It wasn’t enough that we started 2016 with one of the worst weeks in the recent history of Chinese and global markets, but the panic continued into the following weeks and wreaked a great deal of damage to confidence. A lot of the reflexive China bulls are cautioning against misinterpreting the implications of the stock market collapse, and of course they are right, but the fact that the plunging Chinese markets can easily be misinterpreted should not in any way suggest that things are fine. Two weeks ago in the FT Alphaville blog (which is the best place to read regularly about China’s vulnerabilities, in my opinion, especially in their relentless focus on the changes in the various components of the balance of payments) Peter Doyle discussed one of the standard set of responses that we’ve seen repeated regularly since 2011 and 2012. The bull refrain has been, in his words: “things really aren’t that bad or surprising, and there’s considerable willpower and ammunition left in Beijing should it be necessary.”

“This makes good copy,” Doyle suggests, and adds, more diplomatically than I might have, “but is not persuasive”. It certainly isn’t, and he discusses some of the reasons why. On the same day George Magnus published an OpEd in the Financial Times that makes a point that too many people, as he points out, are still overlooking.

China’s chief vulnerability, and the main factor driving the tendency towards the increasingly fragile balance sheets that underlie the series of interrelated financial-market disruptions that began seriously in June 2013, is the inexorable rise in debt, and any analyst that fails to come to grips with the problem of excess credit is simply wasting his time. In the article Magnus writes:

Important economic reforms to the real economy and state monopolies have stalled, or succumbed to inertia and pushback. Policies designed to develop new sectors have not been matched by those needed to tackle problems in larger ones, such as poor productivity, chronic overcapacity and now a fourth consecutive year of producer price deflation. Tellingly, China’s most serious problem — the relentless accumulation of debt — received passive attention at most.

I will return to his point about stalled reforms, but Magnus is right about the debt. China’s most serious problem is “the relentless accumulation of debt”, and economic conditions will continue to deteriorate until Beijing directly addresses the debt. In fact it doesn’t really matter if China is able to report growth rates for another year or two of 7%, or 6%, or even 8%. If the only way it can do so is by allowing debt to grow two or three times as fast, there will have been no improvement at all, the economy will not have adjusted, and China’s longer-term outlook will be worse than ever.

It is only when credit growth begins to decelerate much more rapidly than nominal GDP growth that we can begin to talk hopefully about China’s moving in the right direction, and it is only when credit growth falls permanently below the growth rate of the economy’s debt-servicing capacity that China will have adjusted. The astonishing ability of the China bulls, both foreign and Chinese, to celebrate every unexpected decline in growth and every new surge in debt as if they somehow justified nearly a decade’s worth of denials of the urgency of China’s rebalancing has done so much damage to China that the sooner Beijing’s leaders finally turn against the bulls, as I believe they might finally have done, the better for the Chinese people and the Chinese economy.

Beggaring thy neighbors

Before I explain why I think Beijing has decided that it has been misled in recent years, I should point out that what worried me most about the events of the past weeks was not the stock markets themselves, nor even the change in how investors and businesses inside and outside China perceive Beijing’s ability to manage the economy and the markets (I have already said many times that just as most people systematically over-rated the quality of Chinese policymaking in the past, they are likely now to be overly harsh in accusing Beijing of mismanagement). I am far more worried about how other countries might misinterpret the rapid decline in the RMB, accompanied by what seems like another surge in capital outflows.

Contrary to some of the muttering out there, I don’t think Beijing is planning competitive devaluations in order to strengthen the tradable goods sector, in the hopes that surging exports will revive growth. Certainly if the PBoC ever were to stop intervening, and to let the RMB depreciate to some imagined fundamental “equilibrium”, we would quickly see that there is no such equilibrium level. In a speculative market, the market does not tend towards some stable value, with self-dissipating movement in any one direction reducing pressure for further movement in that direction. Price movements instead are self-reinforcing, and can quickly overshoot fundamentals.

Beijing is more likely to believe that the economic slowdown was caused by been weakness in domestic real estate and infrastructure construction, and not because exports are weak, and the latest trade dataconfirms the relatively strong export performance. Although manufacturing overcapacity is certainly a problem, much of it is in areas in which global demand has simply collapsed, and isn’t coming back, and so a cheaper currency would have little impact beyond temporarily reducing excess inventory, which is not enough of a benefit to justify the many costs of a weaker currency. Production facilities would still have to be closed down.

I think the real reason for the recent RMB weakness lies elsewhere. Beijing is trying to boost domestic liquidity in the hopes that this will generate stronger domestic demand, but expanding liquidity fuels capital outflows, and these put downward pressure on the currency, while increasing PBoC concerns about the monetary impact of money leaving the economy which, as an article in last week’s FT argues, might be worse than we think. Last week’s People’s Daily reports that prominent Tsinghua professor and former member of China’s Monetary Policy Committee, Li Daokui, claimed at Davos “that at least $3 trillion foreign exchange reserves in China is required to prevent foreign debt default risk”, for reasons that elude me, but if this reflects official views, after dropping $513 billion in 2015, current PBoC reserves of $3.33 trillion might suggest that two or three more months of continued strong outflows might prompt further steps by the PBoC to limit outflows.

The biggest risk created by the weaker RMB, as I see it however, is not a Chinese risk but rather a global one. The rest of the world may view recent Chinese RMB weakness as a signal for a new round of competitive devaluations. I have already said that I expect 2016 to be another bad year for trade, and I am worried that it seems as if every major economy in the world has implicitly decided to use US demand to bail out its own faltering economy. This will very likely derail the US recovery in 2016 or 2017 unless the US, too, decides to step in and intervene in trade. If that happened, of course, the impact on Europe and China would be terrible, but it seems to me a matter purely of logic that if the hard commodity and energy exporters are nearing the limits of their absorption capacity, either the major surplus nations or the US are going to have to absorb a bigger share of the demand deficiency created in Europe, China, and Japan.

