Praying for a China recession

ByJoe Zhang *

South China Morning Post, 24 January,

China’seconomic 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 therestructuring that the country urgently needs.

Slowing growth has clearly worried globalmarkets, but as a private investor – and a loyal Chinese citizen – I pray foran even bigger fall.

It is no secret that China’s highgrowth in the past three decades has been spurred by aggressive fiscal andmonetary stimulus, as well as higher productivity.

China’sbank credit has expanded at a compound annual rate of 18 per cent, and moneysupply at 21 per cent over the last 27 years.

Such rapid growth has allowed a large arrayof 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 theprices of at least three things: utilities, credit and the currency.

I want to see tariffs on water, gas andelectricity 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, theprices of utilities have lagged far behind inflation, and this has led to hugeamounts of waste, pollution and depletion of resources.

Despite condemnation by the government andthe public, most of the heavy polluters continue to operate because theyextract “environmental dividends” from the planet without paying an adequateprice.

If, as I hope, many big polluters were shutdown, that would be a welcome change – despite the economic recession that suchaction would likely contribute to.

Second, in most of the past 35 years, China’sinterest rates on bank deposits have not reflected the sacrifice of the saverswho are delaying consumption. And, indeed, interest on those deposits has been belowthe inflation rate.

That rip-off has led to huge and persistentsubsidies to business. They get low interest rates on loans and consequentlylow hurdle rates for returns on investments. That has artificially boostedeconomic activity for too long.

Finally, whatever your school of thought,the clearest test of a currency’s fair exchange rate has to be its tradebalances in the medium and long term.

The fact that China has run a trade surplus oflarge magnitude in the past two decades proves the point that its currency isundervalued.

The mainstream view is that this currencydistortion benefits China.I argue the opposite.

In addition to extra transaction costsassociated with currency controls, it amounts to a reduction of Chineseconsumers’ real incomes, particularly in terms of the quantities of importedgoods they can purchase.

It is a subsidy the household sector isforced to provide to businesses. It depresses private consumption. It isanother rip-off.

Logic dictates that if something is unsustainable,it will eventually stop.

China’srapid growth, fuelled by fiscal and monetary stimulus, will stop. The onlyquestions are when and how?

Given the dominance of the state sector,which has a high tolerance for low returns, and the existence of millions oflow-wage workers, China Inc’s business model can continue for a long while tocome.

But that does not mean that allowing it todo so is in the best interests of China’s citizenry.

The sooner the economy slows on the back ofhigher utilities tariffs, higher interest rates and a higher exchange rate forthe yuan, the better it will be for the country.

A sharp slowdown in the economy does notmean weak returns for equity investors. This is shown by the US experience.

In an essay published in 2001, WarrenBuffett split the 34 years between 1964 and 1998 into two equal periods.

In the first 17 years, the US economysurged a cumulative 373 per cent, while the benchmark Dow Jones Industrialsindex ended flat, hovering mostly at around 875 points in that period.

But yields on long-term government bondssurged along with gross domestic product, rising to 13.7 per cent from 4.2 percent on the back of rising inflation.

In the second 17-year period, the economygrew by a more modest 177 per cent, but the Dow staged a 10-fold surge (from875 points to 9,181).

Government bond yields fell steadily from13.7 per cent to 5.1 per cent, thanks to the tough monetary policy of the thenchairman of the Federal Reserve, Paul Volcker, that brought down inflation.

Buffett was not trying to prove that GDPwas negatively correlated to equity returns but simply that in the long run, itwas the inflation rate (and thus nominal interest rates) that mattered most toequity valuations and investor returns.

You cannot find a better response to theexperience of the US than China today.

In the past two decades, investors in China equities got a lousy deal – both thedomestic stock market and Hong Kong’s H-sharemarket disappointed hugely – despite the double-digit real growth of theChinese economy year after year.

The reasons included poor corporategovernance 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 andequity valuations.

The counter-intuitive solution to thisproblem is that Chinamust raise interest rates to eventually bring down interest rates, which in theprocess will conquer inflation.

And that is why I pray for a furtherslowdown of the Chinese economy.

Joe Zhang, a former central bank official,is the author of "Inside China's Shadow Banking: The Next SubprimeCrisis?"