14th March 2014
Jan Dehn, Head of Research at Ashmore, has issued a note considering the outlook for Chinese growth and interest rate liberation. We publish the full note below.
Amidst yet another bout of fears about China’s future, we set out our views on the outlook for growth, the financial system, China’s public finances, reforms, and the country’s external balances. China is in the midst of a storming change. Interest rate liberalisation is coming as China prepares to let the bond market play an ever-greater role in macroeconomic policy.
Why the need for change? In our view, the export-led growth model of the past few decades is no longer fit for purpose. As the largest holder of foreign exchange reserves in the world China will be more impacted by the unwinding of global imbalances than any other country. Political realities require dramatic change, quickly.
We think it is essential to look at China in a dynamic setting. Contrary to the current prevailing sentiment, we like China. We see a country facing up to the world of tomorrow, and adapting instead of merely languishing in denial that belongs to yesterday.
China and the US – a marriage slowly falling apart
Over the past thirty years one part of the world accumulated a lot of debt, while the other accumulated a lot of foreign exchange reserves. Emerging Markets (EM) accumulated reserves by selling goods to developed economies. They invested the reserves in the debt that fuelled the purchases of goods in developed economies in the first place. Nowhere was this intimate relationship between debtor and creditor closer than between the US and China. As of today, China has accumulated USD 3.8trn of FX reserves, or 33% of the world’s combined stock of FX reserves, while the US has issued more debt than any country on earth – nearly 400% of GDP as of late 2013.
China’s growth model until very recently was built on alternating bursts of export-led and investment-led growth. China switches from one to the other whenever production capacity constraints demands fresh capital spending. Strong demand from abroad was assured through a combination of active exchange rate management on the part of the Chinese and debt-fuelled consumption-led growth in Western economies.
But the prospect of a much stronger CNY and a sharp fall in the US dollar on the back of QE policies and high debt levels in the US means ‘all change’ for China’s growth model. Export-led growth has no future when debt-fuelled consumption in developed economies is over. Accumulating reserves is becoming more risky as exposure to US fixed income rises. The opportunity cost of accumulating reserves – in terms of forgone consumption – is becoming prohibitive as the need to shift towards domestic demand-led growth grows more urgent. Expanding the capacity to export further could lead to a dangerous misallocation of capital and the hard landing. Finally, China’s ability to manage its own currency diminishes as developed economies turn to inflation to get rid of their debts. If China does not turn away from the growth model of the past few decades soon there will be no growth model at all.
The role of bond markets
In addition to acting as a transmission mechanism for monetary policy the bond market also serves three other important functions:
Discipline local governments – the government is rotating away from local government financing vehicles and bank credit towards outright bond issuance at local government level. This will give markets a role alongside the central government in disciplining errant administrations by raising their borrowing costs
Increase transparency – the experience from 2008/2009 showed that rapid credit expansion via local government financing vehicles can backfire. Issuance in public auctions is more transparent and therefore less risky
Increasing consumption – China’s savers are mainly confined to investing in stocks and property, but returns to both tend to be highly cyclical. Bonds have the wonderful feature that they rally when other assets fall. Bond markets will help to stabilise savings portfolios and thereby reduce precautionary savings rates. This helps to raise consumption
China’s fixed income market is already one of the world’s largest. The onshore market is worth USD 4.4trn comprising interbank loans, OTC bonds, exchange traded fixed income securities, and other types of fixed income. China wants this market to function more efficiently, which is why the government is expanding access for foreign dedicated institutional investors via the QFII and RQFII quota systems.]
Are China’s credit markets too large?
Developing countries are poor because they have less capital per worker. But if there is a silver-lining to poverty it would be that each unit of capital in poor countries has a higher return. Capital should therefore flow from developed economies to Emerging Markets, bringing about what economists call economic convergence.
Sadly, most EM countries are able to attract a very small share of global capital, in part because regulators in developed economies are doing everything they can to hold on to it (financial repression).
China has managed to ease this capital constraint by sustaining very high savings rates. This naturally means that China’s credit markets are also larger than those of other countries.
Indeed, the ratio of total credit to GDP in China is about 230%, but with a deposit base of about 160% of GDP the leverage ratio in the banking system in China is actually very low compared to most developed economies (where savings rates are much lower and credit markets larger).
As long as China maintains good macroeconomic policies with solid regulation we think a large credit market is an asset rather than a liability: China will be less constrained in its economic convergence than less credit-endowed EM economies.