Lifting China's mask

PORTFOLIO POINT: There’s a saying in China that "all warfare is based on deception", but if you peer behind the mask, Beijing is in far less control than it would like to appear right now.

"China's weekend reform of its currency regime nails shut the coffin on the last remains of doubt about whether the world's second biggest economy has successfully steered a course past a hard economic landing."

So screamed the lede in a Reuters news feature last night that appeared across major papers this morning.

The metaphors were mixed, but the message was not: China is A-OK despite the hiccup of 8.1% GDP growth year-on-year for the March quarter – the lowest in three years – versus expectations of 8.4%. By widening the yuan's trading band to the US dollar, Reuters said, Beijing indicated it was comfortable with the slowdown in growth and, more importantly, was confident in its management of China's economic model away from exports and towards consumption.

Yet this widening – from 0.5% to 1% on an intraday basis – masks, like so much in Chinese policy, something completely different. Having appreciated the currency dramatically from its previous peg, lifted in June 2010 (see inverse chart below), the Yuan has been steady since the beginning of the year, which is undoubtedly where the People's Bank of China wants it to be. The widening will allow a greater fluctuation sure, but in itself that says nothing about further depreciation, let alone further rebalancing.

A new plateau: Chinese yuan to US dollar
Source: Bloomberg

Similarly, the slower GDP number did not indicate a coordinated soft-landed rebalancing – far from it. Consumer spending, which China ostensibly wants to increase as a share of GDP, rose 14.8%, but urban fixed asset investment, which China wants to decrease as a share of GDP, rose 20.9%, in effect exacerbating the imbalance. The only thing that decreased was the rate of export-led growth, but this was, obviously, due to a weaker economy in Europe, China's biggest trading partner, rather than anything Beijing said or did.

As Chinese philosopher Sun Tzu said, "all warfare is based on deception." Successive Chinese leaders have applied this aphorism very well for 2,500 years, but if you can peer behind the mask, China’s leaders are in far less control than they would like to appear.

This of course has been vividly illustrated not just by Friday’s GDP and quarterly data release but by Tuesday's stunning announcement that the wife of ousted Politburo member Bo Xilai had been named as chief suspect in the murder of a mysterious British businessman (for background, see China’s Ides of March).

It has all the makings of a Graham Greene novel: old-Harrovian, possibly a spy, in crumpled linen suit befriends prominent Chinese political family; ambitious son of former Mao lieutenant makes good, cracks-down on organised crime, rises through ranks but ruffles feathers higher up; tough-talking police chief sees danger, flees to US consulate in 70-car high-speed chase and confesses crime; businessman/spy dies in his hotel room of alcohol poisoning, but friends say he never drank.

Yet it also reads like something by Aleksandr Solzhenitsyn, the dissident who wrote The Gulag Archipelago and One Day in the Life of Ivan Denisovich. Bo Xilai’s dismissal was nothing less than a purge and, as students of the USSR and NSW Labor know, a state that purges is a state that’s weak.

In an era of instantaneous communication and rising expectations of the middle class, old-school methods only invite further risk of civil unrest, but amid the closure of websites, the banning of internet search terms and the enormous police presence in Chongqing – Bo Xilai’s former power-base where he was enormously popular – that is exactly what Beijing is doing.

The reason for this, however, is that Beijing has no choice, as I will explain. China has cornered itself into a self-reinforcing model dependent upon high GDP growth and the emergence of a powerful new class of business oligarchs. Without strong growth, China’s government has no legitimacy, and the social compact since Tiananmen Square in 1989 will lose it the mandate of heaven. Without the businesspeople who have delivered that growth, through either low-margin export industries or highly-geared fixed asset investment projects and property development, the Chinese Communist Party has a denuded membership as well.

Bo Xilai, who offered something different through the so-called 'Chongqing Model’ was, ultimately, anathema to such vested interests and though his fall from grace was originally framed in the lens of a dangerous flirtation with leftist Maoism and “red culture” (before his wife was accused of murder, that is), the real reasons were most likely to do with his ideological threat to existing economic paradigms. Whether Bo can be rightly called China's Trotsky, Kruschev or Gorbachev we will never know, as this is a game of matryoshka dolls that Beijing does not wish to play. But what we do know is that the cracks that have hitherto appeared in China’s economic façade are now covering the walls of Beijing’s Zhongnanhai, the central compound of the Communist Party and the State Council.

