Don't Bet Against China: This is a Market Correction Not a Financial Crisis

On my way out of town when the global market slide commenced at the end of last week, I was not able to stay abreast of the news coverage. Old friends who I met asked what I thought. Were we heading into another financial crisis? My answer, for what it is worth, was no. People have been predicting a China meltdown for years, and it hasn't happened yet. The Communist Party has been able to centrally manage impressive growth year in and year out for decades; there is no reason to believe that they can't succeed in converting China to a mature, Western-style consumption-based economy.

That being said, something is definitely happening here. Chinese demand for raw materials is slackening, which has an effect on commodity prices worldwide. Then there is the issue of currency. The dollar has run up in value, which prompted a devaluation in the renminbi earlier this month; and prior to that, the yen. Draped on top of all this is the jingoistic Western press which wants to fix blame squarely with China for the stock selloff. (A good example of this today is Eduardo Porter's fabulistic "Political Risks May Foil Economic Reform in China," or Thomas Friedman's shrill "Bonfire of the Assets, With Trump Lighting Matches.")

I think Chinese prime minister Li Keqiang gets it right (see Neil Gough and Chris Buckley, "China Again Cuts Interest Rates as Concerns Mount Over Economy"):

“Currently, global economic trends are opaque and confusing, and market volatility is quite large, and this has had some impact on the Chinese economy,” Mr. Li said, according to a report on Chinese television news. “But fundamentally the overall stability of the Chinese economy has not changed, and positive factors sustaining a turn for the better in the real economy are accumulating.”

China, he added, would be able to fulfill its economic goals for the year. Mr. Li also noted that there would be no continued depreciation of China’s currency, the renminbi, after a sharp devaluation earlier this month. The currency “can maintain fundamental stability at a reasonable and balanced level,” he said.

This point of view -- that China, the world's second largest economy, is fundamentally sound -- is echoed from both poles of the political spectrum. On the one hand, you have Michael Hudson, in the Democracy Now! video at the top of the post, saying that the Chinese are successfully managing the conversion of their economy away from an export-dominated model, and that the stock drop in the U.S. is basically panic selling to get out of the market before the bubble bursts; while on the other hand, you have an op-ed, "False Alarm on a Crisis in China," by Nicholas Lardy, senior fellow at the Peterson Institute, in fundamental agreement with contrarian firebrand Hudson -- China's economy is strong; what we are witnessing here is a market correction:

Washington — CHINA, many believe, is in a financial and economic meltdown causing anxiety and panic everywhere. China’s stock market dive first dragged down other emerging markets and has now spread to the United States, slicing trillions of dollars off the value of stocks traded here and in other global markets. Since China is the world’s second largest economy and has growing financial ties around the world, developments there clearly have enormous potential implications for both developed and emerging markets.

But the popular narrative is not well supported by the facts. There is little evidence that China’s economy is slowing significantly from the 7 percent pace reported by the government for the first part of the year. Wage growth is running at about 10 percent annually; the pace of creation of nonagricultural jobs is stronger than in any recent year; both real disposable income and consumption expenditures of Chinese households are growing strongly. It is not the picture of an economy heading for a hard landing. 

Services, not industry, are driving China’s growth, as has been the case for three full years. This is likely to continue since per capita incomes in China are reaching a level where a growing share of spending is on entertainment, travel and other services rather than on goods.

Naysayers question government economic data, continuing to focus on weakness in China’s industrial sector and the extremely slow growth of electric power output. But steel production, for example, is significantly more energy intensive than entertainment, so the demand for electricity has fallen sharply as the structure of the economy has evolved.

Assuming that electric power growth is a good proxy for China’s overall economic expansion is like trying to drive a car by looking in the rearview mirror.

Some economists watching from abroad believe that the country is in the midst of a financial crisis because of the excessive debt burden it incurred in recent years. But that view is even less well supported. After a very modest two-day depreciation earlier this month, the exchange rate of the renminbi has changed little against the dollar for eight consecutive trading days; capital outflows continue at a moderate, very sustainable pace; bank liquidity remains strong. This does not yet look remotely like a financial crisis.

Rather than a financial and economic meltdown, China is experiencing an overdue correction in its equity market. And the connection between China’s equity market and China’s real economy has always been tenuous.

Don't bet against China.

China's Currency Devaluation: End of Dollar's Hegemony?

Dipping into the coverage of what is being labeled China's "currency plunge," one finds reporting that is all over the map. For the alarmist perspective -- China's robust growth is actually an Oz-like mirage; an incipient trade war is brewing with cascading currencies devaluations -- read Neil Gough's "Devaluation Hints at China’s Rising Distress Over Economy" which appears today on the front page, upper right corner, of the NYT national edition. 

While Gough includes some helpful numbers to illustrate ebbing construction in China, the idea that the country might be headed for recession seems absurd to me; in fact, Gough undercuts it himself in his choice of a closing for the article:

As the government pumps money into the market and the broader economy, it will help, along with moves like the devaluation. It is just not clear how solid the economy will actually be. 

“It’s all about the quality of growth,” said Victor Shih, a China scholar at the University of California, San Diego. “If they want to, they can always achieve the right rate of growth.” 

The Chinese government, he added, just needs to find a group of people and “tell them to go dig a ditch.”

The Chinese government has proven repeatedly to be adept at managing its high-growth economy, something that you will not see acknowledged in the Western mainstream press. In the United States, the idea that markets can be effectively manipulated by government bureaucrats is akin to championing child molestation.

A good story to go for one-stop shopping is Neil Irwin's "Why Did China Devalue Its Currency? Two Big Reasons." Those two reasons are 1) because the Chinese renminbi is pegged to the dollar, and the dollar this year has appreciated against other currencies, the renminbi is overvalued:

The renminbi on Monday was at about the same exchange rate versus the dollar that it was in mid-December. But in that time, the dollar index was up 8.7 percent, meaning the dollar — and by extension the renminbi — was up that much against other advanced nations’ currencies, like the euro, the yen and the British pound.

And 2) China is making a play for the renminbi to be included in the basket of global reserve currencies:

China is looking to assert more of a leadership role in the global economy, and an important piece of that is establishing the renminbi as a reserve currency. The dollar and the euro have a reach and a usefulness far beyond the borders of the countries that use them, and China would like the renminbi to have a similar sway in global trade and finance, especially in Asia.

But you can’t really be a global reserve currency when you maintain all the restrictions that China insists on in the interest of keeping control of its domestic economy. The dollar wouldn’t play its central role in global finance if the American government made it illegal to exchange it for other currencies in many circumstances or used legal prohibitions and aggressive interventions to keep its value from fluctuating in response to market forces. 

In other words, China has wanted some of the diplomatic benefits it would gain if the renminbi became a more important currency abroad, without paying the price at home. 

Just last week, the International Monetary Fund said that the renminbi was not quite ready for inclusion in the basket of currencies the I.M.F. uses for “special drawing rights,” a reserve asset that currently is a mix of dollars, euros, yen and pounds. Christine Lagarde, the organization’s managing director, said China needed to make its currency more “freely usable.” And the policy change on Tuesday, by moving closer to a world in which markets determine its price, is a step in that direction.

What is being touted by some as proof of rot in the Chinese economy could actually be the moment when U.S. dollar hegemony begins its end.