Investors can’t help but notice two kinds of news coming out of China these days. One tells a story of near-panic-driven stock market declines, a falling currency, high and rising debt levels, and a rapid slowdown in growth — all adding up to evidence of a so-called hard landing for the world’s second-largest economy. The other type of news portrays a confident, rising superpower that is setting up institutions to rival the World Bank and the International Monetary Fund, a country whose companies are embarking on a record-breaking spree of offshore acquisitions while its wealthy elite drive up property prices from Manhattan to Mayfair.
China is increasingly presenting a bipolar persona to the world, confusing its trade partners and global investors, who can’t seem to agree on which portrayal is more accurate. Complicating the matter is the fact that Chinese officials — who seemed poised and methodical when growth rates were high — appear much more fallible these days. Regulators’ abrupt interventions in the stock market last summer and sudden minidevaluation of the yuan frightened investors and stoked market volatility rather than providing reassurance. Officials rarely talk openly about the rationale behind their strategies, and when they do talk, they often give mixed signals, fueling doubts about both their ability to handle the nation’s difficult transition and their commitment to the reforms required to move China away from investment- and export-led growth toward greater reliance on domestic consumption and private sector development.
Concerns about China carry extra prominence this year, as it is Beijing’s turn to serve as president of the Group of 20 nations, for the first time. China overtook Japan to become the world’s second-largest economy in 2010 and now has a gross domestic product of $11.3 trillion, almost three times the size of its Asian neighbor’s. It has stood out with its leadership in the formation of new multilateral lenders — the Asian Infrastructure Investment Bank and the New Development Bank — placing officials in Beijing in a unique position to challenge their counterparts in the U.S., Europe and Japan, who for decades collectively set the rules of global finance through the G-7, the World Bank and the IMF.
“This is the first time that China has played such a key role in coordinating policy for the world economy,” says Kenneth Courtis, a former vice chairman of Goldman Sachs Asia who now chairs his own investment firm, Starfort Investment Holdings. Notwithstanding talk of a Chinese hard landing, Courtis says the mainland remains a source of strength for the global economy. China generated nearly 40 percent of world growth in 2015 and is on course to do the same again this year, he contends. “She is more than carrying her weight,” he says. “Remember, China is but 13 to 14 percent of world GDP.”
Others are not so sanguine. Last month Moody’s Investors Service lowered the outlook on its China sovereign debt rating of Aa3 to negative from stable, citing concerns about a weakening of the country’s fiscal and financial position. Moody’s noted a rise in government debt to 40.6 percent of GDP at the end of 2015 and a huge decline of $762 billion in foreign exchange reserves last year. In addition, the rating agency said there was increasing “uncertainty about the authorities’ capacity to implement reforms — given the scale of reform challenges — to address imbalances in the economy.”
The debt concerns surrounding Chinese banks and nonfinancial companies are even greater. Corporate leverage has risen sharply because the authorities provided stimulus to the economy in the wake of the 2008–’09 financial crisis through a big increase in bank lending. Although official figures say less than 1 percent of Chinese bank loans are nonperforming, a recent report by Katherine Lei, a banking analyst at J.P. Morgan in Hong Kong, said the real level of NPLs is about 7 percent if one includes loans through the shadow banking system, which includes credit extended via brokerages, wealth management products and other avenues.
“After 2008, when Beijing launched a massive investment push, the global ruling elite all praised China for saving the global economy,” says Andy Xie, an independent strategist in Shanghai who previously worked as Morgan Stanley’s chief economist in Asia. Since 2008, China has increased overall credit — including bank lending, shadow banking credit and government borrowing — by more than $20 trillion, or 176 percent of GDP, to finance the construction of factories, apartment buildings, roads and railways, he says. But, Xie adds, “investment does not guarantee final demand.”
The rapid rise in credit produced a bubble in property prices and fueled an explosion of short-term loans through the credit cooperatives, trusts and other entities that make up the shadow banking sector. Analysts estimate this sector has $5 trillion in outstanding loans, equivalent to 44 percent of GDP, with much of the credit extended to local government–linked companies and invested in infrastructure projects that take years to mature. And analysts can’t help but question how the Chinese government will be able to handle a crisis if large volumes of defaults occur.
