What Wall Street Gets Wrong About ChinaBY BILL POWELL 8/25/15 AT 12:48 PM

Volatile global markets got some respite from the latest blood-letting on Tuesday as bargain hunters nudged up Asian

and European stocks, though China, at the center of the rout, was smashed again. YVES HERMAN/REUTERS

 

 

 

 

 

FILED UNDER: Business

The number of people yammering on the TV networks who know next to nothing about China has reached an all-time high. And for these mostly U.S.-based Sinologist soothsayers, the verdict is in: China, the world’s great growth story, is imploding. Its stock market continues to plummet—down another 7.6 percent Tuesday—and its real economy slowing sharply. And because China is the world’s second-largest economy, they say, and one of the U.S.’s largest trading partners, it's going to drag us down with them.

It's that simple.

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Except it’s not.

Try Newsweek for only $1.25 per week Here's how to think about what’s gone on these last few weeks in the markets. The proximate cause of the latest volatility was an unexpected “devaluation” of China’s currency—the renminbi (RMB)—on August 10 and 11. For over a decade, China’s currency had either been stable against the U.S. dollar, or appreciating steadily. That Beijing allowed the RMB over the course of two trading days to sink by 3 percent came as a shock; not because that is a significant devaluation but because of the global environment in which it took place. Two major currencies (the euro and the Japanese yen) and a whole host of minor ones (the Russian ruble, the Brazilian real, etc.) have been sharply devalued over the past couple of years. These devaluations have in turn intensified deflationary pressures in the global economy, because goods and services in dollar terms have become less expensive.

If China—manufacturer to the world—were to join what appears to be the beggar thy neighbor parade, and proceed to continue to weaken its currency in order to help its flagging export sector, then that would be a matter of serious concern. And indeed, that’s how the markets evidently took the news. 

That’s likely to be wrong. Beijing is in the process of trying to internationalize its currency, albeit slowly; it eventually wants the RMB to be a "reserve" currency, like the dollar, i.e., one that international trade is priced in, and that foreign central banks hold as reserves. Toward that end, it wants to be part of the International Monetary Fund’s special drawing rights scheme—a supplementary stash of foreign exchange, to be used only in extremis—the IMF declined to admit the RMB earlier this summer and said the currency needs to be subject more to market forces. Indeed, at about 6.2 RMB to the dollar, most economists believed the Chinese currency was slightly overvalued. The 3 percent devaluation was an adjustment that signaled the People’s Bank of China (Beijing’s Fed) was in fact going to allow the RMB to float a bit more.

The over-the-top-market reaction obviously took Beijing by surprise, and that to a degree was Beijing’s fault. Whatever communication occurred between central bank and finance officials in Beijing and other major cities around the world—Washington and Frankfurt most importantly—was clearly insufficient. The battlefield clearly hadn't been prepared. That’s a combination of Beijing’s inexperience on the world stage and its arrogance. The Chinese are not as inclined to work closely with the U.S. and Europe as, say, the Japanese are. 

Having said that, some of the rhetoric from China’s trading partners was hard to believe. Tokyo’s Minister of Finance Taro Aso won the chutzpah award—how do you say chutzpah  in Japanese?—when he decided to warn the world about Beijing’s “dangerous” 3 percent devaluation. Earth to Aso: The yen is down 60 percent against the U.S. dollar since 2012!So, amidst a tenuous global economic environment, the slight adjustment was a bit of a shock; that’s fair enough. But it does not mean that China is going down the road of a Japan or Euro style full-bore devaluation. And that, make no mistake, is a good thing.In the immediate wake of the currency shock came a wave of fears about China’s overall economy slowing dramatically—one that has obviously played a role in the recent U.S. equity correction. To those of us who work here as correspondents—particularly for those like me, who’ve been here a long time—

the reaction of both the markets and the commentariat has been nothing short of depressing. Apparently, no one reads anything we write.

Since the government of President Xi Jinping and Prime Minister Li Keqiang came to power in 2012, it has made it clear that the growth drivers of the Chinese economy—investment and exports—needed to give way to more consumption-led growth. Further, the party’s platform stated straightforwardly that “market forces” were to be "decisive" in China going forward. That was a signal that the era of heavy loan growth to state owned companies to build infrastructure was coming to a close. The Chinese economy, as economists say, was going to undergo “rebalancing.”

That meant, as government acknowledged, that annual growth rates were going to come down. The target for this year is 7 percent, down significantly from the 10 percent era—and one that Beijing may not even make.

