Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Tuesday, 17 July 2012

Will China Conform to History?

The noises on China are rising to a crescendo. There is enough analysis for everyone and investors can pick the outcome which best suits their confirmation bias:
  1. Meltdown
  2. Hard landing
  3. Soft landing
  4. Stimulus-led perma growth
I personally veer between 2 and 1. The reason for it is simple: No command economy can achieve sustainable growth without upheaval.

History has shown that all experiments by “wise men” to direct economic growth and achieve a higher standard of living have ended in disaster. Just looking at the 20th century throws up enough examples, the biggest being the Soviet Union. The myth of the Soviet Union was formed during the Great depression which it supposedly escaped unscathed. In the 1960s and 70s it was supposed to overtake and annihilate the west. Instead it crumbled and ceased to exist by 1991. More recently, the Japanese debacle and the Asian crisis show that state-directed capitalism leads only to transient economic strength. The greater the level of interference, the bigger the reckoning and more muted the recovery.

Friedrich Hayek said that it is impossible for a directed economy to replicate the price mechanism which combines dispersed knowledge of all participants in a capitalist economy. Unfortunately this insight escapes hubristic politicians irrespective of whether they are in democracies attempting ‘Keynesian’ micro-management or in autocracies attempting the same old ‘new’ social experiment.

The reason why state-directed capitalism (an oxymoron if ever there was one) does not work is because of five reasons.
  1. Power corrupts: The directive elite forms a kleptocracy increasing economic inequality and imbalance within a country.
  2. Communication breakdown: Messengers are shot so bad news is suppressed from those in power and responsible for directing the economy. Alongwith point 1 above, it isolates those in power from ground realities.
  3. Perverted growth: The economy is directed to hit official targets and ensure promotion through the ranks of the elite. Combined with point 2 above, this weakens the power of the centre over its apparatchiks in the provinces. (A common problem responsible for the fall of empires starting from ancient Egypt).
  4. Malinvestment: The true price of capital is suppressed to ensure social and political goals are fulfilled leading to unproductive assets. Fear of failure and ambition (points 2 & 3) ensure a cover up worsening the problem and enhancing the eventual impact. This also explains the prevalence of banking crises in countries with 'innovation free' captive banking systems.
  5. Lack of mandate: The tension between the in-group of elites and the out-group of commoners surfaces eventually either because the out-group is economically transformed (the rise of middle and working classes post industrial revolution) or deprivation/inequality hits an extreme (most revolutions).
China ticks most if not all the boxes above. While it is hard to determine the exact timing of the denouement, it is easy to forecast its inevitability.

The various narrative threads being spun at the moment seem to indicate that denouement is not far off. Hopes of those looking for a soft landing and/or growth resumption are being pinned on the next round of stimulus. It may succeed in delaying the reckoning but it can’t prevent it unless structural reforms proceed apace. Unfortunately structural reforms are antithetical to any entrenched elite and China is no exception. As John K. Galbraith said, people of privilege will always risk their complete destruction rather than surrender any material part of their advantage.

A reading list of some recent and interesting China analysis (the preponderance of FT Alphaville links attests to their brilliance):

  1. General
    1. Andy Xie: http://articles.marketwatch.com/2012-05-17/economy/31749727_1_global-economy-commodity-prices-export-growth
    2. Michael Pettis: http://www.mpettis.com/2012/07/04/what-is-financial-reform-in-china/
    3. The Economist special report from May: http://www.economist.com/node/21555915
    4. John Hempton, Bronte Capital: http://brontecapital.blogspot.com.au/2012/06/macroeconomics-of-chinese-kleptocracy.html
  2. Dollar shortage
    1. http://ftalphaville.ft.com/blog/2012/07/09/1075431/china-and-those-dollar-shorts/
    2. http://ftalphaville.ft.com/blog/2012/06/26/1060301/chinas-amazing-short-usd-position/
    3. http://ftalphaville.ft.com/blog/2012/06/27/1061531/chinas-foreign-debt-keeps-rising/
    4. Tax cut to encourage overseas investment has to be seen in the context of dollar shortage: http://www.ft.com/cms/s/0/f2bff8ba-ccd0-11e1-b78b-00144feabdc0.html
  3. Falling demand
    1. http://ftalphaville.ft.com/blog/2012/07/10/1077271/more-slowdown-news-from-china/
    2. http://ftalphaville.ft.com/blog/2012/07/04/1071341/the-curious-story-of-sany-and-chinas-booming-inner-provinces/
    3. http://ftalphaville.ft.com/blog/2012/07/02/1066611/chinas-inventory-building-masking-a-bigger-demand-slump/
  4. No rebalancing
    1. http://ftalphaville.ft.com/blog/2012/07/13/1081961/china-doubles-down-on-imbalance/
    2. http://ftalphaville.ft.com/blog/2012/07/06/1073761/chinas-asymmetrical-and-anti-bank-rate-cut/
  5. Dodgy data
    1. http://ftalphaville.ft.com/blog/2012/07/17/1077301/is-chinas-electricity-data-worth-any-of-your-precious-attention/
  6. Kleptocracy
    1. http://ftalphaville.ft.com/blog/2012/07/11/1079141/a-tale-of-two-chinas/
    2. http://www.bloomberg.com/news/2012-06-29/xi-jinping-millionaire-relations-reveal-fortunes-of-elite.html
For those looking for more in-depth analysis, this book is a good starting point.

Although not recent but it provides an excellent account of China's financial system. The tales of financial repression and imbalances are not as shocking to an Indian as they would be to a westerner. Therefore the alarming tone is slightly overdone but it provides a comprehensive argument against sustainability of the Chinese model. The prose could be improved but then it is rare to find Shakespearean financial analysis.

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