• Sat
  • Dec 20, 2014
  • Updated: 9:41pm

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

PUBLISHED : Friday, 24 January, 2014, 10:51am
UPDATED : Saturday, 25 January, 2014, 3:21am

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.

I want to see tariffs on water, gas and electricity rise substantially — by as much as two to three times immediately, if possible

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

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?


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This article is now closed to comments

Please Joe, you really need to get yourself an education about China mate. Seriously. Please at least read "What the US can learn from China".
You wrote: "I’d like the government to liberalise the prices of at least three things: utilities, credit and the currency." Seriously. Are you really serious. Were you born after 2008 mate. Liberalising banking and currency trading IS the reason why the west crashed so spectacularly. If China had a recession it would throw the entire world into recession and then war - that is how it works - history has taught us too many times. Your words are nightmarish Joe.
From everything I have read on China and what I have personally experienced living there for 8 years and building a factory there, China's central Government is doing just fine. They are outperforming the west because of competence in Beijing.
The day that China adopts the so-called Washington Consensus and unleashes the 'hounds of hell' (investment bankers, day traders, currency traders, derivatives traders and their handlers) is the day I will leave China.
To blame the 2008 crisis only on the 'investment bankers, day traders, currency traders, derivatives traders and their handlers' in the West is very strange indeed.
'The roots of the financial crisis can be traced directly and primarily to affordable housing policies initiated by HUD (U.S. Department of Housing and Urban Development) in the 1990s and to massive risky loan purchases by government sponsored entities Fannie Mae and Freddie Mac.'
The well-intentioned-but-misguided US Congress wanted to help the US poor to own their own houses. (Sounds familiar in Hong Kong right now!)
The sad fact is that the important functions of all the above people are sorely needed in the upcoming financial reforms in China.
I think Brit_in_China has to leave China some time in the future.
If there is only one thing that is universally true at any time for any excuse in any way, it is this:
every other person will put his or her interest before you --- that’s for sure.
Indeed, human is born selfish, as is argued by Richard Dawkins in ‘The Selfish Gene.’
In China, low tariffs on water, gas and electricity, low price of credit, and undervalued Renminbi currency rate, are all indirect forms of subsidies given to those factory owners like Brit_in_China, at the expense of all the other Chinese consumers who suffer from the concommitant hidden taxes.
Problem is, the present investment-driven and export-led growth model can’t persist forever, it has to gradually end and give way to a domestic consumption-led growth model in the future.
Rising and unsustainable debt has always been the Achilles’ heel of the investment-driven growth model almost everywhere in the world, not just in China.
If China's business is as usual, Brazil’s famous lost-decade after 1980 and Japan’s lost-two-decades after 1990 will be China’s foreseeable future.
Of course the coming reform means a wealth or income redistribution from the factory owners and others back to the Chinese consumers.
An economic problem often boils down to an income-redistribution issue, which usually can only be solved through the political process.
From the response of Brit_in_China we can see the heavy resistance from the vested interest standing in the way of China’s coming reforms.
Well, not even a highly-revalued Renminbi currency rate could greatly reduce China’s present trade surplus (as is often argued by the US officials).
China’s trade surplus is a residual of her excess savings (over investment).
‘Washington pushed Tokyo into the 1985 Plaza Accord, an agreement to strengthen the yen. But even after the Japanese currency appreciated by a whopping 87% over the following three years, the bilateral trade gap continued to grow.’
(From ‘The Yen and Japan’s Trade Deficit’, Jan 16, 2014, WSJ ASIA.)
Charles Wolf Jr., quoting Professor Charles Horioka of Osaka University, argued back in August 1989 that Japan’s high private saving rate had fuelled her export-led growth over the years.
An aging Japan means that now, she is gradually importing more than it is exporting.
So will China in the future.
Michael Pettis has also argued that China's coming rebalancing act is only consistent with a much lower nominal GDP growth rate.
He thinks that '3-4% average GDP growth for a decade is likely to be the upper limit once Beijing seriously begins to rebalance the Chinese economy.'
Considering the article "Consumption part of China GDP 'underestimated' amid gift giving" published by the morning post this morning, the average growth rate in the coming decade may be as high as 5%, perhaps.
(To know more about Warren Buffet’s argument, you can read ‘Warren Buffet on the Stock Market’, December 10, 2001, ‘Tap Dancing to Work’. Page 191.)
Dow Jones Industrial Average:
Dec. 31, 1964: 874.12
Dec. 31, 1981: 875.00
Dec. 31, 1998: 9181.43
Gain in Gross National Product:
1964-1981: 373%
1981-1998: 177%.
I must be cruel only to be kind.
Thus bad begins and worse remains behind.
(Hamlet, Act 3, scene 4)
Joe Zhang:
‘China must raise interest rates to eventually bring down interest rates, which in the process will conquer inflation.’
Perhaps we need the help of Paul Volcker once again.
When a sincere and honest person like Joe Zhang speaks, we’d better listen.
If successful, only better remains behind.
To solve some problems in the world, we really need paradoxical solutions some of the time.


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