China’s Risky Reforms

Ian Bremmer, David Gordon

FEB 14, 2014
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NEW YORK – When it comes to economic reform, China’s leaders no longer believe that time is on their side. With a new sense of urgency, President Xi Jinping and his inner circle are attempting one of the most ambitious economic and social-policy reform plans in history.

But in any authoritarian country, change creates risk. Consider the scale of the proposed plans. For China to reach the next stage of its development, a much larger share of Chinese-made products now destined for Europe, America, and Japan must be sold to consumers inside China. This shift will require a big increase in local purchasing power – and, therefore, an enormous transfer of wealth from large domestic companies to Chinese households.

In addition, China’s leaders appear to be on the verge of approving 12 new regional free-trade zones, which will drive competition and efficiency on a new scale in many economic sectors. They also recognize the need for further liberalization of the country’s financial system, a move that will require tolerance for outright defaults on bad loans – and the anxiety and anger that comes with them.

Here, as in other areas of the reform plan, change is dangerous; but Xi has come to believe that pressing ahead is vitally important if China is to take the next crucial steps toward building a middle-class, digital-age economy. Moreover, the reforms are crucial for the Chinese Communist Party’s long-term hold on power.

The leadership will also try to increase state-owned enterprises’ efficiency by withholding support (and money) from those that underperform, potentially putting large numbers of workers out on the streets. And the government’s steps to tackle China’s heavily polluted air and water, a problem that officials can no longer ignore or explain away, will weigh on short-term growth as well.

In the past, the CCP has responded to slowing growth with a surge in state spending meant to create jobs and keep the system humming. This time, the authorities are allowing growth to slow at a measured pace, partly because the slowdown is a precondition for the kind of growth that does not depend on the state, and partly because the slowdown helps sustain demand for reform.

To accomplish these goals, Xi is centralizing power, launching a charm offensive, and cracking down on official corruption and extravagance. He is also using anti-corruption and reeducation efforts to intimidate (real and potential) reform opponents within the CCP. Finally, the leadership has created new party institutions, answerable directly to top officials, to ensure that all changes are implemented as planned.

Nonetheless, while the reforms are crucial for China’s future, they are certain to produce a backlash. Some of the losers have the means to defend their interests: purged officials, companies, and industries that face new regulatory scrutiny, as well as firms forced out of business, have well-placed friends within China’s enormous bureaucracy. Moreover, free-trade zones bring greater competition, including from foreign firms, which raises risks of increased unemployment and capital flight.

China’s leaders have long feared publicly visible divisions within the elite, given the risk that infighting could expose sensitive secrets. Xi’s proposed reforms are just the sort of changes that might have this effect.

That risk is much greater today than it was ten years ago. With hundreds of millions of Chinese now online, and other twenty-first-century communication tools available to an unprecedented number of citizens, ideas and information cross China’s internal and external borders with unprecedented ease and speed. In response, the CCP continues to develop new technologies to stifle or redirect dissent; but the battle for control of China’s public discourse is not one that the country’s leaders can win every day for the foreseeable future, and they know it.

There are broader questions as well. The authorities appear confident that they can manage the risks generated by a gradually slowing economy. What if they are wrong? What if bank defaults pile up, creating a major credit crisis? What if unrest grows to levels not seen in many years?

These scenarios are highly unlikely in 2014. But early signals suggest that if trouble develops, the party will choose a crackdown over concessions, and there is no guarantee that party unity will hold in such a scenario.

For outsiders, the reform process also poses risks that extend well beyond the global economic fallout of a sharp Chinese slowdown. The country’s neighbors, particularly Japan, have the most to fear. If reforms become broadly unpopular or expose dangerous divisions within the leadership, the government will have good reason to divert public attention from controversies at home by picking fights abroad. Frictions between China and the Philippines, Vietnam, and others in the South China Sea persist, but confrontations with Japan, including over territorial disputes in the East China Sea, are more likely to cause the most damage.

No one in power in either country wants a war, but diplomatic dust-ups between China and Japan, the world’s second and third largest economies, respectively, have already taken a toll on their commercial relations. In particular, Japanese companies operating in China have sustained significant reputational and financial damage during recent episodes of trouble between the two governments.

