China's Number One Objective is to Avoid Disorder, Whatever the Cost

Of the ten conflicts in human history with the highest death tolls, five were civil wars in China.  Chief among these was the Three Kingdoms War (184-280 CE) when up to 40 million are reckoned to have perished in military operations and from the destructive consequences of warfare.  This is an enormous number, considering that the global population at that time is unlikely to have exceeded 400 million.  More recently, the Taiping Rebellion (1850-1864) claimed more than 20 million lives while the civil war that brought the Communist Party to power in 1949 resulted in 7.5 million deaths, over and above the 20 million estimated to have been killed in the roughly contemporary Japanese invasion.  This is not the history we were taught at school but Chinese leaders are well aware of these facts.  When disorder breaks out in China, things turn very nasty indeed.  It is best, therefore, to avoid disorder at almost any cost.

Admittedly, it is very difficult to imagine the Chinese families happily thronging Oxford Street in this holiday season resorting to insensate violence.  But these are the ones who, for the moment, are the beneficiaries of China’s erstwhile economic success.  It is those who cannot afford to travel abroad, and we do not see, who might potentially be the foot-soldiers of disaffection.  The hundreds of millions of rootless workers, floating between countryside and city, who are content enough when receiving regular wages, are apt to become a threat to internal security when idled through a collapse in demand for their products.  This is why it has long been a cardinal principle of the Communist Party leadership to avoid a rise in urban unemployment.  It should come as no surprise that, according to figures supplied to the IMF, China’s unemployment rate has averaged 4.1% in every year, without exception, from 2010 to 2014.  It is officially projected to average 4.1% in 2015 and 2016, too. What are the chances that such a progression is natural?  We should be cautious about accepting this remarkable data as evidence of Beijing’s success in achieving its full employment goal, since it is not entirely clear how the figures are collated.  It is plausible to argue there is a floor to China’s jobless rate, seeing there is a supply of under-utilised rural labour to meet any shortage of workers in the cities.  But it is rather puzzling there has been no upside variation in the data either, for all the variability in demand to which China’s industries are subject.  We can only assume that the unemployment figures are even more politically sensitive than those for GDP, where the authorities have allowed at least the occasional fractional deviation from forecast to be published.

Doubts about China’s economic growth statistics are fuelled by whatever high-frequency data are published.  Thus, in the first half of this year, auto output rose by only 2.6% while electricity generation increased by a mere 1.3%.  Steel production fell by 1.6% between the first half of 2014 and the first half of 2015, while rail freight traffic was down by 11.4% over the same period. It is difficult to square figures like these with the official estimate of annual growth in real GDP of 7%.  Beijing’s statisticians make a valiant attempt to harmonise the power consumption data with the published GDP figures, claiming that the difference represents the more efficient use of energy in production processes.  It is less easy to explain away the freight data.  To be sure, there are some industries, production of electronic goods for example, that are still recording spectacular rates of growth.  All the same, overall growth in industrial output, which includes these expanding industries, was still scarcely more than an annual 6% in the first half of 2015 and would normally be expected, at China’s current stage of development, to be delivering stronger growth than other sectors of the economy. Admittedly, there may have been quirks in the second quarter of 2015 economic statistics that could have resulted in an above-trend result for GDP growth in that quarter.  Net trade could have made an unusually positive contribution to China’s GDP, with the rate of decline in imports outstripping the fall in exports.  But that would not be a pattern characteristic of a sustainably strong economy.  The conclusion must be that the Beijing statisticians are making some very favourable assumptions in sticking to their view that China’s economy is achieving, and will continue to maintain, 7% growth this year.

If China’s economy is not as large as it is commonly assumed to be, the ratios of debt to output could be even more stretched than they appear to beFor some time past, economic analysts elsewhere in the world have greeted China’s quarterly GDP data with scepticism.  Oddly enough, they have been willing to accept without demur the GDP levels consistent with those growth rates, taking them as an accurate reflection of reality.  Thus, statements that China now has, in purchasing power parity terms, the largest economy of any nation in the world go unchallenged.  Yet, if the GDP growth rates are lower than claimed, the GDP levels must also be lower. It is not only sticklers for statistical accuracy that need worry about this. If China’s economy is not as large as it is commonly assumed to be, the ratios of debt to output, already worryingly high on the basis of the published figures, could, in fact, be even more stretched than they appear to be.

The case of China, indeed, well illustrates the drawbacks in tracking output-based measures of GDP highlighted in our briefing last week.  As a practical matter, it is extremely difficult to get an accurate fix on production in the wide range of industries that make up an economy, especially when the output of some of those industries is not material but consists in the provision of services.  If GDP is reckoned to be a measure of social welfare, there is also a problem in taking output data as a guide.  It may be that some output does not satisfy social needs and, to that extent, may be deemed superfluous.  In China’s case, there is the suspicion that some recent construction has not been directly aimed at satisfying social demands but has been a response to governmental diktat. From one perspective, this might be regarded as a waste of resources rather than an economic good.  In welfare terms, it might well seem that it makes a negative contribution to the economy.  However, if economic performance is measured solely by the volume of output, it may appear positive.  Tales of phantom cities and stockpiles of raw materials and intermediate goods suggest that some of China’s recent reported growth has yet to find a social use.  To that extent, it should be subtracted from reported GDP to arrive at a just assessment of the extent to which China’s economy has satisfied demand, a true measure of its underlying strength.

