06 July 2015

Stock Slump Casualty: The Myth of Chinese Exceptionalism

Andrew S. Erickson and Gabe Collins, “Stock Slump Casualty: The Myth of Chinese Exceptionalism,” China Real Time Report (中国实时报), Wall Street Journal, 6 July 2015. 

China’s dramatic stock market plunge and the resulting uncertainty as to how Beijing will try to manage the situation are calling China’s economic growth and political stability into question. This financial risk story could ultimately have much greater implications for the global economy than the Greek debt drama much of the world is currently fixated on. Yet it is also one of widespread myths and hubris.

As data points fly later today and over the course of the week, it’s important to consider the structural factors behind the current difficulties. The more one considers the larger picture, the less the latest developments should be surprising. The bottom line is that China is not as exceptional as its leaders claim, or as some Chinese and foreigners imagine. It is not immune to laws of economics, the business cycle, or the gradual slowing of national economic growth and power accretion that typically besets maturing societies. And Beijing has not created a superior hybrid state-market model that can miraculously reap the benefits of more market- and legally-oriented economies while avoiding their drawbacks. Instead, it has created a massive bureaucracy that is strong and concentrated in some respects, but weak and conflicted in others. Moving forward, in assessing China’s prospects, analysts need to take a hard look—in part by considering the issues outlined below.

Suspending Stock Disbelief

The last few quarters should have sounded alarm bells for more investors as China’s stock market completely decoupled from the country’s weak underlying economic fundamentals. The market rose meteorically, traded on easily available funds and massive leverage, and eschewed fundamental analysis of China’s rapidly slowing real economy and largely tepid consumer economy. Real economy indicators suggested that China’s stock market rally was not underpinned by robust “bricks and mortar” activity.

One had only to consider the “Keqiang Index,” an aggregation of statistics concerning electricity consumption, rail cargo volume, and amount of loans disbursed. The resulting figure — reportedly advocated as a more accurate metric of real Chinese economic activity by Premier Li Keqiang himself — suggested substantially lower GDP growth than did official numbers. Even these official figures, which Premier Li reportedly denounced as “man-made,” had themselves been ebbing. Tellingly, before the downdraft began, the Shanghai Stock Exchange had risen approximately 150% in the past year, while electricity consumption had basically flat-lined for the past five months and counting.

Where are Reforms When You Need Them?

So why wasn’t China’s vaunted bureaucracy able to head off this policy train wreck? Well-documented bureaucratic turf wars between the People’s Bank of China (PBOC) and China Banking Regulatory Commission (CBRC) helped sow the seeds of some of China’s most pressing current economic problems—such as ballooning debt and use of shadow banking. Such infighting continues impeding the Chinese government’s response to the current market downdraft. Unlike other major central banks, the PBOC is not politically independent. Indeed, in a Chinese political system where “de facto federalism” is the default modus operandi, banking is one of the few areas where policy authority is far more centralized, in part a product of the pre-WTO reforms spearheaded by former Premier Zhu Rongji.

As such, the PBOC likely faces significant political pressure to continue pumping the stock market up, as this helps distract the populace from the fact that the market for residential real estate—the prior hot investment area—is flagging. For its part, the CBRC has likely been “captured” by the very banks it is supposed to regulate, further contributing to amplified systemic risk from shadow banking activities that are tougher to track and regulate than lending conducted through normal bank channels. Ultimately, conflicting bureaucratic priorities and infighting send contradictory messages to investors and likely fuel additional market instability.

This is part of a larger pattern in which China increasingly needs reforms that its political power structure appears ill-suited to implement effectively. China’s leadership has proved unwilling and unable to implement reforms sufficient to maintain current levels of economic growth amid gathering challenges. Markets were clearly over-optimistic about President Xi Jinping’s reform agenda: reforms have progressed more slowly, and less successfully, than expected. Xi and other Chinese leaders appear to know what economic reforms are needed, but how, when, and to what degree can they actually implement them without assuming unacceptable political risks? This remains the problem, and it remains unanswered. Initial enthusiasm for new policy initiatives, for instance state-owned enterprise reform, faded fast with opposition from “red families” and other powerful vested interests.

Broader Headwinds for Growth

Fundamental economic and social forces are amplifying Beijing’s struggle to regulate financial markets and implement economic reforms. Left unchecked, these internal and external challenges—including pollution, corruption, chronic diseases, water shortages, growing internal security spending, and an aging population—will feed off of one another and exact increasingly large costs. Projections by former World Bank Chief Economist and Senior Vice President Justin Yi Fu Lin in 2013 that “China can maintain an 8% annual GDP growth rate for many years to come” and that “annual growth potential should be… 8% for the 2008-2028 period” were never realistic.

Without dramatic—and potentially politically untenable policy shifts—these structural factors will continue to place the growth of China’s economy, and its overall “comprehensive national power,” on an S-curve-shaped slowdown trajectory. For all its policy navigation, efforts to guide national development, and claims of exceptionalism, China is not immune to larger patterns of economics and history. It will thus almost certainly experience an S-curve-shaped growth slowdown like so many previous great powers have suffered, and the one that so many observers believe the United States is undergoing today. In fact, China is encountering such headwinds at a relatively much earlier stage in its development than did the U.S. and other great powers. This is due in part to China’s late start in modernization, its dramatic internal disparities, and its draconian one child policy and other political dynamics.

None of this means that a Chinese “collapse” is inevitable. Indeed, the multi-trillion-dollar economy and the nation behind it retain significant strengths. Rather, it’s time to debunk the myth of PRC exceptionalism and achieve a “new normal” in China analysis. This should be sobering not just for China’s leaders—who surely know their nation’s specific weaknesses more than nearly anyone else—but for people around the world. China’s comprehensive global market-moving power has become immense and spans equity, debt, and hard asset markets with trillions of U.S. dollars in combined investor exposure.

The corollary of this power is that China’s ability to transmit risk into global markets has also become massive. Indeed, at present there are perhaps only three other individual countries to which global financial markets are so comprehensively exposed: the United States, Japan, and Germany. While specific decisions by Chinese political actors are almost impossible to predict from outside, we recommend that investors and policymakers focus on the structural factors we outline, as these provide the fundamental framework within which Chinese regulators will likely take their policy actions.