The Chinese central government has allowed some local governments to sell municipal and provincial bonds in an effort to convert the short-term loans to longer-term debt instruments, but these efforts may not work fast enough to avert a sharp rise in NPLs. In a worst-case scenario, such bad debts could surge to 20 percent of GDP, says J.P. Morgan’s Lei. That estimate “is far from our base case,” she writes in her report, “but if it happens, China’s commercial banking system would need 5 trillion yuan of capital.” The government, which still sits on more than $3 trillion of foreign exchange reserves, can afford to recapitalize its banks, Lei says, but that would just perpetuate the credit dependency that leaves the economy vulnerable.
The economy itself has a dual nature that gives rise to both optimism and pessimism, generating uncertainty about the real outlook, says Andy Rothman, a veteran China watcher and investment strategist at Matthews International Capital Management, a $23.7 billion, Asia-focused asset manager in San Francisco.
“Manufacturing weakness has led to the development of a distinct rust belt in China, where industries related to construction and natural-resources extraction are concentrated,” says Rothman, who went to China in 1983 as a U.S. Foreign Service officer, then worked as a Shanghai-based strategist with Credit Lyonnais Securities Asia for 14 years before joining Matthews International in 2014. The rust belt consists of five provinces where GDP growth was only 5 percent in 2015 and unemployment is nearly double the national average of 4 percent. By contrast, China’s other 26 provinces, home to 84 percent of the population, grew at a rate of about 8 percent last year, Rothman estimates.
In the slow-growth provinces — Heilongjiang, Liaoning and Jilin in the industrial northeast and mining-dependent Shaanxi and Henan south and west of Beijing — thousands of state-owned enterprises employing millions of workers need to be restructured because of overcapacity or lack of competitiveness, says Rothman. But debt is concentrated among a relatively small number of state-owned companies, while the private companies that generate most of China’s new jobs and investment have already deleveraged, he says.
Notwithstanding the severity of China’s challenges, there are signs that government reform efforts are moving the economy away from its dependence on public sector investment and export-led growth. For the first time, services and private sector consumption accounted for more than half of the country’s GDP, or 51.4 percent, in 2015, up from 41.4 percent a decade ago. The strength of those sectors is mitigating weakness in manufacturing and construction, Rothman says. If this rebalancing continues, China’s economic deceleration will be gradual, he contends.
Yet fresh stimulus measures are raising concerns among some analysts that policymakers are going soft on reform to maintain social stability.
Less than a week after China hosted the G-20 meeting of finance ministers and central bank governors in late February in Shanghai, Premier Li Keqiang announced a slew of initiatives aimed at supporting growth. They included cuts in bank reserve ratios and mortgage down-payment requirements, an expansion of value-added tax reductions to all industries and a $245 billion budget for infrastructure spending this year. Li also announced a $15 billion allocation to retrain several millions of workers who will be laid off as a result of the massive restructuring of state-owned companies.
The government is budgeting for a fiscal deficit of 3 percent of GDP this year — up from 2.3 percent in 2015 and the highest level since 1949 — to ensure a “reasonable range” of growth, Li told delegates to the National People’s Congress in Beijing on March 5. He also set a growth target of 6.5 to 7 percent for 2016, down from 7.5 percent in 2014 and 7 percent in 2015. It was the first time the government had adopted a range rather than a precise growth target.
Officials face a tough balancing act in trying to reduce excess capacity while maintaining social stability, and some analysts believe Li’s measures fail to get the balance right. Although the government can’t afford to move too quickly, it needs to eliminate excess capacity if it wants the economy to thrive in the long run, says Jianguang Shen, Mizuho Securities’ Hong Kong–based chief Asia economist. “With more attention being placed on stabilizing the economy, structural reform may be delayed,” he says. “However, we believe that only through concrete structural reform can China boost productivity and make growth sustainable.”
MANY OFFICIALS CAME TO THE G-20 meeting worried about China’s health and the impact of its slowdown on their own economies. At a news conference in Hong Kong on his way to the G-20, French Finance Minister Michel Sapin said concern about Chinese growth was one of the main causes of global financial market instability.
