On the list of Chinese jobs that might deliver more stress than they are worth, central banker, securities regulator, economic minister and surely Xi Jinping's role as president are climbing the rankings early in this new year. The renminbi crashed, the stock market dipped and the country’s new model for economic growth is elusive. It’s enough to make Chinese officials want to bang their heads against the Great Wall.
Having steered the country through over 30 years of economic growth, a generation of Chinese policymakers are justifiably proud of their achievements. But it’s also true that an understanding of how to navigate a market economy through myriad situations isn’t institutionalized across China's vast government. And China is now running up against challenges that demand that its officialdom all pull in the same direction.
So imagine that Xi brings in a young Chinese economist, educated in New York and London, experienced in Hong Kong but a loyal communist with the right connections in Beijing. He's going to brief some party cadres who are visiting Xi from some less-developed regions of China who have seen the headlines about Chinese currency policy being in disarray, and they don't understand why something that seems to move so quickly can't be fixed equally quickly. He speaks in stark terms, and relates the advice of experts he’s gotten to know in his travels over the years. Listening in on their conversation, we gain insight into why it's so hard for China to do what needs doing.
We’ll call our young expert The Whiz Kid. He's talking to The Party Cadres.
Whiz Kid starts with a quick summary: The only realistic solutions are ones that lead inexorably to new problems that demand other, equally realistic solutions. In other words, there are no quick, individual fixes, only interlinked trade-offs. The Cadres murmur to themselves, shift uncomfortably in their seats, before bombarding him with questions.
Whiz Kid takes a deep breath before speaking truth to power because he’s developed strong feelings during his time abroad, but has never expressed them so openly. His policy prescriptions might sound a tad ... Western. But to convince them, he has to argue that they serve China’s interests.
Choose a Successful Currency Policy
Party Cadres: OK, our currency is sinking. What do we do?
Whiz Kid: To get its arms around a volatile exchange rate, China needs three things that it hasn’t really had for a while: a strategy for managing the rate, an explanation of said strategy and then consistent execution.
China manages its exchange rate around a point set each day, but that point has been dropping lower without any particular rationale, creating panicked selling with no logical endpoint. The currency is probably fundamentally overvalued, and China generally wants to see it go lower, which will help its export industry. But it doesn’t want a long, sharp decline, which would create friction with trading partners in Asia and North America, and delay its shift away from an export-led economy.
“It all points to a danger of overshooting,” said Sebastian Mallaby, a fellow at the Council on Foreign Relations. “The government wants a weaker currency but since everyone knows that, it might weaken faster than they want.”
One solution might be for China to let the currency fall by a substantial amount, then signal to markets through the daily fixing of the exchange rate that it won’t go any further. With $3.3 trillion in reserves, China doesn’t have to bluff.
Creative Fresh Incentives to Invest in China
Party Cadres: Let’s say your currency policy works. We’ve also given people the opportunity -- the incentive, really -- to ship their money out of the country before it weakens. And what if they start testing our resolve anyway?
Whiz Kid: One approach would be for China to create opportunities for financial investors -- pension funds, insurers and above all, central banks -- who take the long view for which the Chinese are famous. And it would dovetail with China’s desire to have the renminbi strike roots as a true international currency.
The International Monetary Fund admitted China into its basket of elite world currencies, but investors don’t just want to buy renminbi, they want to invest it in renminbi-denominated securities that bring a return. They lust after solid Chinese equities and above all bonds, which is where conservative, long-term investors put their money. The domestic bond market was worth about $5.6 trillion -- at the end of 2014, according to Goldman Sachs. “Opening the bond market in more than a symbolic fashion is at the heart of the renminbi being a true reserve currency,” said Derek Scissors, a senior fellow at the American Enterprise Institute.
This approach isn’t risk-free, but China needs foreign capital inflows, as Deng Xiaoping persuaded us 30 years ago. Without them, China will eventually face questions about its forex reserves. True, $3.3 trillion is a lot. But it’s not limitless. If China doesn’t attract patient foreign capital, the currency quandary becomes harder. Recall the answer to that first question.
One bit of good news about the recent stock market rout: Equities just don’t matter much for China’s overall economic health. Only 6 percent of Chinese households own stocks, according to economist Nicholas Lardy of the Peterson Institute for International Economics. About 55 percent of Americans do, so lower share prices dampen consumer spending in the United States. That won’t really happen in China. “The same is likely to be the case if the latest market correction continues in the new year,” Lardy said.
Adjust China's Underlying Economic Model
Party Cadres: So we can strengthen bond markets, and worry less about stocks. But how do we keep the patient investors around? Foreigners who build factories can’t just pull them out, but financial investors, however patient they are, only have to press buttons to get out. We remember the Asian financial crisis in the 1990s.
Whiz Kid: By developing a strategy for growth that China explains publicly and executes. It’s a bit like the currency question, but doing it will take longer.
For years, China powered up to 10 percent growth annually by churning out things the rest of the world wants to buy. But China has the limits of that strategy, requiring a more modest growth target of 6.5 percent. Now China needs to nurture part of growth that’s fired by domestic consumption, which means reallocating resources or using policies to drive private capital in that direction.
For example, China needs to downsize or wind down its remaining state-owned enterprises that live or die through exports. The steel industry, for example, is ripe for consolidation, having built up excess capacity in the last decade. On the other side of the equation, Chinese taxes on labor could come down, putting more money in consumers’ pockets that becomes the revenue of new companies.
China missed a crucial opportunity during the torrid growth of previous years. The steel business, for example, thrived as cheap money fed a building boom, but China didn’t use its policy levers to force the industry to become more efficient. “A reasonable strategy would have been to buy time with credit expansion and infrastructure spending while reforming the economy in ways that put more purchasing power into families’ hands,” Nobel Prize-winning economist Paul Krugman wrote recently. “Unfortunately, China pursued only the first half of that strategy, buying time and then squandering it.”
Again, China’s choices are of a piece. Allowing foreigners into its capital markets (the question of stocks and bonds) and creating a stable framework for the currency (the question about currency) help achieve the growth we want.
The good news is that China is still growing at a pace that other emerging markets can only envy. “China’s economy is growing at a 7 percent pace, give or take. That may be disappointing to some people, but it is no basis for a crash,” said Carl Weinberg, chief economist at High-Frequency Economics.
Relax Communist Party Control of the Economy
Party Cadres: OK, let’s say we work through your list. Where does the Communist Party fit in here? You haven’t mentioned the party at all.
[At this point, it’s the turn of Whiz Kid to shift uncomfortably. But he presses on.]
Whiz Kid: On some level, China’s challenges are not economic, they are political. Things it needs to do require upending entrenched interests and inflicting pain on some ordinary Chinese, and there are no technical solutions to that. We will need to offer something in return, and that might be to relinquish some control. China needs to make fewer efforts to jawbone private citizens into doing what they want -- whether it’s selling renminbi or dumping stocks -- and spend more time creating incentives that lead to virtuous behavior. That means improving the rule of law, not the rule of the party.
[A stony silence ensues. The meeting ends.]
There are two possible outcomes to Whiz Kid’s presentation after he leaves President Xi’s office.
1. They take his advice. Whiz Kid goes on to do great things from a high perch in Beijing as Chinese growth proves strong and long-lasting.
2. He disappears and is never heard from again.