A glance at economic history shows that when a sizable economy, like China’s, moves from one growth model to another, the shift is rarely painless. (See Brazil in the 1960s, Korea and, most pointedly, Japan, more recently). As Beijing-based economist Michael Pettis points out repeatedly, rebalancing usually takes longer, and is uglier, than the bureaucrats and mandarins would like. (See his excellent book The Great Rebalancing.)That China’s economy has been slowing—and may be slowing more rapidly than most expected—seems to have shocked global equity markets in the last week. Up to a point this is somewhat understandable. China’s economic managers gained a reputation, particularly after steadying their economy in the wake of the global financial crisis, of having magical powers, not possessed in capitals elsewhere. Actually, what they had was a lot of government money to throw at the economy and, unlike in the U.S., a lot of jobs that actually were “shovel ready.” (When the Chinese want to build infrastructure, they don't let pesky environmental impact statements get in the way.)

That era is over, as Xi and Li have made clear. The transition to a more consumer-led economy will take time, but it is occurring. Consumption

accounted for 60 percent of GDP in the first half of this year. This year, the service sector and consumption will be bigger than the manufacturing and construction sectors—the third straight year that will be the case. Personal income continues to grow at nearly 10 percent.

Why then, is China’s stock market crashing? In part because it had gone irrationally high last year: When the so called "A-share" market in China—companies that trade on China exchanges that for the most part only Chinese are able to invest in—began to crumble, it was 96 percent above its year ago levels. The truth is, China’s stock market is a speculative hothouse, and it is not very indicative of where the economy is going. Only 7 percent of the urban population own stocks, and 69 percent of them have less than the equivalent of $15,000 in their accounts, according to Andy Rothman, senior investment strategist at Matthews Asia. The bottom line: Do not assume that because its stock market is cratering that China is going down the tubes.

But what about our stock market cratering because of slower China growth? Are investors right to be concerned? Yes, up to a point. Corporate CEOs, like some equity analysts, tend to fall in love with straight-line analysis, and during the first decade of this century, when it came to China’s economy, that straight line was going up—and only up. China would be the world’s largest market for everything, and its growth would continue; so therefore, the U.S. Fortune 500, and everyone else, invested like crazy in their China businesses.

Excessively so, in all likelihood, particularly if they were leveraged to the industrial-infrastructure sectors. A friend serves on the board of two large U.S. manufacturers, and he reports that their sales growth in China is 4 to 6 percent this year. The problem is, they had planned for 8 to 10 percent growth. Partly as a result, both companies are now losing money in China—the first time in over a decade in which that has been true.

So some reaction in U.S. equity prices was understandable. But what we have had is an overreaction—arguably a big one. And that’s why Apple CEO Tim Cook took the unusual but wise step on August 24 to email CNBC’s Jim Cramer

and say, hey everyone, at the moment our iPhone sales are actually growing faster than we expected in China. Why would that be the case? Because urban consumers in China have money, and they are still spending. And that’s not going to change appreciably anytime soon.

There are two other critical points to remember about China and its economy. First, while the macro slowdown does hurt the bottom line of a lot of multinational companies, the transition China is now making—from an investment and export-led economy to a consumption driven economy, is good for global economic growth. As Patrick Chovanec, managing director at Silvercrest Asset Management in New York points out, "People talk about China being a global growth driver, but in fact, by running chronic trade surpluses, it has been a global growth de-river [by definition, if China was running surpluses with the world, that was subtracting from growth everywhere else]. Now, by propping up consumption in the face of an otherwise wrenching economic adjustment, China can become a source of much-needed demand and a true growth driver for the world economy.” This is exactly correct, and after the close on Tuesday, the PBOC announced further cuts in interest rates and in the reserves China’s banks have to maintain at the central bank—policy steps it hopes will increase cash in the economy, and thus consumption.

The darkest cloud in China remains debt, which has surged from an estimated 85 percent of GDP in 2008 to about 280 percent now. That’s debt held largely in the hands of state-owned enterprises, the financing arms of local governments and real estate developers. This means that there is virtually no chance that the government can gin up massive credit growth again as a way to spark the economy. The question is whether they can avoid an unexpected debt crisis—a massive bank run or large defaults in the so called shadow banking sector. Neither is beyond the realm of possibility. But if over time, China’s growth slows, but debt issuance grows ever slower, the debt to GDP ratio can begin to shrink. 

That’s the best case for China: slowing growth, and the system getting a grip on its debt problem. To be sure, that's not 10 percent growth forever and ever. Those days are never returning. But it's not necessarily a crisis—indeed, it's what China and the world needs.