At the meeting itself Chinese officials sought to reassure their partners that Beijing remains committed to economic reforms that will keep growth on track. They vowed not to engage in any competitive devaluation of the yuan. For their part, Western officials urged Beijing to continue economic and market reforms and to be more transparent in its actions; U.S. Treasury Secretary Jacob Lew hammered on that theme in a number of speeches and media statements at the G-20. “We welcome China’s efforts to transition to a more consumption-driven economy, including through fiscal policies that support household demand and actions that reduce excess industrial capacity,” Lew told journalists at the summit. “It is also critical that China continue to move toward a more market-determined exchange rate and transparent exchange rate policy in an orderly manner and clearly communicate its actions to the market.”
China’s currency, which weakened again in November and December, has stabilized lately at about 6.5 to the dollar. But many analysts believe the yuan needs to decline further to facilitate the country’s economic evolution.
“The yuan should fall over time,” says Paul Schulte, who heads his own, Hong Kong–based research firm, Schulte Research International. “This is part of an economy in transition from an investment-led to a consumption-led engine. Korea had this in the 1990s. Japan had this in the 1980s. The U.S. had this in the 1960s. Europe’s turn was in the 1970s.”
Chinese officials indicate that any yuan weakness will be gradual. The leadership is well aware that it cannot devalue its way out of the current economic slowdown, says a senior executive at the country’s sovereign wealth fund, China Investment Corp. (CIC), who advises the government on financial policy and spoke on condition of anonymity. “China cannot afford a currency or a trade war,” the executive says. “Officials will let the currency gradually slide to no lower than seven yuan to the U.S. dollar in the coming few years and will hold steady there for some time to come.”
Chinese officials are beginning to realize that, more than ever, their markets are interlinked with global financial markets and that they cannot escape addressing the worries of investors in faraway lands. At the recent World Economic Forum in Davos, an adviser to President Xi Jinping admitted that poor communication had contributed to global market anxiety over China’s falling currency. “Our system is not structured in a way to communicate seamlessly with the markets,” Fang Xinghai, vice chairman of China’s securities regulator and a member of a key Communist Party financial policy committee, told a Davos audience, seeking to reassure investors that Beijing was not pursuing competitive devaluation. He added, “You bet we can learn.”
The poor communication reflects the fact that the Communist Party leadership is still trying to find the right balance between giving in to market forces and controlling markets through administrative planning, says Laurence Brahm, a Beijing-based lawyer and entrepreneur who has advised the Chinese government on initiatives including the 2007 launch of CIC.
At the moment, the leadership is having a difficult time finding the middle ground. Consider the run-up to last summer’s stock market rout and the authorities’ response to it. Officials spoke favorably about the stock market in late 2014 and early 2015, leading many investors to believe the authorities were sanctioning a bull market. When prices fell by more than a third between June and August 2015, wiping some $5 trillion off Chinese equity values and triggering major sell-offs around the world, the authorities took a heavy hand, temporarily banning margin trading and selling by certain major shareholders and targeting people accused of short-selling or destabilizing the market.
“The leadership encouraged a bull market in a short period of time and then took drastic action against market participants, punishing them for following through on the government’s encouragement,” Brahm says.
As part of the crackdown, the authorities arrested half a dozen executives of China’s largest investment bank, CITIC Securities Co. They also arrested Xu Xiang, a billionaire and founder of hedge fund firm Zexi Investment Management, on charges of insider trading.
“China liberalized many leveraged financial instruments, which opened the Pandora’s box on speculation,” Brahm says. “In the end the tycoons saw what was coming and shorted the market. People lost money and were angry with the government. So it got back at the angry investors by arresting the tycoons and punters, and then propped up the market using clearly administrative rather than market mechanisms.”
The policy confusion and mixed signals stem in part from the fact that President Xi has been muscling in on Premier Li’s territory, sources say. Premiers have traditionally managed economic affairs while presidents focused on politics, foreign policy and defense. Xi, however, has seized control of all portfolios since taking over as head of the Communist Party in 2012. Technocrats like central bank governor Zhou Xiaochuan have made fewer public pronouncements under Xi’s leadership; Liu He, head of the General Office of the Leading Group for Financial and Economic Affairs of the Communist Party’s Central Committee and a senior aide to Xi, is often quoted in Chinese media these days.
