The potential of political fight at the top in Beijing has galvanized the attention of Chinese and foreigners alike. With little actual information or press leaks, we are generally left to try and interpret fuzzy shadow puppetry while placing them in a complex play. I am not any type of connected political insider and can add nothing about the intrigue or personalities. However, from everything I have gathered there is a distinct economic element that is being overlooked here, which I believe I can add to the discussion.
The whispered discussions about who is siding with who in the palace intrigue that comprises Party politics, omits any focus on the clear economic dividing lines that separate the parties. As I have noted on numerous occasions, something that is not frequently recognized about the Chinese economic situation is that the longer this situation continues, the narrower the range of reform options at its disposal. Currently, not only does China have an increasingly narrow range of options to make meaningful change but those options both come with some type of significant risk.
Let’s take a simple example that is relatively realistic. Last year, total social financing grew at almost four times the GDP growth in absolute RMB terms. Based upon the rapid rate of TSF through April, that ratio will have only increased.
Beijing faces a simple tradeoff: a) they want strong economic growth of no less than 6.5% to ensure social stability and that there isn’t a wave of defaults AND b) they want to deleverage and lower the rate of growth of debt. They absolutely cannot have both.
The economic debate then becomes one of priorities. Do you want to prioritize growth or deleveraging? There are those that understandably prioritize growth over deleveraging. The rationale is simple: if TSF was four times GDP growth in 2015, economic weakness would become much more pronounced if debt growth was restrained. Given the already shaky financial condition of firms, it is simply too risky a time to make deleveraging a priority with the economy in such a weakened state. If you choose to prioritize deleveraging now, you run the risk of a major economic slowdown. Imagine what will happen to growth if TSF is significantly smaller. GDP growth even by official standards could easily be in the low single digits.
Those prioritizing restraining debt growth are making the same argument in reverse. They believe that the rapid growth in debt, what Barry Eichengreen has called maybe the largest and most rapid expansion of debt in human history, poses greater risks to long term stability. The concern being that either deleveraging will be essentially forced on China or it will ultimately result in some type of crisis or event that will result in a much more painful restructuring.
The fundamental question is this: what do you believe is the greater risk to China? Put another way, would you rather face potential labor instability this year or financial risks later? In all kinds of professions whether a surgeon or a stock trader, people are always looking at too risks with two potential benefits and trying to determine where their risk adjusted return is higher. China is faced with in reality a simple decision: which risk factor presents the greater risk?
The decision to pump credit now and try to grow your way out of the problem or deleverage now and try and manage the downturn present clear risks. Continuing to pump credit keeps growth moving but runs later risks that Beijing may be unable to manage the ultimate credit problems. Deleverage now runs the risks that social stability may escape Beijings controls presenting a clear and present danger to the Communist dictatorship in Beijing.
The other thing to remember, as in any situation where people are trying to manage or assess risk, is that the risks you and I are focused on are not necessarily the risks the others are focused on. To me and many China watchers it makes perfect sense to focus on the increasing financial risks. However, while they are certainly aware of the financial risks in Beijing, that is not necessarily the primary risk (which I am about to explain why).
One of the most common mistakes people make when considering risk is they overestimate their ability to manage either a specific or range of risks. Many might call it hubris. Beijing is essentially betting that they can manage the risks even if there is a significant financial or economic event that results from their continued economic incompetence which they have been warned about. They are telling us, even if there is some type of financial or economic event, they believe they have the tools at their disposal to address the situation.
If we unpack this, it becomes a worrying scenario. First, it implies that Beijing continues to pump credit, money, and investment to drive growth. If the level of total credit growth was 4x the level of GDP growth in 2015, imagine how bad it would have been without that level of policy support. We can only expect this level of distortion to continue to increase. Even as the rate of expansion of credit has slowed so far, it still is three times faster than cash flow growth of firms and about 2.5x GDP growth rate. In other words, we should continue to expect more of the same policies that will build up the risks facing the Chinese economy.
Second, when the eventual problems come, and they will come, you can expect a brutal and harsh response by Beijing. This entire policy of credit expansion when it has already risen faster than probably any other credit expansion in the history of the world in a country littered with bad loan examples with asset prices at eye bleeding levels depends entirely on Beijing’s belief that it can manage the downturn.
The stock market rescue is both a good and poor example of how Beijing will act. Good in the sense that it shows Beijing will throw any amount of money at a problem regardless of how misguided the policy and no matter how poor the result. Bad in the sense that rescuing the stock market is relatively easier that say the real estate market or preventing panic with a bank collapse. The fundamental point is that Beijing will go to virtually any length to prevent or bailout a financial or economic event regardless of cost, either financially or otherwise.
The politics of who supports what merely reflect the basic divide over economic decisions that are increasingly narrowed down to “which bad option can you tolerate”? How Beijing is handling the current problems should give us pause to consider what comes after?