By Vasilis Trigkas and Qian Feng, The Diplomat, 28/8/2018
The fourth round of Sino-U.S. trade negotiations held recently in Washington, DC ended with a whimper, and so the largest trade war in post-World War II economic history continues unabated while a nascent crisis in emerging markets has alarmed investors worldwide. Motivated by the misperception that China’s economy is in critical condition, an emboldened U.S. President Donald Trump looks determined to escalate the war.
The president’s senior economic adviser, Larry Kudlow, during a recent cabinet meeting, asserted that China’s economy “looks terrible, it is heading south.” The United States, he further declared “is crushing it, having a genuine boom.”
Kudlow’s averment seconds the views of other American prognosticators who have subscribed to the old myth of an imminent Chinese economic meltdown, most famously pushed by the inveterate “doomsday prophet” Gordon Chang. Their linear reasoning is the epitome of conventional economics and goes as follows: The debt levels of local governments and state-owned enterprises (SOEs) can only be maintained at a sustainable level while the economy is soundly growing, meaning Chinese GDP is expanding by over 6 percent. As a trade shock will drag growth to levels below 6 percent, highly indebted organizations will be unable to grow their way out of pressing liabilities. This will spark a massive debt crisis, loss of confidence, and eventual economic meltdown. Meanwhile, pressure on the renminbi (RMB) will increase and China’s $3.2 trillion currency “war chest” will be unable to prevent a collapse of the exchange rate even with draconian capital controls fully applied. With economic trust shattered, the property bubble bursting, and inflation rising abruptly due to the RMB’s free fall, the Chinese Communist Party’s very legitimacy would be questioned. To avoid such an ominous scenario, the CCP would have to capitulate early and offer Washington sufficient trade concessions — or so the argument goes.
American prophesies that a trade war will provoke a Chinese economic meltdown are incentivizing Trump to be hawkish rather than conciliatory. However, as Yukon Huang of the Carnegie Endowment for International Peace has contended, “China defies typical classifications.” Linear thinking and conventional economics will only have minor success in evaluating the impact of a trade war on the world’s second largest economy; an economy also shaped by many unconventional factors with singular Chinese characteristics. As Huang retorts:
China’s financial and fiscal metrics simply do not point to a looming “Lehman moment,” despite all the periodic warnings to the contrary. China’s debt problem differs from previous crisis cases in that its debt is concentrated in the state sector rather than among private agents, and sourced domestically rather than externally. China’s current challenges may be more complex, but the financial situation in the late 1990s was more severe, and even then the difficulties proved manageable.
In international relations, accurate strategic perceptions are essential for deal making. If one side overestimates its capacity to influence the strategic environment of its adversary, then undue conflict would persist, whereas a mutually beneficial accord would have otherwise been attainable. The repeated failure of U.S. and Chinese negotiators to reach a mutually beneficial trade deal reflects mostly this wrong diagnosis, which has led to an underestimation particularly from the American side of China’s economic resilience, and an overestimation of America’s perpetual economic pre-eminence.
As Robert Jervis, one of the fathers of modern political psychology put it:
Although the story about the drunkard looking for his keys under the lamp post because the light is better there is a joke, we find it funny because it is all too true. Biases lead to looking at information that is most readily available, easiest to process, and most understandable rather than to probing more deeply for what is more illuminating and diagnostic.
American economists have thus focused mostly on China’s stock market valuations and the debt-to-GDP ratio for this information is all too readily available and easy to process – particularly when the commander-in-chief has populist inclinations. It is thus essential that American strategists “probe more deeply for what is more illuminating and diagnostic” and objectively evaluate China’s economic fundamentals before drawing easy conclusions on the fragility of the Chinese economy and consequent propensity of the CCP to submit.
Three key “China specific economic facts” should be considered in some detail: the total information management of the Chinese government concerning state owned assets, emergency nationalization overruling property rights, and China’s capacity for fiscal expansion as the cashless revolution is boosting national tax revenues. These are all compounded by China’s ability to still draw on its substantial rural labor pool as its urbanization rate remains below those of South Korea, Taiwan, and Japan had when their growth rates slowed down. China’s cities could continue to expand boosting national productivity by mega-agglomeration effects.
The CCP’s Control Over Financial Information
As research from some of the world’s leading economists has attested, information is a key input shaping the behavior of economic agents, influencing the viability of credit networks and the overall aggregate direction of the market. A major difference between the West and China is that financial information is proactively screened by the government. In the case of a large state-owned enterprise or local government facing pressing liquidity constraints, Beijing can limit this news from dispersing, hence slowing down an “information cascade.” As most highly indebted institutions are within the state sector (SOEs and local governments) this would provide essential time for regulators to act with the suitable regulatory, monetary, or fiscal remedies to prevent the crisis from contaminating other actors and becoming systemic.
