What's Wrong with China?
What caught my eye this week including Chinese bonds, Beijing's flawed model, Biden's bad bets, German carmakers, Ukraine's golden opportunity, and why Kamalonomics beats Trumponomics
I am delighted that the brilliant guest post by John Crompton earlier this week on Rachel Reeve’s Big Opportunity generated such a strong interest. Do read it if you haven’t already. The issues he raises apply well beyond Britain. I hope to have more on this topic next week. Meanwhile there is a strong China theme running through this week’s newsletter. It is remarkable the extent to which so many of the more pressing geopolitical and geoeconomic issues facing the world today revolve around China. I hope you find it interesting. As always, I welcome your feedback and comments.
1. Vote of No Confidence
Perhaps the oddest story of the week was the news that the Chinese authorities have been intervening in the domestic bond market. We have grown used in recent years to central banks intervening to drive DOWN bond yields to try to engineer lower borrowing costs for economies that are struggling to grow. What we have not seen is a central bank intervening to drive UP bond yields in an economy at risk of deflation. Yet this is what the People’s Bank of China (PBOC) effectively did last week.
What spooked Beijing was a fall in 10-year government bond yields to 2.1 per cent from 2.6 per cent earlier in the year. That seemed to reflect legitimate concerns about the state of a Chinese economy in which growth has slowed, inflation is non-existent and demand for credit is evaporating. As the WSJ noted, net new bank loans turned negative in July for the first time since 2005 as households and businesses paid down debts, business investment is slowing and the property market is in the doldrums.
Yet the PBOC instructed rural banks to stop buying government bonds in a bid to keep bond prices down and nudge yields up. Why try to push up the price of credit when demand for credit is low? Why try to buck the market? As The Economist says, there are three possible explanations, none of which make a great deal of sense:
The first is the official explanation which is that it is worried about the health of the Chinese financial system, and in particular a repeat of the Silicon Valley Bank debacle in the US, when banks loaded themselves up with expensive bonds only to be hit with heavy losses when interest rates went up and the value of the bonds sharply fell. But as the Economist rightly points out, this makes no sense: “the prospect of rate hikes in China is so distant that this danger seems remote. And the threat would be best resolved through bank regulation, not bond-market manipulation.”
A second possible explanations is that the PBOC is indeed worried about the health of the banking system, not because of its exposure to government bonds but because of the threat that low bond yields posed to its profitability. This is a particular concern at a time when banks are facing heavy losses on past property lending. Banks make money by borrowing at low short-term interest rates and lending long. Under this scenario, the PBOC’s intervention may have been aimed at steepening the yield curve by driving up long-term borrowing costs. But how does it help bank profitability to stop them buying any bonds at all?
A third explanation is that the PBOC’s real concern was not the bond markets but the currency markets. The growing divergence between US and Chinese bond yields is putting downward pressure on Renminbi. But that cuts across official Chinese policy which is to seek a strong Yuan. A weaker currency would risk inflaming trade tensions with the rest of the world by making Chinese exports cheaper. On the other hand, it is an odd way to try to strengthen the Yuan by artificially propping up bond yields, particularly when domestic economic conditions are crying out for lower rates.
Perhaps the most plausible explanation was the one suggested by Robin Harding in an excellent column in the Financial Times: that the PBOC’s true concern was over the downbeat and potentially self-fulfilling signal sent by falling bond yields.
They amount to a vote of no confidence in government policy, a forecast that economic conditions will not improve and a warning that deflation will take root if nothing is done to stop it. The next stage in 1990s Japan, note economists at Morgan Stanley, was for companies to respond to the low-price environment by limiting wage growth. That is how a deflationary spiral can take hold.
Will the PBOC’s intervention work? It may have pushed yields up modestly last week, but its seems unlikely to work for long. As Harding says, the problem is the lack of alternatives: equities, property, credit and deposits.
With no end in sight to China’s housing market downturn, households have little appetite for property, while domestic companies are suffering from weak consumption and the aftermath of Beijing’s crackdown on the technology industry. Deposits, meanwhile, are only attractive if you expect interest rates to rise in the future. With the outlook so gloomy, it seems wholly rational for Chinese investors to flock into bonds and gold.
2. China’s Over-Capacity Trap
What lies behind the weakness in the Chinese economy? Most commentary tends to focus on recent policy choices, as well as the bursting of the country’s property bubble. But China’s real problem, according to Zongyuan Zoe Liu, a fellow at the Council on Foreign Relations, a Washington-based think-tank, lies in deep and long-standing problems with China’s economic model. Her fascinating essay in the latest edition of Foreign Affairs, is essential reading to understand the tensions that lie at the heart of the global economy and are indeed driving geopolitics.
