The China Delusion

By Robert Johnson, President of the Institute for New Economic Thinking and a Senior Fellow and Director of the Global Finance Project for the Franklin and Eleanor Roosevelt Institute in New York. Originally published at the Institute of New Economic Thinking website

China’s management of its exchange rate peg continues to rattle global financial markets. Uncertainty about renminbi devaluation is fuelling fears that deflationary forces will sweep through emerging markets and deliver a blow to developed economies, where interest rates are at, or near, zero and thus cannot be lowered to defend against imported deflation. Fiscal gridlock in Europe and the US is heightening the angst.

But the current bout of exchange rate anxiety is really just a symptom of the fact that China’s transition from an export-led growth strategy to one propelled by domestic consumption is proceeding far less smoothly than hoped. For some people, visions of the wonders of capitalism with Chinese characteristics remain undiminished. They are certain that, after more than three decades of state-directed growth, China’s leaders know what to do to turn their slumping economy around.

The optimists’ unreality is rivalled by that of supply-siders, who would apply shock therapy to China’s slumping state sector and immediately integrate the country’s underdeveloped capital markets into today’s turbulent global financial system. That is a profoundly dangerous prescription. The power of the market to transform China will not be unleashed in a stagnant economy, where such measures would aggravate deflationary forces and produce a calamity.

The persistent downward pressure on the renminbi reflects a growing fear that Chinese policymakers have no coherent solution to the dilemmas they face. Floating the renminbi, for example, is a dangerous option. After all, with the Chinese economy undergoing wholesale economic transformation, estimating a long-term equilibrium exchange rate that will anchor speculation is virtually impossible, particularly given persistent doubts about data quality, disclosure, and opaque policymaking processes.

But if the current exchange-rate peg to a basket of currencies fails to anchor the renminbi and prevent sharp depreciation, the deflationary consequences for the world economy will be profound. Moreover, they will feed back on the Chinese export sector, thus dampening the stimulative impact of a weakened currency.

The key to stabilising the exchange rate lies in creating a credible development policy. Only then will the pressure on the renminbi, and on China’s foreign-exchange reserves, subside, because investors will see a clear way forward.

Establishing policy credibility will require diminishing the muddled microeconomic incentives of state control and guarantees. It will also require reinvigorating aggregate demand by targeting fiscal policy to support the emerging economic sectors that will underpin the new growth model.

But, as usual with China, such a strategy is riddled with contradictions. For example, reducing the size of the state-enterprise sector is necessary, yet would be certain to depress aggregate demand at a time when demand is already soft. Likewise, cutting fiscal support (via government-directed bank lending) to zombie firms would free up fiscal capacity and enable resources to be redirected to new sectors that facilitate services and urban employment; but this would exacerbate – at least at first – the current demand shortfall.

Slashing the state sector abruptly and expecting to achieve transformation through austerity is not the way forward. Economic historians, notably Michael Bernstein in his study of the great depression in the US, have convincingly shown that an economy in transition requires strong aggregate demand to pull resources into new sectors. If both the old and new sectors of an economy are in a slump, capital formation will sputter, investment in upgrading human capital will decline, and structural adjustment will stall. Robust aggregate demand is always essential to successful transformation.

An equally large obstacle to China’s economic transition – the problem that almost dare not speak its name – is the widespread worship of China’s hybrid market economy. Simply put, current muddled market incentives impede transformation by favouring state-owned enterprises.

In early 2012, when the Chinese leadership moved toward stronger private ownership, stocks in the private-sector sub-index outperformed the state-owned sector sub-index on both the Shanghai and Hong Kong stock exchanges. But since the spring of 2014, this trend has reversed, and the state-owned sector sub-index has outperformed the private-sector sub-index. As the Chinese economy slows and default risk grows, the value of state guarantees rises, directing capital away from private-sector growth.

This hybrid system clearly impedes credit allocation from catalysing development while creating and sustaining vested interests opposed to change. This holding pattern is particularly harmful because profound transformation will surely depend on financing from a sound sovereign bond market, which cannot function properly until uncertainty related to the government’s contingent liabilities – all those implicit guarantees – has been resolved.

China has it within its power to stabilise its exchange rate via credible reforms, particularly policies that redirect resources to invigorate domestic demand and pull resources toward the newer high-value sectors. The overhaul China needs cannot be accomplished in a slump, or by a large exchange-rate depreciation that deflates the world in a vain effort to turn back the clock to an era of export-led growth that stagnant demand in the west has rendered nonviable.

