore, simple maths suggests that GDP growth slowing towards 5% is highly probable over the next five years. The world may not be prepared for this type of slowdown.

The reasons are basically: a). Market de-regulation will hurt the companies that produce the majority of China's current earnings,  b). Not enough attention was paid to local debt, and c) China's slowdown (as consumption growth won't be able to offset reductions in investment) to 5% will have a negative impact on the global economy.

On point a). I get the point, and it is plausible. It just seems a bit "all else equal" (cetris paribus in econ parlance, meaning: this analysis isn't terribly representative of the real world). Reducing market distortions will, all else equal, hurt companies that benefit from market distortions. If those companies have a material impact on the overall performance on the stock market, then the stock market will perform poorly... all else equal. So, fair enough.

Failing to wrestle with the benefits associated with freeing up the financial sector, allowing private smaller companies access private capital (albeit on smaller scales), and allowing the larger banks to set rates and allocate capital in a market informed manner seems a bit short sighted. All else isn't equal, and that is kind of the point of these reforms.

On point b). Local debt is certainly a big issue, especially if we are to see significant land reform (hinted at) that would give the rural populace a more equitable share of the land purchase proceeds that are currently flowing to local government coffers. The CPC have requested a more detailed inquiry into the debt levels of local government, so we should get a better idea of how extensive this issue is. In addition, the expansion of bond issuance privileges and liberalization of financial markets should increase efficiency and transparency of debt and investment allocations. This may not be enough to mitigate the unknown debt tally, but it should, at the very least, offset it to some level.

On point c). The slowdown in China's growth rate is certainly an issue that the global economy will have to wrestle with. But I wonder whether it's the growth rate or the nominal change in the economy that matters here. In 2000 China's 8% real GDP (RGDP) increase produced a Nominal GDP (NGDP) increase of $100B. In 2005 China's 11.3% RGDP increase resulted in $400B more NGDP. In 2012 China's 7.8% RGDP growth produced $910B (it is worth noting that this is the equivalent of adding a Canadian sized economy every two years) worth of NGDP. Does 2005's 11.3% have a greater impact then 2012's 7.8%?

My point is that a lower growth rate on a larger number often produces a larger change. When considering how a slowdown in China's growth rate will impact consumption levels and China's appetite for resources (both consumed in nominal terms) we should consider the nominal change in current GDP rather real growth rate.

I appreciate that the author brought up China's consumption growth rate. Already around 9%, the author wonders how much higher it can climb. We completely agree on this point. Consumption growth at 9% doesn't really necessitate urgent change (in my opinion). How much higher would you want that rate? I've never really heard any answer to this beyond a comment it's relative share of GDP growth.

Ultimately, we kind of agree on all three points. I just take a less pessimistic view on their resolutions. Eliminating the inefficiency that has built current market champions will broaden and diversify the economy. I'd bet that the net effect is VERY positive in the long run. Assuming that the broadening of financial markets extend beyond private and state owned enterprises to include local governments (current not able to tap financial markets for funds), debt overhangs should be challenging but manageable. And if China's growth rate does settle around 5% level in the future (it will, but maybe not until after the 5 year timeline suggested) the huge principal results in this growth rate having a profound positive impact on consumption and the global economy.

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