Conflict with the United States is unlikely for the moment. At such a delicate time internally, China would gain nothing from antagonizing the US. But trouble with US allies, particularly Japan, could draw the US into a fight that it would strongly prefer to avoid.

In short, China is on the brink of large, necessary, and dangerous transformations that promise to change the country for the better – or make everything, including regional stability, much worse. The entire world has a large stake in what happens next.


Ian Bremmer is President of Eurasia Group and the author of Every Nation for Itself: Winners and Losers in a G-Zero World.

David Gordon, a former director of policy planning in the US State Department, is Chairman and Head of Research at Eurasia Group.

Buttonwood

The growth paradox

Past economic growth does not predict future stockmarket returns

Feb 15th 2014

EMERGING stockmarkets go in and out of fashion. They were battered during the Asian and Russian crises of the late 1990s, but then recovered to offer double-digit annual returns in the first decade of the 21st century. Since 2010, however, they have reverted to underperforming their developed-country rivals.

The arguments in favour of investing in emerging markets are the same as they ever were. Such countries have faster growth, on average, than the rich world and a smaller weight in global equity indices than they do in the world’s GDP.

But as Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School have pointed out in the past, there is no automatic link between economic growth per person and stockmarket returns. In their latest report for Credit Suisse, a bank, the academics explore this issue in more detail. 

They find one slightly odd distinction: the correlation between equity returns and economic growth per person since 1900 has been negative, but that between equity returns and aggregate GDP growth is actually positive. A growing population, in other words, is better for equities than a richer one.

This relationship is, alas, not very useful for investors. Let us assume that they make forecasts of economic growth by extrapolation from the data for the previous five years, and put money in the equity markets of the countries that have grown the fastest. Since 1972, that approach would have delivered a return of 14.5% a year in dollar terms. But had they invested in the economies with the slowest growth record, investors would have earned 24.6% (see chart).

This may partly be down to a “value” effect, similar to that observed with individual stocks. Countries with good growth records become favoured by investors who bid up share prices accordingly; future equity returns are thus lower. But countries with poor growth records see their stockmarkets shunned; their share prices are thus cheap and offer higher subsequent returns. Another problem is that extrapolating from past economic growth simply doesn’t work. The report finds no correlation since 1900 between GDP growth per person in an individual country in one year and growth two years later.

Furthermore, a stockmarket is not a perfect representation of the domestic economy; successful companies may be privately owned and not listed on the market while many big companies (as in China) may be owned by the state. As they grow, companies issue more shares; as a result, existing shareholders do not gain all the benefits of higher profits.

Over the long term, these dilution effects mean that investors do not get all the benefits of GDP growth, in the sense that dividends grow more slowly than the economy. Between 1900 and 2013, real dividends declined slightly (0.1% a year) over the 21 countries for which the academics have data, while GDP growth was 2.8% a year. Even in America, the most successful economy over the period, real dividends grew by 1.6% while GDP growth was 3.4%.

The report does find that prior knowledge of GDP growth would be useful. If investors had had perfect foresight of which economies would grow fastest over the following five years, and had invested accordingly, they could have earned 28.8% a year. Then again, if the fates were to grant investors perfect foresight, it would be simpler for them to be aware of the best performing markets, not the best economies.

In the absence of such powers, emerging markets still have their attractions. The academics reconstruct an emerging-market universe going back to 1900 using a definition based on GDP per head; starting with a group of seven (China, Finland, Japan, Portugal, Russia, South Africa and Spain). Over the extended period, emerging markets underperformed, returning 7.4% versus 8.3% for the developed world.

However, the biggest period of underperformance was in the 1940s, when Japanese equities lost 98% of their dollar value and the Chinese market disappeared in the revolution. Since 1950, emerging markets have returned 12.5% a year against the developed markets’ 10.8%. This is the right result, in theory: emerging markets are riskier (in the sense of being more volatile) and so investors should demand a higher return.

The good news is that volatility has declined over time, both in absolute terms and relative to developed markets. The bad news is that, in the five years to the end of 2013, the correlation between emerging markets and their developed brethren was twice as strong as it was in the early 1990s. Globalisation has integrated developing stockmarkets as well as their economies.

