Jacques deLisle and Peter Conti-Brown on China's Economic Crisis

Concerns over China’s slowing economy that sent global stock and commodity markets on a recent free fall are heightened by the opacity and conflicting signals from the country’s political leadership and its central bank. While the markets recovered somewhat in subsequent days and the panic ebbed, the obstacles China faces remain along with their implications on the global economy. Those issues have cast a cloud over the prospects of a widely expected interest rate hike by the U.S. Federal Reserve in September.

China responded quickly to the stock market meltdown on August 24, dubbed “Manic Monday.” It lowered interest rates by 25 basis points to 4.6% and cut the reserve requirements for banks by 50 basis points to 18%, a move that is expected to increase liquidity by 650 billion yuan or about $101 billion. Those moves followed attempts two weeks ago by the People’s Bank of China (PBOC), the Chinese central bank, to let market forces play a bigger role in setting the value of the yuan, leading to a surprise devaluation of around 2%, which would boost Chinese exports.

China is able to dig deep into its foreign exchange reserves — the world’s largest at $3.65 trillion as of July 2015 based on Chinese government data — to manage the yuan’s value. But Peter Conti-Brown, Wharton professor of legal studies and business ethics, wondered how much of the reserves China could use and how long they would last. “Before they go through those resources, we will see a dramatic panic” about China’s ability to sustain the yuan’s value, he said.

However, the overriding concern is whether China will be able to sustain a growth rate of 7% to 7.25%, or the “new normal” after years of double digit growth, said Jacques deLisle, professor of law and political science at University of Pennsylvania Law School and director of Penn’s Center for East Asian Studies. With its latest moves to restore confidence, China may have come close to exhausting its ammunition, he felt. “These are all classic stimulus tools,” he said. “The concern is they are already pretty deep into the toolbox.”

Conti-Brown and deLisle discussed China’s moves in the latest crisis on the Knowledge at Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

“China has already lowered interest rates, allowed pension funds to invest in stocks, and asked state agencies to purchase stocks,” added Wharton professor of international management Mauro Guillen, who is also director of The Lauder Institute. “Those are patches, of course. What needs to be done are reforms to create more transparency.”

“[China’s recent moves] are all classic stimulus tools. The concern is they are already pretty deep into the toolbox.” –Jacques deLisle

Meanwhile, a weakening economy could expose other kinks in China, according to Wharton emeritus management professor Marshall Meyer, who is a longtime China expert. “The big unknown is the indebtedness of Chinese firms, SOEs (state-owned enterprises) especially, and local governments. This could be ugly,” he said. Also, “a crackdown on underground banks is underway.”

Investors remain worried about the Chinese government’s ability to manage the decline, selling off shares. The Shanghai Composite Index fell nearly 27% in eight consecutive trading sessions – dropping from 3,993 on August 17 to 2,927 by August 26. The recent declines also bring up a fundamental issue about “whether it had the right valuations in the first place,” said deLisle. “What is driving it is a real concern about whether China’s growth has slowed in a lasting way and has slowed worse than people expected.” Also in question is the ability of the Chinese government to control and contain those declines. “What has been a quite capable and determined state seems to be all thumbs all of a sudden, not quite figuring out what policy response it wants to take and sending some mixed signals,” deLisle noted. “That has hurt confidence.”

Conti-Brown pointed to other hurdles to the Chinese government’s struggles to manage the decline. “The economic policy planning process within the Chinese state is so inscrutable, so hard to determine, and [it is] so hard to even get really accurate data, we cannot say that the PBOC model is motivated by a standard central banking model or if it is toeing the Communist party line,” he said. “This is what makes studying central banking in China so exciting and so vexing.”

The crisis has cast doubt on China’s growth model, according to Conti-Brown. “For the last several decades, China has emerged as an alternative to the capitalist democracies of the West and to a completely centralized state,” he noted. “The enthusiasm over China’s robust growth has led to this idea that this state can do it all, and manage quasi-independently a currency while stimulating growth at extraordinary rates. These selloffs and these crashes and the People’s Bank of China’s responses bring some doubt about whether this ‘Third Way’ is possible.” He added that the 7% growth in GDP predicted for China after downward adjustments is still “extraordinarily robust” and “hints at what we’ve come to expect from the Communist Party and from China.”

Guillen said the fundamental issue China faces is that a GDP growth rate of 7% “is not enough to appease the public and to keep on lifting people out of poverty.” Clearly, it is “very hard” to sustain a growth rate of 10% or 12% over a long period of time, he explained. “So they need to reform the economy and switch tracks away from exports and into domestic consumption.”

Major concerns and solutions

According to deLisle, China’s responses to combat inflation is another challenge it faces. “It had ruinous inflation before the current regime started and they’ve shown a pretty skittish response to spikes in inflation in the many years since,” he said. Another concern is the overexposure of its banks to badly performing loans, he added. DeLisle noted that not all lending by Chinese banks are entirely on the basis of credit-worthiness, and that preferential lending to state-owned enterprises is commonplace. Against that backdrop, a lowering of the reserve requirements of banks could spell trouble if some of those loans go bad, he warned.