Though the neo-Kremlinology is fascinating and could fill a book, what is relevant for Australian investors is that China remains a big question mark as a source of future economic growth.

Most economists seem in agreement that a soft-landing of circa 7.5% GDP growth per annum can be achieved and that China will transition over the next five years to a consumption and service-based economy, but I still believe this ignores the pattern of history, not only in terms of Communist Russia – which itself was a huge contributor to global GDP growth before its capital and military-intensive model imploded in the late 1980s – but in terms of Japan leading up to the same period.

Just as mainstream commentators today talk about China overtaking the United States in economic, military and cultural power (see China’s false dawn), it was widely believed once that the Soviet Union and Japan had come across a superior economic model and would soon eclipse the West in both productive capacity and material living standards. Yet building big pipes and ballistic missiles does not make for a sustainable economy, nor does the type of real estate speculation that once resulted in Ginza property prices reaching $US20,000 per square foot.

Peking University economist Michael Pettis says that China only has five choices in how it transitions to a consumption economy, or as he calls it, engineers a transfer of wealth back from the state sector to the household sector: 1) it can slowly raise interest rates and the value of the yuan while lowering income and consumption taxes; 2) it can quickly do the same thing; 3) it can privatise assets and use the proceeds to boost household wealth; 4) it can absorb private sector debt; or 5) it can cut investment sharply "resulting in a collapse in growth, but it can mitigate the employment impact of this collapse by hiring unemployed workers for various make-work programs and paying their salaries out of state resources."

Pettis, derided as a China bear by most (and subject to a famous Steve Keen-like bet with The Economist), yet who has been unfailingly accurate in his analysis of China’s macro and microeconomics, added that only two of his five options are politically plausible: a privatisation of state assets or a "backdoor privatisation" via the absorption of private and corporate debt. The problem with the first option, however, is that should the privatisations happen too quickly, China could end up like post-Soviet Russia, stripped of its national wealth – and with a wealth profile even more skewed to inequality. The problem with the second option is that should debt be absorbed too readily, China could end up like post-crash Japan, with massive public debt leading to what Nomura economist Richard Koo would call a balance-sheet recession.

And in any case, a pursuit of either the Moscow or Tokyo “models” will be politically unpalatable for a people used to the unequal, but at least consistent, improvements wrought through the Beijing and Chongqing models. Further, the double bind that policy makers are presented with will likely only lead to more Bo Xilai-style purges, as reformist battles recalcitrant. This won’t be good for the Communist Party’s image either, despite both its best and worst efforts.

Perhaps, then, that leaves us with the ultimate, unspeakable option: a correction, followed by much slower growth (Pettis says 3% p.a.), most of which will give no benefit to Australia's mountain of China-dependent resource projects. But indeed, that is how economics tends to work. Despite the best laid plans of mice and men, the economy will do the reforming and rebalancing for you: brutally, quickly and chaotically. The United States probably has more political and economic experts than any other country, yet its great crash of 2008 was neither foreseen by the government nor controllable beyond later efforts by the Federal Reserve at quantitative easing – an option China doesn’t even have because its currency is pegged.

This, unfortunately, is still how I see China and the latest data – even what some thought to be strong official PMI figures – has only reinforced that view.

Another of Sun Tzu’s axioms was “let your plans be dark and impenetrable as night, and when you move, fall like a thunderbolt.” He was referring to military strategy, but the maxim reads ominously like an economic prophecy. China may well continue to grow for months, if not years, on its current unsustainable model, but I can’t help but see the risks to that and the futility of expecting a smooth transition.

On the 100-year anniversary of the Titanic, we should be cautious of headline appearances when passing through massive, unknowable icebergs. Despite the myriad opportunities available to you if you’re a China bull, I can’t help being a China bear.