Simply put, in many crucial economic sectors, China is producing far more output than it, or foreign markets, can sustainably absorb. As a result, the Chinese economy runs the risk of getting caught in a doom loop of falling prices, insolvency, factory closures, and, ultimately, job losses. Shrinking profits have forced producers to further increase output and more heavily discount their wares in order to generate cash to service their debts. Moreover, as factories are forced to close and industries consolidate, the firms left standing are not necessarily the most efficient or most profitable. Rather, the survivors tend to be those with the best access to government subsidies and cheap financing.
According to Liu, these excesses are not the result of recent policy choices but stem directly from the lopsided industrial strategy adopted by former leader Deng Xiaoping when he opened up the economy in the 1980s. His first five year plan (1981 - 1985) was almost entirely devoted to developing China’s industrial sector, expanding international trade, and advancing technology, with only one of its 100 pages given to the topic of increasing income and consumption. Despite vast technological changes and an almost unrecognizably different global market, that effectively remains the Communist party’s economic strategy today.
The underlying assumption is that Chinese producers will always be able to offload excess supply in the global market and reap cash from foreign sales. In practice, however, they have created vast over-investment in production across sectors in which the domestic market is already saturated... In the early years of the twenty-first century, it was Chinese steel, with the country’s surplus capacity eventually exceeding the entire steel output of Germany, Japan, and the United States combined. More recently, China has ended up with similar excesses in coal, aluminum, glass, cement, robotic equipment, electric-vehicle batteries, and other materials. Chinese factories are now able to produce every year twice as many solar panels as the world can put to use.
Central to this economic model is the idea that China’s advantage lies in keeping consumption low and savings rates high. In other words, Beijing deliberately suppresses the standard of living of ordinary Chinese, not least via minimal levels of welfare provision, in order to generate the capital via excess savings that can fund a state-controlled banking system which in turn can funnel loans into industry. At the core of China’s overcapacity problem is the burden placed on local authorities via top-down industrial plans to develop China’s priority sectors. Local officials are in turn given broad discretion to arrange off-balance-sheet investment vehicles to fund this industrial expansion with the help of regional banks.
About 30 percent of China’s infrastructure spending comes from these investment vehicles; without them, local officials simply cannot do the projects that will win them praise within the party. Inevitably, this approach has led to not only huge industrial overcapacity but also enormous levels of local government debt. According to an investigation by The Wall Street Journal, in July, the total amount of off-the-book debts held by local governments across China now stands at between $7 trillion and $11 trillion, with as much as $800 billion at risk of default.
Liu’s key point is that no matter how lop-sided China’s economic model may be, it is not going to change, or at least not quickly. Partly that is because it will take years for Chinese efforts to boost domestic demand and lower the savings rate even if the Chinese Communist Party follows through on vague commitments at its recent Third Plenum to widen the social safety net. Partly it is because the West’s attempts to isolate China economically have only fuelled President Xi Jinping’s conviction that China needs to aim at self-sufficiency and global leadership in key technologies. But above all it is because the model itself create a vicious cycle from which it is hard to escape: firms backed by bank loans and local government support must produce nonstop to maintain their cash flow.
But as firms produce more, excess inventory grows and consumer prices drop further, causing firms to lose more money and require even more financial support from local governments and banks. And as companies go more deeply into debt, it becomes harder for them to pay it off, compounding the chance that they become “zombie companies,” essentially insolvent but able to generate just enough cash flow to meet their credit obligations. As China’s economy has stalled, the government has reduced the taxes and fees levied on firms as a way to spur growth—but that has reduced local government revenue, even as social-services expenditures and debt payments rise. In other words, the close financial relationship between local governments and the firms they support has… left the economy in a hard-to-reverse overcapacity trap.
The lesson for Western policymakers is that attempts to isolate China are likely to backfire, leading to continued over-production and increasing the risk that China slides into that Japanese-style deflationary trap, with all that would imply for the global economy. To convince Beijing to change its economic model, says Liu, the West would do better to try to keep China within the global trading system, thereby creating incentives to seek more balanced growth. That is surely right.
3. Biden’s Tarnished Flagship
Of course, there is little chance that the West will take Liu’s advice. The direction of travel in terms of policy towards China has been set for some time. America has hit China with tariffs and introduced vast subsidies via the Chips and ScienceAct and Inflation Reduction Act in part designed to boost domestic production of critical technologies. It accuses Beijing of hampering innovation and competition in the global marketplace with its over-capacity, threatening jobs in the United States and elsewhere. Other countries have followed suit, not least the European Union, but also Brazil, Mexico and Turkey which have all imposed tariffs in the past year on various imports from China, including but not limited to electric vehicles.
