TOKYO — As China struggles to spur growth, it’s heartening to see Chinese Premier Li Keqiang internalizing — apparently — the work of Milton Friedman.
How? Recalling the Nobel Prize-winning economist’s edict that a crisis is a terrible thing to waste.
This week, Li called on local officials in six key provinces to take bold steps to put a floor under China’s economy. These six regions – which generate 40% of gross domestic product – are precisely the ones that Beijing should consider as platforms for growth. Production and consumption are cratering amid Covid lockdowns and falling land values.
Li wants local governments to increase debt issuance programs “reasonably”, to act “in accordance with the law”, while new construction projects should prioritize “sound” fundamentals.
But it’s not just Friedman that Li is channeling.
After the conclusion of a national leadership conclave, Li traveled to Shenzhen this week to “present a flower basket to Comrade Deng Xiaoping’s statue at Lianhuashan Park”, Xinhua reported.
Probably thinking of Deng, the great reformer, Li said, “China should continue the process of reform and opening up. He added with a poetic touch: “The waters of the Yangtze will not turn back.”
Fine words, but to dive into the specifics: Li thinks it’s time for China to get serious about building a stable, reliable and globally attractive bond market. And what better time than now, when the debt issuance machinery comes to life again?
white elephant hunt
At a recent meeting of the State Council, Li stressed that the financial system must have a clear and credible framework to ensure the orderly issuance of government bonds and municipal debt to ensure project transparency and productivity.
“Fund management should be strengthened to prevent risk of indebtedness and prevent idleness of funds,” Li said. “The construction of new government buildings in violation of regulations should be strictly prohibited, and no vanity projects will tolerated.”
This mindset without white elephant plans is vital on three levels.
First: attract the inflows of foreign capital needed to fuel growth and internationalize Chinese markets. Two: Remove fuel from the very reckless borrowing behavior that Beijing has tried to discourage with the deleveraging campaigns of recent years. Third: Put China on a more sustainable long-term path.
Deeper capital markets are essential to building a consumer-driven economy. They are key to giving small private companies – including tech startups – access to funding to scale and disrupt a top-down growth model. They are key to creating vibrant social safety nets to absorb a rapidly aging population.
Clearly, the pressure is strong to boost GDP. The topic seemed to dominate the annual party conclave at the resort town of Beidaihe in Hebei province.
Low Growth vs. Open Markets
News that China grew just 0.4% in the April-June quarter year on year is prompting President Xi Jinping’s government to roll out further fiscal stimulus. Xi is just months away from securing an unprecedented third term as leader of the Communist Party.
Qi Wang, CEO of MegaTrust Investment, finds great significance that Li made no mention of the 5.5% growth target.
“Actually,” he notes, “you can hardly find any reference to that in official discussions or documents lately. Does that mean China is giving up on the seemingly unachievable goal? I think so. .”
Nomura Holdings now expects growth of 2.8% this year, while Goldman Sachs expects 3%. Last month, the International Monetary Fund lowered its forecast for China to 3.3% from 4.4% previously.
“China’s rebound from Omicron has stalled and near-term growth prospects are poor,” said economist Julian Evans-Pritchard of Capital Economics. “Virus outbreaks are occurring with increasing frequency.”
Beijing’s latest budget is expected to allow local authorities to issue at least $220 billion in additional debt this year for infrastructure purposes. The six provinces that Li relies on – Guangdong, Henan, Jiangsu, Shandong, Sichuan and Zhejiang – already account for about 60% of China’s total foreign trade and foreign investment.
Having them leading the relaunch charge makes perfect sense. The Politburo has long looked to economically dynamic regions to lead efforts to spur national growth. The key, however, is to use this latest response to the Covid crisis as an opportunity to improve China’s bond market infrastructure. This involves increasing transparency, establishing a more credible national credit rating agency system, and moving towards full convertibility of the yuan.
China is working on it, of course.
On June 30, the People’s Bank of China gave foreign investors access to onshore bond markets based on the Shanghai and Shenzhen stock exchanges. PBOC Governor Yi Gang’s team says the move to open up, coupled with upcoming mainland bond market reforms, “will further facilitate foreign institutional investors’ investment in China’s bond market and unify management.” cross-border funds”.