Western capitalism cannot emulate this, as the press will immediately report a liquidity crisis or even sensationalize the threat, making the government only a post-hoc actor with limited capacity to contain a nascent crisis. When Lehman Brothers collapsed in September 2008, interbank lending – a very important function of the global financial system – rapidly declined as economic agents started to sensationalize the risk of insolvency. Accurate and inaccurate information about the liquidity of systemic financial institutions mixed with toxic securities lead to an informational cascade, which further exacerbated the crisis while policymakers struggled to find a remedy within very tight time margins and for a crisis that they had never predicted. Trust — the invisible hand that keeps the financial system afloat — collapsed.
The CCP’s Capacity to Nationalize Systemic Economic Agents on the Spot
In China, the national interest stands supreme; when the stability of the national economy is at stake, a big financial corporation or a systemic market actor can be nationalized and liquidity fixed by an adequate capital injection under emergency procedures. The recent case of Anbang is a prime example. The company was taken under national trusteeship rapidly and its chairman arrested on the spot. In the United States, Congress, the White House, and the Treasury would have had to fight a months-long legal war with armies of lawyers and lobbyists to achieve a similar result, losing essential time. One may again consider the 2008 financial crisis, Solyndra’s insolvency, or the bailout of the U.S. auto industry and the time it took Congress and the Executive Branch to act.
As Nobel Laureate Joseph Stiglitz has declared, “with too big to fail, too interconnected to fail, too correlated to fail,” the success of banks or large systemic corporations “may not be based on relative efficiency [of their business model]” but on relative size, linkages and ability to distort the market mechanism to their benefit. Government intervention is essential to normalize the system both during ordinary conditions but most importantly when in crisis.
In the West, the powerful financial lobby has shaped a regulatory structure that entails unacceptable levels of public risk bearing. The Chinese government, however, has remained insensitive to the interests of big finance. It imposes capital controls and directs financial capital toward long-term investments. This has been one of the key reasons why its financial system remained robust when the markets of Wall Street and London collapsed in 2008. Similarly, during the 1997 East Asia financial crisis, China’s economic prescriptions proved more advanced than IMF’s dogmatic support for open capital accounts and draconian austerity.
To be sure, economic policy is the art of managing trade-offs by utilizing the appropriate levers of economic management. While centralized control of information and emergency nationalization can be beneficial, if overly applied, it exacerbates moral hazard and do not contribute to the long-term efficiency of the price signaling mechanism. It could even hinder long-term economic growth. As Emilios Avgouleas, chair professor of global banking regulation and finance at the University of Edinburgh, put it in a discussion with one of the authors, China’s economic exceptionalism is based on the premise that extreme tools could forcefully be applied when national economic stability is at risk. Yet once overly exercised these could actually push the economy further off-balance and lose their credibility.
The upshot is that with pervasive market and information asymmetry, forceful yet prudent interventions can typically increase efficiency and equity. When information management and emergency nationalization is applied strategically only as instrument of last resort then its impact upon economic activity could be positive. In doing so nonetheless, accountability is pivotal so that moral hazards do not become endemic as SOEs that are too big to fail would otherwise engage in riskier and less productive activities.
The Cashless Revolution: a Bonanza for Tax Revenues
China is a global leader on cashless transactions, with its fintech outmatching the United States’ by a factor of 10. For instance, Alibaba’s Ant Financial, “which controls the world’s largest money-market fund, has… handled more payments in 2017 than MasterCard, and completed over $8 trillion of transactions via its online payments platform last year alone.” Cashless provides an enormous amount of data to Alipay and WeChat Pay, allowing them to create complete credit rating profiles for over 800 million users. This is a massive efficiency boost to private capital allocation as both moral hazard and adverse selection – financial capital allocation’s two endemic problems – are minimized by credit profiling.
Certainly, this does not resolve the meteoric indebtedness of local governments, but it can alleviate pressure on the national government budget, because cashless transactions make taxes easier to collect. Moreover, if China pivots toward a cashless economy, the shadow economy would immediately be included in national statistics and the debt-to-GDP ratio would decline. The transition to cashless would also lead to a future cash-flow effect (as tax revenues would continue growing well into the future), boost trust in the central government’s ability to undertake a fiscal expansion, and bail out insolvent institutions without a national debt overshoot. The ongoing effort of Beijing toward deleveraging could thus be achieved by a gradual boost in state revenues able to smoothen the process of sustainable debt reduction without constraining short-term fiscal expansion. This becomes even more essential, as local governments have seen their revenues declining from curbing land sales and thus need alternative revenue sources.