The nine-point summary

But all this is preamble. Rather than add to the mass of coverage that the recent market events in China have generated, or to continue expressing my concern about the intractable arithmetic of global demand imbalances, I plan to discuss the process of Chinese reform and adjustment in this issue of my blog. While these may at first seem unrelated, in fact financial market disruptions are tightly tied into the self-reinforcing processes of rising debt, capital flight and slowing growth that recent reforms were supposed to untangle and address – and for which they have clearly failed.

I will argue that most economists have an incoherent understanding of China’s rebalancing needs, and for this reason many if not most of the reform proposals of the past few years, about which economists widely agree and even celebrate, are in many if not most cases largely irrelevant. This is going to be a long post, so for those who want the 9-point summary:

Evaluating Beijing’s policies

It might seem exceptionally contrarian to say that most of the reform proposals of the past few years, about which economists widely agree and even celebrate, are in many if not most cases largely irrelevant, but I think that senior policymakers in Beijing are beginning to agree. I say this because with the end of the Central Economic Work Conference last December, Beijing has announced with some fanfare that it plans to design and implement a new reform program consisting of what are being called “supply-side” policies.

A new reform program would seem only to be necessary if the old one has failed or is failing. It does seem to have failed. Chinese businesses and investors are very obviously increasingly concerned about both Chinese and global prospects, and so it is fitting that stock markets have been so accident prone this year. Like everyone else I have often cautioned against reading too much about China’s economic fundamentals into stock market performance. To the extent that there is informational content in the price behavior of stocks, however, we are more likely to see it expressed in the volatility of the markets than in its actual price level.

While opinion is still very split about the outlook for the Chinese economy, there is clearly a growing sense of unease about progress to date on the successful management of China’s economic adjustment, and this unease is at least part of the reason for market volatility. That is why the important news for me has been the announcement of the new reforms and the form of the announcement. Analysts are still very uncertain about what this new package of supply-side reforms that we’ve been hearing about since at least November may entail, but they way in which the reform package was announced suggests, at least too me, that the leadership is no longer satisfied that the policies Beijing has been pursuing during the past three years are having the intended effect.

I will discuss why later, and in spite of the limited information available, I also plan in this blog entry to try to place the package of reforms in some sort of useful context and to evaluate whether or not in principle these reforms are likely to be consistent with the rebalancing process. This might not be as difficult a task as it may at first seem, because rather than try to guess what Beijing will or won’t do, I will instead try to specify the conditions, albeit very abstractly, under which various policies will, individually or in the aggregate, be consistent with the rebalancing process.

It helps of course that China’s development model is not unique, and that its experiences are “different” only in the sense that with its powerful and rigid institutions (most importantly the extensive government involvement in the economy and its control of the banks) it has pushed the typical imbalances associated with its growth model often to levels that are unprecedented. There have otherwise been dozens of other countries that have experienced investment-led “miracle” growth in the past century, and their histories have been remarkably consistent.

Based on these histories we should be able to make fairly reasonable predictions about some of the problems that China faces today. Indeed we should have been able to do so a decade ago, but because very few economists seem to be familiar with the history, no matter how predictable they were each new reversal or systemic shift always seemed to come as a surprise. This is an important point to stress, especially if we want to understand what kinds of policies are likely to prove useful over the next several years. China’s extremely successful growth model was always likely to generate sustainable and rapid if unbalanced growth under certain easily-specified conditions. It was also always likely to cause the financial sector and the various government and business balance sheets to evolve in a specific direction and imbed certain risks.

This is why nearly a decade ago – even if none of the economists or analysts writing about the Chinese economy understood why, with the exception of a handful, mostly Chinese academics – it was clear that the Chinese growth model would have to be reformed, and that these reforms were generally fairly easy to specify. Imbalances can persist for many years if the institutional constraints preventing adjustment are very strong, but all unbalanced systems tend towards rebalancing, and eventually the institutional sources of the imbalances are reversed, and they do.

Must everything cause a crisis?

Not everyone sees things this way. In the standard economic framework the economy is always at or close to equilibrium, and when exogenous shocks or policy distortions push it away from equilibrium it is only temporary. For that reason most economists seem to assume that the longer what looks like an imbalance persists, the less likely it is really to be an imbalance that must ultimately reverse itself, when in fact the opposite is true. Imbalances can persist and get deeper year after year, but that only means that the reversal is more certain and likely to be more disruptive.

For the same reason most economists also seem to assume that if anyone thought that the Chinese economy was deeply imbalanced, and that debt was growing at an unsustainable pace, he was necessarily predicting an imminent crisis. This belief is so powerfully embedded in the standard equilibrium models most economists use that, strangely enough, even those of us who described the imbalances in one paragraph and in the very next paragraph insisted that a crisis was unlikely – in China’s case because of the government’s very high credibility and its role as financial guarantor – were automatically assumed to be predicting an imminent crisis.

Earlier this year, for example, a strategist at a Chicago-based fund by the name of Brian Singer said:

“Everyone is aware of China’s horrid debt levels and [Chinese financial markets analyst] Michael Pettis has done some great work, but he is China’s ‘Chicken Little’,” Singer said, referring to his panic-style predictions. “He discovered through his research that China has built up a lot of debt and he is right. China’s debt to gross domestic product (GDP), however, is pretty close to the United States’ and Germany’s.

“If we’re all so terribly concerned about China’s debt to GDP levels, why aren’t we equally as concerned about the US?…Even if [China’s] growth is slowed from double digits down to 4 or 5 per cent, they would still be absorbing that debt a lot faster the US could.”