IMF's China: Blind Men And The Elephant?

by: Cam Hui, CFA

I have been meaning to write about this but other tasks got in the way. Last week, the IMF released its Article IV report on China. There were lots of concerns and suggestions, but to me, it seemed like the story of the blind men and the elephant.

There were many summaries of the report. This WSJ article hit most of the main points, namely prescriptions to slow down the growth rate and to focus on economic reforms:

The International Monetary Fund warned that China's growth rate could plummet in the coming years unless Beijing speeds up the pace of its economic reforms.

In its annual review of China's economic prospects released Wednesday, the IMF forecast that China's economy will slow to 7.1% growth in 2015, from a projected 7.4% this year and continue to slow further later in the decade. It said the forecast is based on the assumption that China continues at its current pace to overhaul its economy so that it relies more on consumer demand and less on exports and capital-intensive industries.

If it falters and doesn't carry them out, the IMF said, China's GDP could fall to 3.5% by about 2020, and close to 2.5% after that. China last year reported growth of 7.7%.

The IMF urged Beijing to"promptly" carry out financial reform and exchange-rate liberalization and to make a number of fiscal changes within two years, including taxing real estate. The IMF now expects China to phase in such changes over five years, though there is a possibility that the changes would be delayed further or not enacted.

"If they aren't able to move reasonably fast [on reform], we see the risks of a disorderly adjustment rising," said IMF China chief Markus Rodlauer in an interview.

More telling was the fact that Chinese controlled media Xinhua de-emphasized the IMF projections of slower growth into the future:

The Chinese economy is expected to grow about 7.5 percent this year and implementation of reforms would help the country achieve a more balanced and inclusive growth, the International Monetary Fund (IMF) said on Wednesday.

Key risks
The IMF outlined the now familiar key risks to the Chinese economy in its report. One is the torrid pace of credit growth. In all past instances of such episodes, the countries involved experienced banking crises (emphasis added):

Previous studies suggest that a credit boom that starts from a higher level of credit-to-GDP ratio and lasts for longer period is more likely to precede a systemic banking crisis. In the past five years, China's TSF stock increased by 73 percent of GDP,2 while adjusted TSF and bank credit to nonfinancial sector increased by around 30 percent of GDP. Looking at a sample covering 43 countries over 50 years, staff identified only four episodes that experienced a similar scale of credit growth as China's recent TSF growth. Within three years following the boom period, all four countries had a banking crisis. With a lower threshold of a 30-percent-of-GDP increase in credit over five years, there are 48 episodes of credit boom, half of which were followed by banking crises.

The second concern raised by the IMF was the pace of re-balancing the economy from one driven by infrastructure growth to consumer-led growth. As the chart below shows, China has been dominated by investment at the expense of private consumption compared to other economies:

As well, the contribution of investments to GDP (green line) far outpaces private consumption (blue line). While the two have started to converge in the last few years, the degree of convergence has been extremely slow:

Indeed, the most recent divergence between the positive trajectory of the manufacturing PMI compared to the slippage of the services PMI indicates that Beijing still has much work to do in order to re-balance growth.

Financial repression reforms
The IMF prescribed reforms measures to liberalize the financial markets and to end "financial repression" (my words, not theirs). The Chinese authorities recognized that financial reforms were the right course of action and reiterated the Third Plenum goals of allowing market forces to dictate policy (emphasis added):

The authorities agreed that financial sector reforms were critical, and highlighted the progress already made in this area. They planned to introduce deposit insurance in the near future and advance deposit rate liberalization as circumstances allowed. They also agreed that removing implicit guarantees, pervasive throughout the financial and corporate landscape, was key. This saw moral hazard as distorting the allocation of credit and investment, posing a risk to the success of financial liberalization which rested critically on hard budget constraints. Linked to this, the authorities explained that their strategy for SOE reforms included leveling the playing field and opening up to more competition, with the exception of some strategic sectors. Regarding the monetary policy framework, they agreed on the importance of relying more on interest rates over time.

Sequencing, sequencing!
Just as I believe that many outsiders didn't understand how economics and politics were intertwined in the eurozone (see Lest we forget, or why you don`t understand Europe and Mario Draghi reveals the Grand Plan), many western analysts don't understand how political decisions affect the economics of China and vice versa. They just focus on one piece of the puzzle and wind up like one of blind men in the story of the blind men and the elephant. They only understand the elephant as a leg, a trunk or a leafy ear but don`t understand the big picture.

So I will use a term most often used by the European Central Bank in addressing the problems of the eurozone: "sequencing". Just as the remedies of the eurozone problems need to be correctly "sequenced", the remedies addressing the problems of the Chinese economy need to be "sequenced" as well.

The first step in the sequence is Xi Jingping's Grand Plan for China is his anti-corruption drive in order to consolidate power in order to effect financial reforms (see my previous post Dissecting the bull case for China):

Many western analysts misunderstand the term "reform" when it comes to China. They think in terms of westernized institutions, such as transparency, property rights, democracy, etc. For Beijing and President Xi Jinping in particular, reforms starts with a consolidation of power through an anti-corruption drive. Otherwise, no financial reforms are possible because Beijing would issue edicts and the bureaucracy would resist.