“The big unknown is the indebtedness of Chinese firms, SOEs (state-owned enterprises) especially, and local governments. This could be ugly.” –Marshall Meyer

Conti-Brown noted that Zhou Xiaochuan, the governor of the People’s Bank of China, led the bank’s recapitalization some 12 years ago. He is also known for his toughness in dealing with bad bank loans and belief in market mechanisms. “In terms of biography, the Chinese central bank is going in with its eyes wide open,” said Conti-Brown. “They know exactly what risks can be run with a failure of their banks and the banking system.” Given that background, the central bank must be taking a calculated risk by using tools like lowering bank reserve requirements, he added.

Meyer suggests a five-point program of reforms for China to get back on track and restore confidence in the markets. First, he advised it to forge a “unity government,” or a coalition between different political interests. “Call off the sniping at the Jiang Zemin faction,” he said. He was referring to attempts by the current government to undermine the influence of former President Jiang Zemin.

“Second, back off the anti-corruption campaign,” said Meyer. “It has paralyzed government at all levels, and the government must act now.” Third, he advocated a set of long-term policies and strategies for China in areas including public health (pollution, food and water quality), health care, social security, educational reform, and hukou (residential permitting) reform.

Meyer also called for “serious land reform” that would include private ownership as well as property taxation to raise revenues and cap rampant speculation. Lastly, he suggests that China should adopt a program of energy independence. “This is related to land reform and capital market reform — both needed to create a class of wildcatters to do in China what they did in the U.S.,” he said. He acknowledged that Chinese shale oil is less suitable for fracking than those in the U.S., but cited “above ground” obstacles including the availability of capital to entrepreneurs and land and mineral rights.

Forex reserves

In the meantime, as China attempts damage control with its forex reserves, challenges abound there as well. Meyer noted that its reserves are “already declining due to outward investment and capital flight.” He described it as significant and warned against accelerating that flight of capital.

Meyer also highlighted what he deemed as “a worse, yet subtler problem.” The PBOC, which holds China’s dollar reserves, collects the foreign exchange from commercial banks by swapping them with so-called sterilization bills that are long-term, low interest notes denominated in U.S. dollars. “If PBOC starts spending the dollars, they can’t cover the sterilization bills and their liabilities increase with the dollar vis-a-vis the renminbi,” he said. “I’m not sure of the consequences, but I doubt they’re pretty. If the PBOC sells a lot of U.S. Treasuries, U.S. interest rates will rise no matter what the Fed does.” Guillen noted that China has already used about $200 billion to defend its currency, adding that with those moves, the renminbi “should not fall too sharply.”

Meanwhile, the devaluation of the yuan could hurt Chinese enterprises that have dollar-denominated debt, said deLisle. Chinese exporters who assemble their products using imported goods will also hurt, he added. He advised against such export-boosting measures as a sustainable solution to stimulate growth. “You cannot be the world’s largest economy and export your way to rapid growth.”

“These selloffs and these crashes and the People’s Bank of China’s responses bring some doubt about whether this ‘Third Way’ is possible.” –Peter Conti-Brown

Misdirected Tools?

Both deLisle and Conti-Brown expressed concerns about China’s relaxation of banking reserve requirements to stimulate liquidity and growth. Conti-Brown noted that central bankers’ monetary policies tend to veer towards managing interest rates rather than changing reserve requirements. “Reducing reserve requirements for banks introduces dramatic financial instability,” he said. Also, Conti-Brown also questioned the justification for China to use “big, broad tools” like interest rate cuts, reserve requirement relaxations and devaluation all at the same time to boost growth. “The standard response is to ride this out — drop interest rates until things stabilize.”

DeLisle added that China seems to be using “all policy tools at once … without an obvious prioritization.” He compared the moves to “hitting the gas and the brakes alternately,” which he said spells ambivalence. He pointed to the PBOC’s moves two weeks ago to let market forces determine the value of the renminbi, only to intervene when it found the extent of the decline was unwarranted. He also pointed to similar conflicting moves in earlier months as China’s stock markets fell. He compared the graph of the Shanghai index to that of “a criminal being interrogated on a polygraph — spikes all over the place.”

Various theories about the rationale behind China’s actions are doing the rounds, deLisle said. One is that insiders know the economy is in “a lot more trouble than we know … and this is why we see this all-hands-on-deck and somewhat scattered response.” The second theory is that Chinese authorities “may just be very skittish. They may not have gotten accustomed to the idea that the economy is a bumpy ride.” A third explanation is Chinese authorities “are just control freaks and that temperamentally they are not ready to let go of a lot of this,” he said.

Confounding all that is the opacity surrounding Chinese actions. While the Chinese Communist Party pledged two years ago to move towards domestic consumption as its main lever for economic growth, its recent actions “call into question some of that commitment,” said deLisle. He also noted that many China watchers had not predicted that Xi Jinping would be as strong as he has been. “A lot of the decision making power has been taken out of the hands of the bureaucracy and specialists and into these small groups who are much more opaque and potentially much more political.”

All this uncertainty about China’s growth has prompted many experts, including former U.S. Treasury Secretary Lawrence Summers, to advise the U.S. Federal Reserve against raising interest rates at its next meeting in September. Raising rates would be a “serious error,” he wrote in the Financial Times in a recent article. “Given that inflation is not a threat, raising rates is not good right now for the global economy, especially emerging markets,” said Guillen. “But then, the Fed’s mandate is to look after conditions in the US, not globally.” Meyer added that he would be worried about “another zero-interest fed asset bubble.” However, he felt “it looks like the wrong time to constrict the economy.”