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  1. PlutoniumKun

    Given that it seems that China has opened up the credit lines again, causing yet another leap in debt levels, its hard to see how aggregate demand can be maintained over a period of intense structural change without creating more problems than the reforms solve. I do wonder if the government has found itself caught in a pattern of continuous pump priming in order to create the space for structural reforms, and then finding it easier to only do token reforms. This can become a self-feeding loop, which can only end in disaster.

    It seems to me that many commentators are too focused on the macroeconomics of reform, and failing to see ‘ground level’ policies that could ease the way. As one example, everyone agrees that there is too much production capacity in the country. But nobody wants to take the risk to internal security involved in shutting down excess mines, cement plants, etc.

    But a policy of putting in place a secure social security protection for ex employees – say, guaranteeing them their pensions plus their salaries for a number of years could allow local governments to systematically shut down older companies and excess plant – this could be paid for by the rising value of the remaining factories as surplus capacity is reduced. The reality is that people don’t fear unemployment – they fear poverty. Addressing this side of the problem could be much more useful for allowing the transition to occur than trying to shore up aggregate demand (which in practice means pumping more credit into the economy), and hoping that lower level cadres do the right thing.

    1. James Levy

      OK, I’m a broken record on this, but nevertheless, the people in charge everywhere will do anything, I mean any harebrained scheme, other than give ordinary people money to increase aggregate demand. So although your suggestion is a good one, it will never fly. I would add a hefty earned income tax credit plus a seriously steep progressive tax over, say, double the average annual salary, plus capital controls. Again–never happen.

      The elite in China have the same problem the elite have here. What’s good for them as individuals is toxic to the economy and body politic. If anything the economic and political elite in China may be even more intertwined than they are here, as extended families are the basic unit of society more than individuals are. In America the connections are more of alma maters, clubs, and neighborhoods; in China they seem to be more of blood and marriage. In both cases the results of policies are seen from a very high, narrow, and skewed perspective. The ethos of “taking one for the national team” is just not that strong, but looking out for yourself and those just like you is. The elites think more like members of the Mafia or the NYPD (completely insular, us-versus-them, keep your mouth shut and protect your own, screw outsiders) than citizens, or, god help us, statesmen.

      1. Steve in Flyover

        “give ordinary people money…..”

        The 1%ers view, in which employment is considered a handout to the wretched refuse..

        I prefer:

        “Paying ordinary people the money stolen from them by the corporate class over the last 30 years……”

        1. MyLessThanPrimeBeef

          All new money belongs to the people.

          Over time, that will swamp anything stolen in the last 30 years (though that is a needed reparation as well).

          I hope more and more people realize they are the people referred to in the government of the people, for the people and by the people.

        2. digi_owl

          And they want to keep the unemployment high, as then they have a cudgel against the masses (at least until riots and revolutions flare up).

      2. fresno dan

        James Levy
        February 19, 2016 at 11:32 am

        “OK, I’m a broken record on this, but nevertheless, the people in charge everywhere will do anything, I mean any harebrained scheme, other than give ordinary people money to increase aggregate demand.”

        Best analysis EVER!!!

      3. fds

        Though what you say about the oligharcic license of the Chinese elite is accurate, Chinese do have an “in” and “out” group. They won’t screw over the culture with foreign ownership of media and they wont destroy themselves with immigrants. They will also rip off foreigners to strengthen their economies.

        So, Chinese society is much more corrupt and incompetent, and less innovative, but there is more cultural solidarity.

    2. susan the other

      It’s Karma (ours) that China embraced free marketeering (somewhat) in the 70s just as we were learning about global warming. And this coincided with us doing supply side economix to control inflation which sent most of our industry to China, making the future problem much worse. But the next move in the karmic universe will be against us because China has the authoritative capacity to shut down coal mines and coal electricity; to shut down cement factories; to dictate the auto industry; etc. We do not have this tool. So it is not illogical to assume that China with its huge pollution problems will take another great leap and start employing its massive population in environmental cleanup and alt energy. China is undeniably shovel ready. It will make our bickering, greedy, fractious democracy look incapable.

  2. Synoia

    1. The key to stabilising the exchange rate lies in creating a credible development policy….

    2. For example, reducing the size of the state-enterprise sector is necessary,

    The first point involves cleaning up their country, a massive undertaking and the second is presented as a “must” which is dubious because it leads to looting. See Russia.

    The Chinese also do not trust their Government (probably with reason) and the Capital flight large, a neighboring City in in SoCal, Irvine, has may cash buyers, typically Chinese.

    That money would be better spent at home in China, but it would have to be spent by the Chinese Government to clean up their country (and generate many state jobs)after being taken by taxes.

    Here’s my suggestions: float the currency, impose Capital Controls, and impose a 5 year plan to address climate change and pollution. China will remain the manufacturing center of the world even with austerity driven diminished demand.