Even before this opening step, Beijing allowed more than 1,000 foreign institutional investors to trade in the centralized interbank bond market. The China Securities Regulatory Commission and the Hong Kong Securities and Futures Commission are working on additional opening steps, including adding exchange-traded funds to programs linking markets in the China region.
But the more China allows foreign influence in its $20.6 trillion debt market, the less Xi’s party can get away with the financial opacity that permeates the market today.
Li, Friedman, Deng and Carville
As Li riffs on Friedman and Deng, there’s an argument that China also needs a James Carville moment.
The reference here is to the early 1990s, when President Bill Clinton’s administration found itself constrained by the bond market. Any sign that the White House might increase the budget deficit sent US Treasury yields soaring.
At the time, Carville, a senior Clinton adviser, famously remarked, “I used to think that if there was a reincarnation, I wanted to come back as president or pope or as that baseball batter .400. But now I would like to come back as a bond market. You can intimidate everyone.
In recent years, especially since 2015, Xi’s government has faced several episodes of stock market chaos.
Each time, including earlier this year, Beijing has managed to pull the stock exchanges back from the brink. In 2015, for example, Beijing reduced reserve requirements and relaxed leverage protocols. It halted all initial public offerings and ceased trading for thousands of listed companies. This allowed average Chinese to use apartments as collateral so they could buy stocks. He urged households to buy stocks out of misplaced patriotism.
But the bond market is a very different animal, as Carville observed. When you lose the trust of bond traders, you lose control of interest rates and the currency.
The intimidating gang to which Carville sponsored These are the so-called “bond vigilantes” who rebel against government or central bank policies that they deem reckless or dangerous. Their protests can be powerful and destabilizing. As they drive up yields and boycott debt auctions, governments may face sharp increases in borrowing costs.
Many senior officials in Beijing have been reluctant to grant this kind of power to private investors, especially foreign ones. But it would be a necessary evil to build a more credible and efficient debt market.
Transparency, transparency, transparency
One of the reasons default dramas like the one surrounding China Evergrande Group tend to surprise traders is the lack of market visibility. The underdeveloped nature of China’s credit rating and other benchmarks industry means that credit spreads are not a reliable early warning system for the country’s markets.
The black box nature of China Inc. tends to distort credit spreads, yield dynamics and secondary trading liquidity. The concern is that if China hits a wall, it could come as a surprise to global markets.
More efficient debt markets could also allow Beijing to gain traction with stimulus.
“This strategy is hardly a surprise,” says economist Andrew Batson of Gavekal Research. “Infrastructure has been a regular countercyclical tool for China since the response to the 2008 global financial crisis.”
Batson notes that “with most other growth engines collapsing, the reliance on infrastructure is even greater this time around. This does not bode well for the economic cycle. The effectiveness of infrastructure spending is often overstated and has never been enough on its own to reverse the cycle. Unless and until the government can stabilize the housing market, growth could continue to slow despite the largesse of public works.
There are two similar challenges in Japan that China seems to be facing. One is a liquidity trap caused by banks finding little demand for the tidal waves of credit that the PBOC has thrown into the markets. The second is that conventional fiscal stimulus is losing potency at the worst time for China’s slowing economy.
The headwinds are intensifying from all angles — from the Federal Reserve’s tightening in Washington to Xi’s endless “zero Covid” lockdowns at home. The housing sector’s distress isn’t helping, says Charlene Chu, a former Fitch Ratings analyst known for her warnings about Chinese debt risks.
“We have a real estate sector that’s almost dead that used to employ a lot of people and a lot of downstream industries,” says Chu, now a senior analyst at Autonomous Research. “All of that is impacted by this real estate downturn, and that’s why I think we’re still early in the game here.”
If China were to face a debt reckoning, Li knows it would be easier to deal with if it had resilient and reliable capital markets. The implications are critical. Carville, remember, is also known for his observation that “it’s the economy, you idiot.”
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