Nonetheless there is growing evidence that from an economic perspective, these polices are not working out as expected. This investigation by Financial Times found that some 40 per cent of the biggest US manufacturing investments announced in the first year of Joe Biden’s flagship industrial policies have been delayed or paused. It cited deteriorating market conditions, slowing demand and lack of policy certainty in a high-stakes election year as reasons given by companies for changing their plans. Many also cited Chinese over-capacity and the impact this has had on global pricing, particularly in clean technology as a further reason to delay planned investments.
As Simon Evenett, professor of geopolitics and strategy at IMD Business School and a leading expert on global trade, noted in a LinkedIn post, this should at the very least temper expectations on the power of industrial policy to deliver a manufacturing revival. Clearly Biden’s subsides are “not enough to sustain a business case for investment robust enough to these developments… they can only counteract (at most) part of adverse factors in the US business environment.” That includes a lack of skilled technicians in many sectors, and difficulties in securing local permits.
Nor have Biden’s tariffs been sufficient to assuage industry concerns over Chinese over-production. That raises questions about the point of them. Indeed, there is now plenty of evidence that all that they have succeeded in doing is pushing up costs for American businesses and consumers, while China has shifted production to countries such as Mexico to evade American tariffs. At the same time, the global trend towards protectionism and subsidy races has created new frictions and costs in the global trading system, while creating the risk of creating even greater global over-capacity, thereby importing China’s problems at a global level. Worrying.
4. Germany’s Golden Cage
One country that clearly did not get the memo when it came to decoupling from China was Germany. There was much egg on faces in Berlin this week when this Financial Times report revealed that German direct investment into China has soared this year, despite pleas from the government for industry to diversify into other markets. Much of this investment was driven by carmakers.
According to Danielle Goh, an analyst at US-based research group Rhodium Group, “German investments have consistently accounted for more than 50 per cent of EU27 investments in China, predominantly due to contributions from German carmakers”. The carmakers are too reliant on profits made in China, according to one anonymous business leader quoted by the FT: “They are stuck in a kind of golden cage”.
The best response to this muddled thinking that I have read this week was by Adam Tooze on his Chartbook Substack. He noted, (as did the FT), that much of the investment is reinvested profits earned in China, reflecting a new “In China, for China” strategy aimed at shifting more production to one of their biggest markets. The carmakers are determined to reduce all risks in their supply chains by reorganising them on a regional basis, through localisation, particularly in China. But as Tooze says, that is not the only reason why they continue to invest in China:
Already back in 2008 China became the largest car market and has since consolidated that position, far ahead of the United States, the EU and Japan. It was a profitable market for sure. But, it is by no means a cage. You can certainly leave. You fight to stay because you fear losing touch with the direction of the global industry. Exiting or deprioritizing China would be a defeat with strategic consequences… If you are in the business of making cars and selling cars at the global level then being in China is not a basket you do or don’t put your eggs into. China is not a market that you can derisk from, or balance with other markets. It is the market, it is the country where both in terms of trends of consumption and production, the future of the global industry is likely to be decided.
The broader point is that Western companies are increasingly in a fight for their long-term survival, such is the speed at which the Chinese industry has stolen a march in electric vehicles. As Tooze says, whatever the doom-laden risks of a conflict between China and the West over Taiwan, these are second order issues compared to the existential risks to their own businesses right here and right now:
For a firm like VW, what is at stake in China, the way it is nowhere else - not in Taiwan or Thailand, in North America or even Europe - is nothing less than the future of the industry. What is being decided in that market, in the current moment, is the future of auto-mobility for the next decade and beyond… When Germany’s leading automakers stop plowing back the billions into China, we will know that the game for non-Chinese producers in the world’s biggest market, is truly up.
The point here, and indeed the point running throughout this newsletter, is that it is too simplistic to accuse German carmakers, or many other businesses, of not taking geopolitics sufficiently seriously. The problem is that too many geopolitical actors don’t take business and the markets sufficiently seriously. I’ve written before about the limits of financial warfare. The best way to confront national security risks is via national security measures, such as increased defence spending. Indeed, to the extent that it creates uncertainty, lowers growth, unsettles potential allies and reduces resources for spending on defence, an over-reliance on economic warfare can ultimately harm national security and increase geopolitical risks.
5. Ukraine’s Golden Opportunity
The most remarkable geopolitical story of the week is the extraordinary Ukrainian raid into the Kursk region of Russia, which is now into its 11th day. Of course, as plenty of generals have reminded us this week, no one should write off the Russian army or underestimate the risks associated with whatever Kyiv is trying to achieve. But as this piece in Foreign Policy by A. Wess Mitchell, a principal at The Marathon Initiative and a former assistant secretary of state for Europe and Eurasia, notes, the Ukrainian offensive, if it can be sustained, creates potentially huge geopolitical opportunities, not least regarding western policy towards China.