    1. washunate

      Isn’t the reason Chinese citizens are buying property in North America that they hold US and Canadian dollars? How exactly do you propose spending dollars at home? At the margin, our friends in Asia have to spend them back here in North America. And spend they have, on everything from real estate to Treasury securities.

      1. MyLessThanPrimeBeef

        They could buy our burgers and soft drinks.

        But they are smart. They buy investment properties and companies.

        1. digi_owl

          That would be smart, if there was a future buyer to be found.

          but when everywhere is in a depression, those “assets” are effectively worthless.

          1. MyLessThanPrimeBeef

            Maybe you’re right.

            Maybe these corporations, like Ingram Micro and Syngenta, or the expensive houses in Manhattan and Irvine, will be worthless.

            But they will be busy extracting rent in the meantime.

            Extracting enough to buy a seat on the rocket out when the two worlds collide.

            1. Mike G

              Maybe it’s about having a place to bolt to if China becomes dangerous through civil unrest or government action, and positioning financial assets beyond the reach of the Chinese government. The history of China is big swings from right to left and back again.

              People worried about confiscation or their physical safety aren’t too fussy about rates of return.

    2. MyLessThanPrimeBeef

      You’re right.

      First, clean up that country, restoring faith in their government, that is, the Communist Party in fact.

      Clean up, physically, but more importantly, mentally.

      To get rich is not glorious would be a good slogan.

      Slow, clean growth is better than fast, dirty growth.

      Perhaps Barefoot Doctor Health Plan for all.

      But to prevent another Red Guard, they must make sure young voters are not easily indoctrinated. If their college education is anything like ours, a typical 20 year old is no match intellectually for a 40 year old professor, and as is often the case, anyone who is interested in getting started in a career with a college certificate usually goes along with the profession in the classroom. Occasionally, there some heroic figures. But they are the exceptions. Young people of that age are better suited for vocational training – here it could mean learning to split atoms to build patriotic weapons or designing new crops of GM foods.

      The real education, the enlightening kind, is best suited when one has one real world experience, so one can challenge any one-side dogma from the professor. Again, there are exceptions.

      So, maybe, if they are lucky, they will have Green Guard this time, instead of Red Guard.

    3. Bill

      Climate change? Same lie in a new wrapper . Remember “global warming” ? That moniker went out with Al “The Penguin” Gore . Have we not had several ice ages on this planet ? We are NOT causing climate change. ,we have, and have had it for millenia . Get by that and you may be wise enough to comment on Chinese economics . Till then , why you are just another Kool-Aid drinking lemming .

  3. washunate

    Floating the renminbi, for example, is a dangerous option.

    Dangerous for whom? Currency pegs are mutually exclusive with sovereign money.

    1. Jim Haygood

      ‘China [can] stabilise its exchange rate via … [redirecting] resources to invigorate domestic demand and pull resources toward the newer high-value sectors.’

      Translation: the cure for central planning gone wrong is more central planning.

      Robert Johnson should stick to songwriting. China got a “Hellhound On My Trail” …

      1. jsn

        What with the Fed’s trading desk, QE, the 29T bailout, GM, foaming the runway and the fact the whole banking cabal is right where it started in 2007, there’s a pretty strong case that our central planning is just better than China’s, at least for asset holders. Central planning it remains, none the less.

      2. Sarah Connors

        Jim, I fully expect you to come out as a gold bug, doomsday prepper, Trump supporter one of these days.

        1. washunate

          I thought Jim was the resident advocate of a gold standard, no secret about it? I think diversity of opinions is important in our era of remarkably rigid intellectual groupthink.

          As far as doomsday, liberals do it just as much, just on different issues. Preparation isn’t some evil thing; it is the key to success. And Trump is more honest than Hillary Clinton and Barack Obama combined.

    2. MyLessThanPrimeBeef


      Only one exceptional country is truly sovereign.

      One can be pseudo-sovereign if one works hard to accumulate lots of global reserve currency.

    1. NotSoSure

      The delusion is thinking that the elites want to have a soft landing. A hard landing would allow them to grab even more power.

  4. Dino Reno

    Money shot: An equally large obstacle to China’s economic transition – the problem that almost dare not speak its name – is the widespread worship of China’s hybrid market economy. Simply put, current muddled market incentives impede transformation by favouring state-owned enterprises.

    It was not fun while it lasted, and what’s next is even worse. This is going to hurt.

