The Best Case Scenario for China’s Transition and the World Economy

By Valentin Schmid, Epoch Times
March 10, 2016 8:42 pm Last Updated: March 20, 2016 3:54 pm

Diana Choyleva has covered China for Lombard Street Research pretty much since she left university more than a decade ago. Lombard had successfully predicted the Asian financial crisis in the late ’90s and she personally foresaw China’s rise to a dominant global player at the start of the year 2000.

By the end of its ascendance, however, she argued China had come to the end of its export-led growth model, forecasting growth to average just 5 percent a year in this decade. 

Right now, the head of research and chief economist of Lombard is cognizant of China’s problems, but thinks a positive outcome for the world is possible under the right circumstances. A refreshing view. 

It’s in the interest of the rest of the world if the Chinese stick with reform to allow this depreciation in the Yuan instead of fighting it.

Epoch Times: How can a China slowdown be good for the world economy?

Diana Choyleva: The thesis that I have at the moment is that the world is still very much lacking genuine consumer demand.

Actually, in this world, having China grow at much weaker rates, is exactly what this world needs because it redistributes income into the hands of the consumer in the West in particular, by lowering the price of commodities and oil as well.

On our estimates in 2015, growth was just 3.2 percent in quarterly annualized terms on average.

Investment share of GDP in percent (Credit Suisse)
Investment share of GDP in percent (Credit Suisse)

Generally, weaker commodity prices move the income from the producers of those commodities into the hands of the consumer. What happens to the overall world economy in terms of net impact depends on whether the boost to income and spending of the consumer will outweigh or not the hit to the income and spending of the producers.

From a psychological point, the negative impact tends to show up first and the positives follow second.

We’ve seen in the economy globally that European Union consumers have spent all the real income gains from lower commodity prices but in the United States that hasn’t happened.

Here, consumers have saved them. This brings me to what’s going on right now in financial markets. The longer financial market volatility continues, the more likely it is that the American consumer will continue saving the real income gains and not spend them.

But if they do spend them this will be great news because China is currently addressing the excessive investment of the past. That means its investment growth will be negative at best, or zero. If they are investing less, they are no longer crowding out more profitable opportunities in the rest of the world. So if the Western consumer does pick up, it’s more likely to be followed by business investment as well.

This is an optimistic take on how the global economy could rebalance. But unfortunately, monetary policy among the major central banks endangers that more benign workout.

The next crisis is going to be worse than the global financial crisis.

Epoch Times: How so?

Mrs. Choyleva: For starters, we are in the midst of a currency war. It’s quite clear that if every major central bank in the world tries to devalue its way out of trouble, no one will succeed, unless of course, we find life on Mars.

Now the Bank of Japan does not need to do quantitative easing (QE). In fact, doing QE makes their situation, their structural economic imbalances, worse. There’s no need for the private sector de-leverage in Japan. Trying to achieve inflation at a time when deflation is the only thing that really distributed money into the hands of consumers is very much the wrong policy goal in the specific circumstances that Japan has.

Yet they’ve purely done quantitative easing with the aim of weakening the currency. It would’ve been to an extent fine if the rest of the world was doing well, but of course, the rest of the world is not doing well. The European Central Bank has gone for competitive devaluation as well, the Bank of England, by not hiking is also having a stealth devaluation and of course BREXIT [Britain exiting the European Union] fears are adding to it.

No one will succeed, unless of course, we find life on Mars.

The only economy sitting out there with an over-valued currency is China. Now China [has] accepted much weaker growth, they are trying to do structural reforms by opening up the financial system. But it will be extremely difficult for them to achieve a rebalancing toward consumer spending without the help of a weaker currency.

Epoch Times: How big do you think the risk of a devaluation is this year?

Mrs. Choyleva: I want to differentiate between devaluation and depreciation. Devaluation is when the central bank is intervening against market forces to bring the currency down. This is not what’s going on right now.

Right now market forces are pushing the Yuan down and the People’s Bank of China (PBOC) is intervening to prevent a sharper depreciation and is losing reserves at a pretty alarming pace.

I think the excess reserves are enough for China to be able to engineer a gradual depreciation of the currency. Again, if it was not for the rest of the world being in this situation that we have now, it would have been much better for them to let the currency go in a one-off fashion. But of course, that would be like a red rag to the bull; whether it’s the Japanese bull or the American bull.