Andrew Collier, former president of Bank of China in the U.S., detects a rising level of bureaucratic infighting in China as officials disagree more than in the past about how to deal with the nation’s challenges.
“As with most countries, there are different groups with different agendas controlling economic policy,” says Collier, who is now founder and head of Orient Capital Research, a Hong Kong–based firm that advises hedge funds. The central bank and the Ministry of Finance were at odds on how to deal with the stock market crisis last summer.
The internal tensions led to “the less sophisticated members of the political elite trying to do an end run around the technocrats,” Collier says, noting that the government spent $300 billion fruitlessly trying to prop up the markets. “They won the battle but lost the war when the markets fell sharply at the end of the summer.”
Aside from the bureaucratic rivalries, officials have made some glaring policy missteps lately. The most notable occurred at the start of January, when regulators activated a so-called circuit breaker in a bid to steady the stock market. Although circuit breakers are common in the West, China’s had two trigger points set too close together. If the market index dropped by 5 percent, trading would be halted for 15 minutes; if the decline reached 7 percent when the market reopened, authorities would shut it down for the day.
Instead of fostering market stability, the circuit breaker caused panic selling to erupt on January 4, the day the new system was introduced, forcing authorities to close the market for the day. After a two-day reprieve, selling triggered another market shutdown on January 7. Xiao Gang, head of the China Securities Regulatory Commission, who had championed the introduction of circuit breakers, was removed from office in February and replaced by Liu Shiyu, former chairman of Agricultural Bank of China.
China is still a mixed economy “with the uneasy coexistence of market measures in conjunction with state fiats,” says Willy Lam, a journalist, adjunct professor at Chinese University of Hong Kong and author of the recent book Chinese Politics in the Era of Xi Jinping: Renaissance, Reform, or Retrogression? “Xi wants the party-state apparatus to remain in control of important sectors of the economy,” he says. “Hence Beijing will continue to allow state-owned conglomerates to control key areas, including oil and gas, banking, telecommunications and airlines.”
Even as the government says it remains committed to market-oriented economic reforms, Xi is pushing the party back to its leftist roots with his efforts to concentrate power in his own hands. China experts say the president is backpedaling on much-needed political reforms and using strong-arm tactics to silence opponents within and outside the party. His anticorruption campaign has led to the arrest and jailing of tens of thousands of cadres, including more than two dozen officials of ministerial rank or higher.
“China is once again gripped by fear, in a way it has not been since the era of Mao Zedong,” says Minxin Pei, a professor of government at California’s Claremont McKenna College. “From the inner sanctum of the Chinese Communist Party to university lecture halls and executive suites, the specter of harsh accusations and harsher punishment is stalking China’s political, intellectual and business elites.”
In the past 12 months, a roster of business tycoons and officials have been arrested or have disappeared for a time, without any official explanation. Chief among them: Guo Guangchang, the flamboyant chairman of Shanghai-based Fosun International, who is often referred to as “China’s Warren Buffett.” Over the past five years, Guo and Fosun, China’s largest private investment conglomerate, have spent more than $5 billion acquiring a range of offshore assets, including French resort operator Club Méditerranée and prime New York real estate.
Guo, who sources say retains ties to the previous Chinese leadership under president Jiang Zemin, disappeared for almost two weeks in December, causing investors to panic and Fosun shares to drop 9 percent. It was later revealed that he was assisting anticorruption officials who were investigating a former Shanghai vice mayor.
The Fosun executive finally reappeared in public at a well-publicized dinner in New York City. Guo has remained free since then and apparently is not being targeted for criminal charges, but the incident illustrates the lack of transparency of China’s political system, under which politicians and business leaders can disappear with no official explanation and without due process.
“There has been no progress in the past few years in respect to the rule of law,” says Matthews International’s Rothman. “This is something I do expect to happen in the coming decades, and the Communist Party does understand they do need to establish the rule of law in order to remain in power, but the rule of law doesn’t come overnight.”
