Why a recession would be good for China
To stem the ills from rapid growth, Beijing should raise utility tariffs, credit costs and the yuan's exchange rate
China’s economic growth slowed in the final three months of last year to 7.7 per cent, the weakest quarter since 2009, but still way too fast to allow for the restructuring that the country urgently needs.
Slowing growth has clearly worried global markets, but as a private investor – and a loyal Chinese citizen – I pray for an even bigger fall.
It is no secret that China’s high growth in the past three decades has been spurred by aggressive fiscal and monetary stimulus, as well as higher productivity.
China’s bank credit has expanded at a compound annual rate of 18 per cent, and money supply at 21 per cent over the last 27 years.
Such rapid growth has allowed a large array of ills to sprout up alongside – environmental degradation, resource depletion, income inequality and runaway government debt. All these ills are interlinked, and they are becoming unbearable.
So how would I like the economy to change?
I’d like the government to liberalise the prices of at least three things: utilities, credit and the currency.
I want to see tariffs on water, gas and electricity rise substantially — by as much as two to three times immediately, if possible.
You may think that is being too aggressive. I’m not.
In the past decade, or two or three, the prices of utilities have lagged far behind inflation, and this has led to huge amounts of waste, pollution and depletion of resources.
Despite condemnation by the government and the public, most of the heavy polluters continue to operate because they extract “environmental dividends” from the planet without paying an adequate price.
If, as I hope, many big polluters were shut down, that would be a welcome change – despite the economic recession that such action would likely contribute to.
Second, in most of the past 35 years, China’s interest rates on bank deposits have not reflected the sacrifice of the savers who are delaying consumption. And, indeed, interest on those deposits has been below the inflation rate.
That rip-off has led to huge and persistent subsidies to business. They get low interest rates on loans and consequently low hurdle rates for returns on investments. That has artificially boosted economic activity for too long.
Finally, whatever your school of thought, the clearest test of a currency’s fair exchange rate has to be its trade balances in the medium and long term.
The fact that China has run a trade surplus of large magnitude in the past two decades proves the point that its currency is undervalued.
The mainstream view is that this currency distortion benefits China. I argue the opposite.
In addition to extra transaction costs associated with currency controls, it amounts to a reduction of Chinese consumers’ real incomes, particularly in terms of the quantities of imported goods they can purchase.
It is a subsidy the household sector is forced to provide to businesses. It depresses private consumption. It is another rip-off.
Logic dictates that if something is unsustainable, it will eventually stop.
China’s rapid growth, fuelled by fiscal and monetary stimulus, will stop. The only questions are when and how?
Given the dominance of the state sector, which has a high tolerance for low returns, and the existence of millions of low-wage workers, China Inc’s business model can continue for a long while to come.
But that does not mean that allowing it to do so is in the best interests of China’s citizenry.
The sooner the economy slows on the back of higher utilities tariffs, higher interest rates and a higher exchange rate for the yuan, the better it will be for the country.
A sharp slowdown in the economy does not mean weak returns for equity investors. This is shown by the US experience.
In an essay published in 2001, Warren Buffett split the 34 years between 1964 and 1998 into two equal periods.
In the first 17 years, the US economy surged a cumulative 373 per cent, while the benchmark Dow Jones Industrials index ended flat, hovering mostly at around 875 points in that period.
But yields on long-term government bonds surged along with gross domestic product, rising to 13.7 per cent from 4.2 per cent on the back of rising inflation.
In the second 17-year period, the economy grew by a more modest 177 per cent, but the Dow staged a 10-fold surge (from 875 points to 9,181).
Government bond yields fell steadily from 13.7 per cent to 5.1 per cent, thanks to the tough monetary policy of the then chairman of the Federal Reserve, Paul Volcker, that brought down inflation.
Buffett was not trying to prove that GDP was negatively correlated to equity returns but simply that in the long run, it was the inflation rate (and thus nominal interest rates) that mattered most to equity valuations and investor returns.
You cannot find a better response to the experience of the US than China today.
In the past two decades, investors in China equities got a lousy deal – both the domestic stock market and Hong Kong’s H-share market disappointed hugely – despite the double-digit real growth of the Chinese economy year after year.
The reasons included poor corporate governance and the rapid dilution of shareholder interests. More importantly, high inflation and therefore high nominal interest rates in the free market – though not the regulated interest rates – have hurt corporate profitability and equity valuations.
The counterintuitive solution to this problem is that China must raise interest rates to eventually bring down interest rates, which in the process will conquer inflation.
And that is why I pray for a further slowdown of the Chinese economy.
Joe Zhang is a former official at the central bank of China, and the author of Inside China’s Shadow Banking: The Next Subprime Crisis?