At the same time, if you’re in China’s shoes and you’re looking at what Japan did earlier this year after they were pointing the finger to the PBOC saying they should introduce capital controls and not competitively devalue.

Diana Choyleva, head of research and chief economist at Lombard Street Research
Diana Choyleva, head of research and chief economist at Lombard Street Research

Then you’re thinking “Well, wait a second. What am I gaining? Isn’t it better for us to open up the capital account in which case clearly the market forces will be net capital outflows, bringing the currency down? We can use the excess reserves rather than waste them trying to help this global rebalancing, recapitalizing the banks.”

There are big problems there in terms of the number of non-performing loans, the real level, not the one they are reporting. That will increase public sector debt and you could use some of the money to write off some of the losses that come from problems of the past.

An open capital account and weaker currency will produce higher domestic interest rates. It’s exactly what China needs in order to move toward higher consumption.

Epoch Times: How does that work, isn’t this counterintuitive?

Mrs. Choyleva: Normally, we’re told that a stronger currency is good for consumer spending but that’s under certain assumptions. The structure that China has, at this point in time, suggests it’s not going to work that way.

The key difference is that the Chinese consumers do not import or consume that many imported goods. China primarily imports raw materials, investment goods, and goods for processing. More importantly, Chinese households hold two-thirds of their financial assets in interest-bearing deposits.

For a long time, they had a closed capital account, somewhat porous, but still closed. By keeping artificially lower interest rates, Beijing has produced this bizarre redistribution of domestic savings, penalizing the savers’ households and feather bedding the corporate sector, which largely has wasted the money. So it hasn’t produced productivity growth and that income hasn’t gone back into the hands of consumers.

If China sticks with reform, tries to rebalance, if it does depreciate the Yuan significantly, then this will be a very interesting buying opportunity.

So actually, unusually, in the case of China, high domestic deposit rates will redistribute income into the hands of households away from corporates. Of course, that means higher defaults in the corporate sector but I think we all agree that given the mess China has produced so far, it has to pay the price of getting rid of the zombie companies and writing off bad debt. They have the funds to fund that by increasing public debt at this point in time.

Interest bearing deposits are one and a half times disposable income so if they increase the rate, it’s a huge income boost as a positive wealth effect.

If this is done under a scenario where they open up the capital accounts, then, of course, households will most likely feel safer about their wealth by being able to put it or diversify it into jurisdictions outside of China where there is more rule of law.

That’s likely to lower the household savings rate and at the same time, your export sector is not suffering from an overvalued currency. For China to rebalance toward consumer spending successfully, this is a huge challenge and they need to have all the help they can get in order for that to happen successfully. So it’s in the interest of the rest of the world if the Chinese stick with reform to allow this depreciation in the yuan instead of fighting it.

(International Institute of Finance)
(International Institute of Finance)

Epoch Times: Is this realistic?

Mrs. Choyleva: My hope is that we find some sort of muddle-through scenario for the global economy because if we don’t, the next crisis is going to be worse than the global financial crisis.

Simply from the point of view that if China goes down the road of a serious economic crisis, then we have to ask the legitimate question of what will happen to their political system.

Epoch Times: So this was the best case scenario, what if that doesn’t happen?

Mrs. Choyleva: Both benign and malignant scenarios going forward involve financial market distress and economic weakness over the next couple of years. Those two scenarios will determine the long term but not necessarily the next twelve or eighteen months.

So in that sense, it’s probably beyond the investment horizon of most people. If China sticks with reform, tries to rebalance, if it does depreciate the Yuan significantly, then this will be a very interesting buying opportunity. The time hasn’t come for that though.

The initial impact will be “risk off”. If the authorities throw money at the problem, forget reform, maybe we will have a short-term relief rally. Given the alarming pace of increase in debt in China, given the investment excesses of the past, given the lack of structural reform in places like Japan and the Euro-area, then it’s very unlikely that this will be a healthy and long term improvement. On the contrary, the fallout from that sort of policy would be much worse.

Epoch Times: Kicking the can down the road.

Mrs. Choyleva: China doesn’t have another ten years to be blowing up bubbles and kicking the can down the road. Given where debt-to-GDP is at the moment, it actually has at most one or two years to do the wrong thing before it blows up. The positive take on this is that it still has the funds to clean up the excesses now if it does the right thing.