I have long argued that the United States’ optimal approach to Russia’s war in Ukraine is to use it as an opportunity to inflict a proxy defeat on Russia on a faster timeline than China is prepared to move against Taiwan. The last two national defense strategies made it clear that the United States is not prepared to fight wars against more than one major opponent at the same time. By using resources in a focused and disciplined way against Russia’s ongoing aggression, the United States has a chance to weaken the Russian threat to Europe—and on that basis, freeing up bandwidth to strengthen deterrence in the Indo-Pacific.
But as Mitchell says, the problem is that America has not used its time over the last two years of the conflict as well as its opponents:
Since the start of the Ukraine war, the U.S. defense budget has remained relatively static, while Russia’s has tripled. China has used this time to insulate its banking industry against sanctions, reorient energy supplies to routes that the United States cannot as easily disrupt, build up assault forces near Taiwan, and accelerate efforts to achieve nuclear parity with the United States. Iran has used this time to increase its defense budget, pump military equipment to its proxies across the Middle East, and shrink its nuclear breakout time to just about zero.
While its adversaries have been arming round-the-clock, the United States has struggled to get its defense industrial base to a state that is even capable of supporting Ukraine. By the Pentagon’s estimates, the United States is on track to producing 80,000 155-millimeter howitzer shells per month. That sounds impressive until one considers that Ukraine needs at least 75,000 a month just to sustain its defensive positions—and that in the mid-1990s, the United States was producing more than 800,000 artillery rounds a month. Russia—whose economy is the same size as the Netherlands’—is currently producing three times as much ammunition as the United States and Europe combined.
But Mitchell argues that the Kursk offensive offers a chance for the West to regain the initiative. If Ukraine can succeed in holding on to Russian territory, it may in time be able to compel Russia to come to the negotiating table on terms that are much more favourable to Kyiv. That is clearly President Volodmyr Zelensky’s goal, as President Vladimir Putin has acknowledged. An end to the Ukraine war would clearly then make it easier to America to prioritise its efforts on deterring a Chinese invasion of Taiwan or to consider a pre-emptive strike against Iran.
The conclusions for America and the West should thus be clear: to give Ukraine whatever support it needs to retain Russian territory. That should mean an end to the policy of vacillation that has been the hallmark of President Biden’s approach so far and giving Ukraine the weapons it needs and the permission to use them as it sees fit. Of course, that carries the risk of escalation, though so far those fears have proved consistently overblown. But the alternative is to see the West’s adversaries continue to get stronger to the point where it might struggle to contain them.
Ukraine has offered the West a potential reprieve. Will Biden seize it?
6. Trump vs Kamalanomics
The dramatic turnaround in the fortunes of the Democratic party in the three weeks since Joe Biden withdrew his candidacy and Kamala Harris entered the race is one of the most remarkable political transformations in my lifetime. At this point, of course, one is required as a journalist to remind readers that the polls still show the contest to be a coin toss, that Hilary Clinton was further ahead at this stage and indeed on polling day but still lost, that the electoral college favours the Republicans and that one should never underestimate Donald Trump.
Whatever. I don’t believe it. I am happy to stick my neck out and say that Trump looks like a stone cold loser. The last three weeks have revealed him to be a mentally unstable, bigoted, misogynistic buffoon amid reports that he may be undergoing some kind of breakdown. There is zero chance of him showing the patience and discipline to abandon his puerile insults and stick to a consistent and coherent message between now and polling day. Meanwhile his weird running mate, JD Vance, is the political gift that keeps giving to the Democrats. Even Trump’s most partisan media cheerleaders are struggling to make any kind of case for him.
Nonetheless, this is still a contest and American voters are being presented with a choice in which the economy will be top of their concerns. For anyone interested in what that choice might mean for the US and global economy, I highly recommend this podcast by the always brilliant Adam Posen, president of the Petersen Institute for International Economics, who assesses both candidates on the basis of immigration, tariffs, tax, industrial policy and - of course- China.
Posen’s non-partisan conclusion is that Trump would be far worse, particularly on immigration, tariffs and taxes. Indeed, he concludes, as I did here, that Trump’s policies are likely to lead to higher inflation, a weaker dollar and a wider current account deficit - the exact opposite of what he says he wants. But that does not mean that Harris’s proposals, as much as we know of them, are all sound. On tariffs, industrial policy and China, she is likely to continue Biden’s flawed approach. She has already pledged to copy Trump’s populist gimmick to exempt tips from taxes, a giant poorly targeted tax cut. And of course, the Democrats may yet come up with further populist gimmicks, including at their convention next week.
Of course, it goes without saying that neither party is talking about tackling the giant elephant in the room: the ever-ballooning American public debt. Whoever wins in November, best keep an eye on the dollar debasement trade.
Thank you. Much appreciated…
This is the best thing that I have read for quite a while.