    1. OpenThePodBayDoorsHAL

      Comparisons are tricky, since China does not have credit creation mechanisms akin to ours, that (used to) reach a capitalist denouement moment when truly excess credit flooded the system. The PBOC sets the credit creation target, which banks must then accept, and the “hot potato” gets passed down down the chain to smaller lenders…and eventually to state-owned enterprises in a wonderful circular fashion. It works like the wartime system in Japan (nicely described in the video The Princes of the Yen). The Japanese money system eventually drove the value of one Tokyo district to exceed the value of Canada (now 30 years later that district is valued at 1/30th the value of Canada).
      In the last two months credit expanded in the Chinese system by $1 *trillion* USD. But if no-one is ever in default, can’t that proceed indefinitely? (I’m sure MMT’ers can describe why the scrip does not eventually lose all value).

      1. cnchal

        . . . But if no-one is ever in default, can’t that proceed indefinitely?

        I wonder, with the power of exponential growth, will there ever come a time when the computers are incapable of calculating the total?

      2. Robert Coutinho

        Well, it seems that for it to lose “all value”, the underlying items securing the loans would have to be unusable. Otherwise, its value can fall–greatly–almost completely. However, Lehman Bros stocks still had a value (I think it was around $0.03) a few years after their demise.

  5. oho

    “the people in charge everywhere will do anything, I mean any harebrained scheme, other than give ordinary people money to increase aggregate demand. ”

    too bad this spot-on analysis can’t fit on a bumper sticker.

    1. animalogic

      Spot on !
      Unfortunately, for elites, economics is primarily a device for the concentration and application of power.
      The efficient management of markets is a necessary, but secondary consideration.

  6. Cry Shop

    Not sure if Xi Jing-Ping is cracking down because the economy is likely to collapse or because he’s cracking down therefore the economy is probably going to collapse. Xi apparently escaped an assassination when he took power, there is very little chance he will bow to either the two term limit nor will he let any damage to either the party money oligarchy or the people’s welfare slow him down. I would not put it past him that he’s even preparing for a hot war with the USA as a tool to re-assert a Maoist dictatorship over the party during the crisis.

    Normally limited war stimulates economics, but with so much being made in China, the embargo, etc; probably will collapse the US/EU economies as shelves empty, and then watch the flood gates of refuges open wide.

  7. Jim A

    Economic strategy is riddled with contradictions EVERYWHERE, not just China. There are many negative feedback mechanisms in economys, and so the near term is often directly in conflict with the long term.

    1. Synoia

      There are negative feedback mechanisms in economys

      I don’t think “negative feedback” means what you believe it means.

      In mathematics negative feedback is perfect under all conditions to which the second order differential equation applies. Please note the theoretical constraint.

      Negative feedback, as engineered, only works within a much smaller specific set of constraints, because of non-linearity.

      In economies the feedback is not continual (as in second order differential equations), not instantaneous, is nonlinear, and not negative under many conditions. Thus Chaos.

  8. Roland

    Speaking of local matters, the big flow of hot money from China to the Vancouver real estate market is not smart investment. There is little economic rationale behind most of the purchases being made by upper-class people from the PRC.

    Almost all of the purchases made here are of residential real estate, which the investors neither occupy themselves, nor flip to other purchasers, nor rent out as landlords.

    The phenomenon has been occurring on a big enough scale here to result in the emergence of entire “ghost neighbourhoods,” eerily like the unoccupied new cities in parts of China. For example, many of the condo units in the big new developments in the Point Grey area of Vancouver are neither occupied by a resident, nor up for rent, nor for sale. You can see during the evening that whole city blocks of recently-built apartments are mostly dark.

    Vancouver now has thousands of vacant apartments, and a housing supply that is growing faster than the population–but rising rents.

    These are not state-directed investments, this is just all about Chinese bourgeois getting some of their money out of the PRC and hedging their political bets.

    However, state policy, both in PRC and Canada, contributes to this sort of “zombie” investment.

    It’s the result of enormous monetary and fiscal stimulus, when such stimulus is neither directed for any sort of social purpose, nor subjected to any sort of market discipline.

    1. Cry Shop

      Same problem of hot money in Hong Kong, Singapore and funny enough Taipei. These investors don’t care if they lose half the invested value — most of this wealth was stolen, and so they see this potential loss as part of the cost of laundering and securing the funds. Their very amateur nature is evident by the ease with which overseas investigators co-operating with the CCP have been able to dig up many of them.

      Most of these guys are old party cadre with very little quality education or exposure to overseas environment. Zhou Yongkang and his brother had a house stacked with loot, one room filled with US$ bank notes, primitive indeed. Hence they tend to invest in a few real estate clusters, very much a herd mentality. They also do not trust stocks, bonds, etc; while they see gold and diamonds are easily stolen. It’s these ubermench who’ve been driving most of the investments in China vis property, infrastructure, etc.

      Hence I wonder when the whole thing will spin apart. Xi’s certainly preparing for war as a way to deflect the blame away from the CCP.

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