Peking University professor Michael Pettis has foreseen the beneficial impact of an emergency fiscal expansion on China’s growth amidst the trade war. Pettis has rightfully asserted that the trade war will not slow down the Chinese economy substantially because the central government will provide a fiscal stimulus to make up for falling exports to the United States. Pettis also argued that under such a scenario deleveraging would slow down if not be totally aborted and the national debt-to-GDP ratio would increase, thus undermining long term Chinese growth. Yet our hypothesis is that as China is transitioning toward cashless, total tax revenues will increase. Therefore, an emergency fiscal expansion will not significantly aggravate national debt.
The People’s Bank of China (PBoC) has gone to great lengths to estimate the impact of going cashless on monetary policy and national product. Macroeconomic modeling and the so-called Macroeconomic DSGE modeling can be complex and it often misleads; however, transitioning toward cashless is a strategic decision that China could easily implement as it already has the tactical technology platforms — the cashless ecosystem — on the ground through Alipay and WePay. For instance, if the government imposes an ad valorem tax on ATM transactions, then people will be incentivized to increase the use of cashless platforms. This would make value added tax (VAT) immediately collected and registered to the national account, thus boosting tax revenues. In addition, transaction data analytics would make income tax easier to estimate and limit tax evasion. Even in the case of a highly indebted country like Greece, as a report by the Foundation for Economic & Industrial Research has attested, a partial transition toward going cashless since July 2015 has done miracles boosting fiscal revenues.
China’s Economic Stability Will Be Determined At Home
Worries about the impact of a trade war on the Chinese economy have also been recited even within China, with an unusual recent verbal confrontation between the PBoC and the Finance Ministry concerning the pace of deleveraging that China should be pursuing amidst a trade war. PBoC officials have supported a wide fiscal stimulus while Ministry of Finance officials have opted for targeted fiscal easing through SOEs. In mid-August, the Chinese government directed banks to ease liquidity toward companies that will be negatively affected by the trade war.
To be sure, the Chinese economy is not impenetrable to global shocks but having already amassed an enormous amount of national wealth and driven by mass grassroots entrepreneurship, China’s economic vibrancy and debt deleveraging will mostly be determined by domestic politics, smart supply-side reform, and sustained opening up. China’s 2013 Third Plenum reforms provide the basis for moving forward albeit calibrated to deal with the ongoing stress from the trade war. As the Financial Times put it, since 2013, “China has significantly slimmed its shadow finance sector, launched initiatives to securitize lending, worked to shore up risks in regional banks and reined in runaway credit creation.” Recently Beijing has also worked to tackle hidden debt and upgrade the quality of its national statistics.
Overall, it is mostly by reform at home that productivity can sufficiently rise, thus boosting China’s national product and normalizing the long-term debt-to-GDP ratio.
Tariffing Cannot Win: Give Trade Peace a Chance
A protracted trade war is not inevitable. But it is essential for American strategists to make an accurate diagnosis of the health of the Chinese economy and to not overestimate the adverse impact of the United States’ punitive trade tariffs on China’s debt sustainability. This would wrongly motivate Trump to escalate the trade war and push China and the U.S. down the path of an otherwise mitigated geoeconomic conflict with grave repercussions for the global trade order.
Even in the 1960s when China was much weaker and its economy only a tiny fraction of the United States’, Beijing pushed back decisively against foreign coercion and simultaneously confronted the Soviet Union and America – the world’s superpowers. After almost three decades of economic growth China is neither doomed to collapse nor poised to take over the world. However successful, China’s economic system is too sui generis to serve as a model for others to emulate while the country’s per capita wealth remains below any Western nation. China is thus not a threat to U.S. democracy and the ongoing trade conflict should not be caricatured as an “existential clash of systems.” In this uncharted geoeconomic territory, intellectually validated, accurate, and calculated evaluation of China’s economy could help bridge differences and bring some trade peace with dignity for both sides.
Vasilis Trigkas is an Onassis Scholar and Research Fellow at the Belt and Road Strategy Institute at Tsinghua University.
Qian Feng is director of the Research Department at the National Strategy Institute, Tsinghua University.
An abridged version of this report was published earlier at the China-US Focus.