The quadrupling in loans outstanding over a four-year period raises questionsProbably the most alarming aspect of China’s development in recent years has been the growth of the ‘shadow’ banking sector.  Anything that is described as ‘shadow’ is liable to raise suspicions.  In this case, the suspicions are probably justified because the lack of transparency in China’s ‘shadow’ banking operations is extreme relative even to the usual ‘shadow’ connotations. However, the expansion of wealth management products supporting trust lending is fairly well documented.  From a level around Rmb1.7 trillion in 2007, trust loans had expanded to almost Rmb7 trillion by the middle of this year.  The latter figure is equivalent to more than $1trillion (for comparison, the assets that fell under suspicion at the outset of the sub-prime mortgage crisis amounted to about $300 billion).  The quadrupling in loans outstanding over a four-year period raises questions.  Among them, we may well ask whether lenders can have conducted proper due diligence before extending the loans.  Furthermore, will borrowers be able to bear the considerably increased debt burden?   An answer to the latter question is already emerging as a rising number of trust lenders find their loans turning sour.  This week there were reports that lenders in Hebei province had appealed to government officials for a bail-out.  This was a deeply worrying development.

What focused international attention on China a few days ago, however, was the People's Bank of China’s - the central bank - move to modify its exchange rate policy.  This was widely interpreted as devaluation, though the PBOC has gone to some lengths to refute that suggestion.  Early this year, there had been a flurry of concern in world markets about the risks of China devaluing its currency.  That was a time, in February, when global deflation fears were at their height   Echoes of that anxiety were heard last week when the exchange rate of the yuan dropped following the PBOC’s policy-shift.  How significant the yuan exchange rate is for world inflation is a moot point.  There had been hardly any comment on what we must presume was the inflationary impact of an appreciating yuan while China’s currency was rising, in effective terms, from 2010 to February 2015.  In fact, according to figures from the Bank of International Settlements, the yuan’s effective rate rose by an additional 3% between February and July, a gain that has so far merely been reversed over recent days.  Given the variable lags between exchange rate movements and their economic consequences, what has happened with the yuan since 10 August is likely to have a negligible effect on the global inflation outlook.  Indeed, the lagged effects of past years’ yuan appreciation are probably still the dominant element in the Chinese currency’s influence on global economic conditions.  After all, the yuan’s effective rate, again on BIS calculations, rose by no less than 30.% between October 2010 and July this year.  It would then take a much sharper, and sustained, fall in the yuan, which the PBOC has stated is not its intention, to make much difference to the macro-economic outlook.

The priority for China’s authorities at the present time must surely be to head off an internal systemic crisisNevertheless, international reaction to the PBOC’s action, even if not rationally based, could have a significant economic impact, if only temporarily.  If market participants interpret the PBOC’s move as deflationary, as it appears they are, commodity prices, including for oil, could be depressed at least until underlying supply/demand factors reassert themselves.  It is worth noting that central bankers in the USA and the UK have, in recent weeks, taken to expressing more forcefully their consensus view that downward pressure on domestic inflation rates from oil and commodities will be transient. A longer-term worry is that the slight reduction in the yuan’s exchange rate will spur competitive devaluations elsewhere, heightening the sense that central banks are in the midst of a global ‘currency war’.  But many central banks are likely in any case to have resorted to currency devaluation as a means of gaining a competitive advantage, without prompting from the PBOC.  The markets may read much into this week’s 1% dong devaluation by Vietnam’s central bank as a response to the PBOC but this followed a similar move as recently as May, which was entirely independent of China’s policy.

There is good reason to believe the Chinese central bank when it says it does not aim for a steep fall in the yuan.  Such a decline might heighten international worries about the value of China-based investments.  The risk then might be that capital outflows from China would intensify, thereby increasing the threats to domestic liquidity that might arise from internal sources.  The priority for China’s authorities at the present time must surely be to head off an internal systemic crisis that could inflict much more damage on employment prospects than would a somewhat overvalued exchange rate.  Consideration of the risk/reward balance is likely to underpin the PBOC’s resolve to avoid too sharp a yuan fall.

The trouble is that China’s policymakers are far from infallible.  The Tianjin explosions are a reminder to the world at large, as to China’s population, that the Beijing leadership is not guaranteed to solve all problems that arise.  Indeed, unpleasant outcomes may now be very hard to avoid, whether they take the form of a ‘shadow’ banking crisis or a cloud of cyanide gas. The refractory mood of the people has been evident in the protests of Tianjin residents against the authorities’ response to the disaster.  The crumbling edifices of the Chinese seaport stand as a metaphor for the state of China’s financial structure after years of expansion without proper regulation.

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About the author

Stephen’s career spanning five decades has made him one of the most respected and unique voices in the City of London. Disclaimer regularly publishes a selection of his elegant and thoughtful essays on the global economy, which he has been writing regularly since he founded Fifth Horseman Publications in the late 1980s. As well as an economist, Stephen serves as Treasurer of the Forum for European Philosophy and was elected to the Royal Institute of Philosophy.

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