US and China
The emergence of China is perhaps the most important economic event of the new millennium. Rapid economic growth has lifted hundreds of millions of people out of poverty while providing the world with goods of almost unbelievable quantity and affordability. If China keeps up its current 12% annual growth rate for the next 20 years, it will become the world’s leading economic power and a transformational force of the highest order.
Seemingly in sympathy with these extraordinary facts, Chinese stock markets have embarked on a tremendous rally, almost doubling since the beginning of the year. But it would be a mistake of the first magnitude for investors to view the Chinese stock markets as reflections of the glory of China’s real economy. Counter-intuitive though it may seem, China’s stock boom does not reflect the triumph of free trade, but rather the influence of the government through capital controls. These policies, embraced by the Communist Party, now threaten economic stability. To avoid catastrophe, China must open up its closed capital markets, radically and swiftly.
Paradoxically, the ascent of the Chinese real economy has been a story of openness. By pursuing free trade, China has enjoyed rapid, almost uninterrupted growth for nearly 30 years – the single greatest spurt of economic development in history. The credit for the smoothness of China’s progress, at least according to the Party, lies in the strict capital controls and other central planning that counterbalance dangerous market volatility. In this narrative, the pegged Renminbi and other barriers to free capital exchange have protected China’s economic miracle from the devastating crises that afflicted regimes that liberalized more wantonly, such as Russia and South-East Asia in the 1990s. For Beijing’s technocrats, free trade brings growth while the wisdom of central planning brings stability.
An important caveat to that narrative is that, whatever its former accuracy, it is wrong today. China now finds itself in the midst of a ferocious asset bubble. Since the beginning of 2006, the Shanghai Composite has risen 230% and has a P/E of 41; over the same period, the Shenzhen Stock Exchange has climbed 280% and has a P/E of 60. But, if such exuberance really embodies the Chinese economic miracle, why do Chinese shares abroad trade at such a steep discount compared to their mainland counterparts?
At a high level, the answer lies in the distinction between the real and the fictional, China and “China”. Real China is the globalization-driven economy that produces strong growth, an insatiable demand for scarce commodities (especially energy) and a prodigious savings rate. “China” is the limited universe into which the fruits of real China’s labour may be invested. Essentially, “China” consists of those assets foreclosed to foreigners and offered only to the Chinese – the equity and real estate markets that are now so overheated. Chinese savers have no choice but to invest the gains of China into “China”, because the inflation caused by a Renminbi peg (designed to boost exports) and escalating commodity prices creates an inflationary scenario in which they have no other choice.
Therein lies the source of the dilemma: inflation is high, in fact, higher than the rates available on bank deposits. Chinese savers are thus faced with the certain erosion of their savings unless they seek alternative investments. Because the state prevents Chinese investors from sending their capital abroad, they must brave the acute sense of vertigo of the mainland stock markets. The more inflation rises, the greater the problem becomes. Inflation currently runs at 4.4% annually, but a 16% rise in retail sales, 19.4% climb in industrial output and growth in fixed-asset investment of 26% annually suggest vast inflationary pressures not disclosed in the headline statistics. The 40% of GDP China currently saves might prefer to find itself invested in less torrid climates, but that is not an option. In a real sense, then, the benefits of globalization in China’s real economy find themselves frustrated by the anti-globalization in China’s financial economy.
The schizophrenia of a globalized real economy and an autarkic financial economy cannot last forever. The Chinese themselves appreciate this, though perhaps not enough. Financial liberalization is underway, albeit tentatively. The Renminbi was put on a crawling peg, but the peg moves with glacial slowness. Chinese financial institutions may now invest abroad, but only in certain instruments and only then in limited amounts. Chinese firms can “go out”, though they are hamstrung by certain understandings about which foreign investments are appropriate (natural resources, mainly). The amount of capital that can take advantage of this tentative liberalization, well under US$ 100 billion, is trivial in the context of the world’s fourth largest economy.
If China is to deflate the bubble, it must globalize its financial economy in the same way it has its real economy. Chinese investors must be offered more options than the certain destruction of their savings by inflation and the near-certain destruction of their savings in the coming equity crash. Chinese investors are entitled to the diversification and higher returns of investing abroad. They are equally entitled to the macroeconomic stability of a bubble-free economy.
It must be understood that China’s real economy and financial economy ultimately link, and that a catastrophe in the financial sector will ultimately infect China’s vibrant real economy. The hesitant steps towards liberalization taken thus far are not enough; the stock markets have simply brushed them off. The problem has grown so significant that only significant liberalization can set things right. If the solution seems audacious, consider it in the context of Deng’s liberalizations 30 years ago. How much boldness can it require to enact reforms that will safeguard and extend the gains of past innovation? As Deng himself put it: “Kaifang!” (Open up!)
Young Global Leader of the World Economic Forum