Winston Churchill famously called the Soviet Union "a riddle, wrapped in a mystery, inside an enigma". He could probably have come up with an even more powerful phrase to describe the last great communist power on earth, China, but for this mortal scribe his description seems apt enough. The Middle Kingdom is about to go through the most important political transition in a decade, when the 18th National Congress of the Communist Party meets. Curiously, though, no one even knows when this gathering will take place.
It is assumed that Xi Jinping will succeed president Hu Jingtao and Li Keqiang premier Wen Jiabao. But how the all-powerful nine-member politburo standing committee gets chosen makes a schismatic medieval papal conclave look like the apogee of transparency. What is clear is that China needs leadership and a new direction. In August, the official purchasing managers’ index fell below 50, suggesting economic contraction. HSBC’s measure has been stuck below 50 for 10 months.
Economists are busily downgrading growth forecasts, although many still expect that some process of statistical alchemy will ensure that the government’s 7.5% growth target for the year is met. A modest slowdown in China hardly amounts to economic failure. After all, it cannot take the blame for the existential crisis in the eurozone and the deleterious effect it is having on global growth, consumer sentiment and demand for Chinese exports.
However, mixed Chinese economic data do highlight structural issues that the new leadership must confront. The stated aim of the Party is to rebalance the economy toward domestic consumption and away from the neo-mercantilist policy prescription that characterized the Hu-Wen era. However, a global growth dip makes that rebalancing harder to achieve.
China is still reliant on exports. If the country cannot sell goods abroad, the next best way to grow is to encourage domestic investment. This is what happened in November 2008. Under government diktat, banks plied local authorities and state-owned enterprises with cash. It helped the world recover and Chinese growth to keep ticking along. But it also represents large-scale – and in some cases venal – resource misallocation, on trophy infrastructure and inefficient businesses controlled by the Communist Party.
The People’s Bank of China has already cut interest rates and some economists in the west urge further monetary loosening. But in all likelihood this will create more bubbles in property and other sectors and a bigger mess to clean up when they inevitably burst. This would exacerbate a festering bad debt problem and hobble the banking system.
The blogger Michael Pettis, a finance professor at Peking University, is correct. Real rates should rise in China and so should the currency. As he writes in the latest edition of China Financial Markets, keeping the renminbi and rates low is an implicit tax on household income and meaningful rebalancing cannot be achieved against this backdrop.
No one would envy the economic cards dealt to the new leadership. However, China still has policy options and levers. One of the most sensible things China could do is to issue government debt (CGBs) in large benchmarks, from three-month bills out to 10-year bonds, both domestically and in Hong Kong and London in renminbi.
CGB issuance would boost the circulation of renminbis onshore and offshore and help build a Chinese yield curve. A yield curve would be a reference for all issuers. Over time it would help to normalize Chinese interest rate markets. Bank depositors would have an attractive alternative asset in which to place cash. Real rates could adjust upward.
China’s huge pile of US dollar and Treasury bond reserves is not a blessing. For the new leadership, it is a curse. Currency debasement seems to be an implicit policy for many debtor nations. Even in good times, foreign-currency reserves and other assets denominated in foreign currencies are as useful as a spiked gun. If you pull the trigger and sell, they will explode in your face as prices move against you. Replacing dollar-denominated assets with renminbis as US Treasury holdings mature is good debt management.
But why would a creditor nation issue bonds and saddle itself with debt-service costs? It could be the most interesting experiment in behavioural economics ever. If the proceeds of bond issuance were clearly and solely aimed at building a social security safety net (hypothecated, to use policy jargon) habits might change.
The Chinese currently spend 50% less of their income on consumption than the OECD average. They save – for health crises, unemployment and the care of ageing parents and relatives. In the absence of social security that is rational. But the provision of basic services might change behaviour. Asia needs to spend more and Europe and the US save. If the rebalancing of the Chinese economy happens hand in hand with global rebalancing, there will be few losers. It is worth attempting a bond-inspired nudge.
Andrew Capon has won multiple awards for commentary and journalism on markets, investment and asset management. He welcomes comments from readers and can be reached at firstname.lastname@example.org