As the highlighted text from the IMF report indicates, one of the Third Plenum objectives is SOE reform to level the playing field. But "leveling the playing field" would hurt SOEs and Party insiders, many of whom have grown obscenely rich because of their positions. The objective of the anti-corruption drive is, as the Chinese put it, "killing the chicken to scare the monkeys". As Caixin reports, the Central Discipline Inspection Commission has a website which reports the results of the anti-corruption drive on a daily basis:

Curiosity is one reason the website of the Central Discipline Inspection Commission (CDIC) attracts up to 2 million page views every day.

Another reason is fear. Some website visitors, for example, want to know whether they or anyone they know has been targeted by a government campaign to root out corruption led by the CDIC Inspection Team.

Since the campaign began in December 2012, 33 high-level government and state company officials - all in positions at the deputy provincial level or higher - have come under investigation for violating laws or Communist Party rules. Each has been removed from office and detained. Some have been kicked out of the party.

This chart from CNBC shows that China's anti-corruption drive has definitely heated up:

The Economist reports that, though the data is spotty, past anti-corruption campaigns seem to have boosted growth, not detracted from it (emphasis added):

China's past anti-graft campaigns, though admittedly less extensive than the current one, hurt the economy little and may even have boosted it. Investigations directed at the local government of Beijing in 1995 and of the port-city of Xiamen in 1999 coincided with growth slowdowns of roughly three percentage points. Both cities quickly recovered. When Shanghai's party chief was toppled in 2006, growth accelerated the following year. Across China, counties that are strongly against corruption tend to have higher incomes than those that go easy on sleaze, according to research by Yiping Wu of the Shanghai University of Finance and Economics and Jiangnan Zhu of the University of Hong Kong.

Just remember the term: "sequencing".

Financial repression and the currency puzzle
The one curious observation which I did not understand from the IMF report was the conclusion that the RMB was slightly undervalued:

The external position is moderately stronger compared with the level consistent with medium-term fundamentals and desirable policy settings (Box 9). On that basis, the renminbi is assessed as being moderately undervalued. In terms of the External Balance Assessment (EBA) model, China's policy gaps (policies different from desired ones, contributing to a moderately stronger external position) stem mainly from intervention, capital controls, and health spending. The pace of reserve accumulation slowed significantly in 2012, but picked up again in 2013 against the backdrop of large capital inflows induced by interest rate differentials, the relatively high real return of capital, and expectations of continued RMB appreciation. Reserves are above the range suggested by the Fund's metric, rendering further accumulation unnecessary from a reserve adequacy perspective.

A flexible, market-determined exchange rate is an important part of the reform agenda. A market-determined exchange rate-in which there is no sustained, large, and asymmetric intervention-is key for sustained rebalancing and as a shock absorber as the capital account is progressively liberalized. Moreover, given the rapid growth in offshore renminbi markets and growing opportunities for financial arbitrage, it is also becoming increasingly important for maintaining an independent monetary policy. The recent doubling of the daily trading band is a welcome step forward. Looking ahead, the goal should be to allow greater flexibility and reduce intervention, which could be achieved by further widening the band and ensuring the central parity better reflects market conditions.

The Chinese disagreed with the conclusion and believed the RMB exchange rate to be roughly at equilibrium and placed part of the blame on the QE policies of developed world central bankers:

Authorities' views. The authorities disagreed with the assessment that the real exchange rate was moderately undervalued and considered that it was close to equilibrium. They reiterated their previous concerns and strong reservations on EBA, and emphasized the importance of evenhandedness. In particular, they considered that the assessment failed to account for the impact of advanced economy monetary policies on global financial flows and emerging market economies, the continued narrowing of China's current account surplus, two-way fluctuations of the exchange rate, substantial appreciation of REER, and the movements of other currencies (such as the U.S. dollar).

Here is what I have trouble understanding. We know that for years, China pegged the RMB to the USD so it had to adopt the US interest rate policy. At the same time, inflation in China was rising, but because of exchange rate and interest rate controls, household savings in the banking system had to make do with a negative real interest rate, which subsidized the cost of capital for (mostly) SOEs, whose Party insiders made out like bandits.

Thus, the natural rate of interest in China is considerably higher than it is in the US, which invited all sorts of leveraged carry-trade schemes like borrowing against copper and iron ore inventories, etc. Now imagine what would happen if exchange rate controls disappeared overnight and the market set rates.

In the short term, the interest rate differential between the USD and CNY would invite the carry trade and put upward pressure on the CNY. On the other hand, the inflation rate differential between the two economies would put downward pressure on the CNY. In effect, market forces suggest that the long term equilibrium exchange rate for CNY is lower than current levels, not higher as indicated in the IMF report.

Perhaps the IMF conclusion that CNY is slightly undervalued is a nod to the political sensibilities of the Washington-based IMF. A falling CNYUSD exchange rates would create political fallout in the United States and make many American unhappy (maybe unhappy enough to follow Sarah Palin's suggestion to stop eating Chinese food).

In this respect, the IMF is also like one of the blind men trying to describe the elephant.

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