The prospect of a more powerful but also more volatile and unpredictable China poses a challenge to the country’s major trading partners. Many analysts expect Beijing to use its G-20 presidency to assert its influence and challenge the global status quo.
“Compared to the hosts of previous years, Beijing will use its G-20 presidency to project both hard and soft power,” says author Lam. “Xi wants China to play a greater role on the global stage, particularly in reshaping the international financial order.” He also wants to use the G-20 to position the yuan as a major global currency following its inclusion in December in the Special Drawing Right, the currency basket of the International Monetary Fund, Lam adds.
More broadly, China will use its G-20 presidency to advance its ultimate objective of establishing a new financial architecture that will rival Bretton Woods institutions like the IMF and the World Bank, analysts say. This includes the recently launched Asian Infrastructure Investment Bank (AIIB), a Beijing-led institution that has attracted more than 50 countries as members, and the New Development Bank, an initiative with China’s partner BRICS countries: Brazil, Russia, India and South Africa.
The U.K. government gave a big boost to China’s ambitions last year when it agreed to join the AIIB, much to the chagrin of the Obama administration. London’s decision prompted several European governments to follow suit.
Mark Boleat, chairman of the policy and resources committee of the City of London Corporation, says many European politicians are more comfortable with China’s rising global power than their American counterparts are.
“The G-20 presidency is a part of the natural process of China becoming an import-driven economic power,” Boleat says. “There is goodwill for China as a leading player, but one has to keep in mind that it will take time for China to become effective in these global institutions.”
Another priority for the Chinese president is the “one belt, one road” initiative, which aims to develop road, rail and sea transportation infrastructure linking China with markets in Southeast Asia, Central Asia and Europe, says adviser Brahm. “So as president of the G-20, Xi will aim to take on the global financial system and try to adjust many of the coordinates in line with this now-two parallel track that is emerging — a North-North cooperation and a South-South cooperation, with some little overlap in between,” he explains.
Some analysts worry that an emboldened Beijing may take risks that threaten regional or global stability.
“China is beginning to involve itself more in global issues, but instead of becoming a responsible stakeholder in the liberal international order, it seems to have chosen to focus on creating parallel governance structures, which it can shape according to its own preferences,” says Wolfgang Ischinger, a veteran German diplomat who chairs the Munich Security Conference, an annual gathering of security and defense officials that was held in mid-February. “And its increasing assertiveness, most visibly in the East and South China Seas, continues to worry its smaller neighbors, who wish for a stronger U.S. role in the region.”
In Beijing, however, analysts believe Xi’s agenda is marked more by cooperation than by confrontation. “The G-20 presidency can help China to promote its multilateral efforts,” says Hong Liang, chief economist and head of research at China International Capital Corp., a Beijing-based investment bank. “In particular, China may stress that these new institutions will only play a role in complementing, rather than challenging, the existing development agencies. This way China can enhance the acceptance of these initiatives by G-20 countries.”
Guan Anping, a Beijing-based securities lawyer and adviser to the government on financial reform policies, says the U.S. and its European and Japanese allies need not see China’s ambitions as a threat. “China will not try to force its political model down the throats of recipient nations in emerging markets as a condition for financing,” he says, adding that Beijing “seeks influence through trade and commerce and is not ideological at all in its approach to the geopolitics of finance.”
China still has a lot to learn from the U.S., Europe and Japan, Guan says. “All we seek is respect,” he explains, adding that China launched its development banks because the U.S. blocked its efforts to gain a greater say in the running of the IMF and the World Bank. In December the U.S. Congress finally approved IMF quota reforms giving China and other emerging-markets nations a greater role in the institution, five years after they were first proposed.
For skeptics and critics of China’s economic and political power, Guan has a simple message. “Yes, we are slowing down and will continue to slow down, and yes, we have huge reform challenges that will take many years to resolve,” he says, “but our growth also will continue for perhaps decades, and that is because we are committed to tackling the challenges — we are not hiding our heads in the sand. Whether the U.S., Europe or Japan likes it or not, China will be a significant player for many years to come.” •
Follow Allen Cheng on Twitter at @acheng87.