The Dollar and the Damage Done

Barry Eichengreen

FEB 13, 2014
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BERKELEY – The US Federal Reserve is being widely blamed for the recent eruption of volatility in emerging markets. But is the Fed just a convenient whipping boy?

It is easier to blame the Fed for today’s global economic problems than it is to blame China’s secular slowdown, which reflects Chinese officials’ laudable efforts to rebalance their economy. Likewise, though Japan’s “Abenomics,” by depressing the yen, complicates policymaking for the country’s neighbors, it also constitutes a commendable effort to bring deflation to a long-overdue end. So, again, it is easier to blame the Fed.

And, for the affected emerging economies, the Fed’s tapering of its massive monthly purchases of long-term assets – so-called quantitative easing (QE) – is certainly easier to blame than their own failure to move faster on economic reform.

Still, the Fed should not be absolved of all guilt. The prospect of higher interest rates in the US weakens the incentive for investors to pour capital into emerging economies indiscriminately. Though a confluence of factors may have combined to upset the emerging-market applecart, Fed tapering is certainly one of them.

It is striking, therefore, that the Fed has made no effort to take into account the impact of its policies on emerging economies or the blowback from emerging markets on the US. Emerging markets comprise more than a third of global GDP. They have contributed considerably more than a third of global growth in recent years. What happens in emerging markets does not stay in emerging markets. Increasingly, what happens there has the capacity to affect the US.

Yet Fed officials, while commenting copiously about their motives for tapering QE, have said nothing about the impact of doing so on emerging markets. They have given no indication of being aware that US monetary policy can affect events outside of their narrow corner of the world.

This silence is all the more remarkable in view of two other recent developments in Washington, DC. First, the US Congress, as part of the government’s recent budget deal, refused to authorize an increase in America’s quota subscription to the International Monetary Fund. The financial commitment was essentially symbolic, but it was part of a larger agreement reached at the Seoul Summit of G-20 leaders to regularize the IMF’s resources and enhance the representation of emerging economies.

This failure to follow through reopens old wounds and raises troubling questions about the legitimacy of an institution that, reflecting the long shadow of history, is dominated by a handful of advanced countries. Emerging-market officials have been increasingly reluctant to turn to the IMF for advice and assistance, undermining its ability to play an effective global role.

The other development was the decision to make permanent the dollar swap arrangements put in place during the financial crisis by the Fed, the European Central Bank, and the central banks of Canada, the United Kingdom, Switzerland, and Japan. Under these arrangements, the Fed stands ready to provide dollars to this handful of favored foreign central banks – an acknowledgment of the dollar’s unique role in international financial markets. Because international banks, wherever they are located, tend to borrow in dollars, the swap arrangements allow foreign central banks to lend dollars to their local banks in times of emergency.

Put these three events – the tapering of QE, the torpedoing of IMF reform, and the entrenchment of dollar swaps – together and what you get is a US that has renationalized the international lender-of-last-resort function. Simply put, the Fed is the only emergency source of dollar liquidity still standing.

But the US has offered to provide dollars only to a privileged few. And in its policy statements and actions, it has refused to acknowledge its broader responsibility for the stability of the world economy.

So what should the Fed do differently? First, it should immediately negotiate permanent dollar swap lines with countries such as South Korea, Chile, Mexico, India, and Brazil.

Second, the Fed should adjust its rhetoric and, if necessary, its policies to reflect the fact that its actions disproportionately affect other countries, with repercussions on the US economy. Might this mean that the Fed should slow the pace of its tapering of QE? Yes, it might.

The Fed may hesitate to extend additional swap lines, because to do so could expose it to losses on foreign currencies. Moreover, it may worry about antagonizing countries that are not offered such facilities; and it may fear criticism from Congress for overstepping the bounds of its mandate if its talk and policies acknowledge its global responsibilities.

If US policymakers are worried about these issues, their only option is to agree to quota increases for the IMF, thereby allowing responsibility for international financial stability to migrate back to where it belongs: the hands of a legitimate international organization.


Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund. His most recent book is Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System.