Andy Xie is a former Morgan Stanley analyst now living in China.
Put Down Trade Spats, Pick Up a Mirror
by Andy Xie
China and the United States should face domestic issues, from middle class support to Wall Street theft, and avert a trade war
A confrontation between China and the United States is looming sooner than I expected. Quite likely, the U.S. Treasury Department will name China a currency manipulator in its April report to Congress. Such a conclusion would require that the Obama administration impose punitive tariffs on Chinese imports.
China may be tempted to strike back with a trade-war volley. But such a move would be in China’s worst interests. China is the biggest beneficiary of globalization and must do everything possible to defend the global trading system. So its best response, in my view, would be to take the case to the World Trade Organization, even though any resolution would be a long time coming and would not help the current situation.
China also would be wrong to stoke a dispute with the United States in hopes of diverting attention from its domestic problems. China’s biggest challenge today is how fruits of its economic growth are divided, not how fast the economy is growing. And a key to this dividing game is held by the middle class, which deserves support.
Unfortunately, a middle class squeeze is under way that is a bigger threat to China’s economic development than slower export growth. High property prices have turned into an unfair tax on the middle class while, in numerous cases, powerful people are enriched. A bit more economic growth will not solve this problem. Meanwhile, low interest rates in an inflation era are actually taxing savers to benefit two classes of borrowers – state-owned enterprises and speculators. Thus, low interest rates are mainly a kind of middle class tax.
The United States is picking a fight with China because it can’t resolve internal problems. Since the financial crisis began, 9 million households have lost homes because they could not or did not want to make mortgage payments. Another 10 million households have negative equity in properties and could be forced or decide to give up homes. That’s 15 percent of all U.S. households. Meanwhile, the U.S. unemployment rate stands at around 10 percent, and the federal government’s deficit is more than 10 percent of GDP. The biggest state, California, faces bankruptcy.
How could a single economy face so many major problems all at once? The immediate cause was the credit-cum-property bubble burst, although the real villains in this case got away with the loot in the confusion after the big bang. Short-sellers were blamed for puncturing the bubble, but guilty parties with power were not.
An asset bubble has many aspects. Most people understand it as the rollercoaster ride for prices. For example, Hong Kong’s property prices quadrupled between 1990 and ’97, then fell 75 percent between 1997 and ’03. In other words, it was a 13-year round trip. China’s A-share market index rose from 1,000 in 2005 to 6,100 in 2007 and fell to 1,600 in 2008 – a round trip that lasted three years.
Why are bubbles so harmful? Because three dynamics are at work:
1) Taking advantage of most bubbles are a few insiders who know how to rob ignorant people. This redistribution aspect can haunt an economy for years after a big bubble bursts.
For example, most subprime mortgage brokers knew they were lending to people who could not repay. Wall Street traders who bought mortgages from these brokers and sold them in pools or CDOs knew the brokers were incentivized to sell poor quality stuff. But the traders didn’t care because they received bonuses for selling the stuff to someone else. Fund managers who bought the CDOs probably knew they would go bad eventually. But they, too, decided to look toward annual bonuses for each year of performance.
The people who got hurt didn’t even know what was coming because they were savers who put money in pension funds, bought insurance products, or invested in bond funds.
The reallocation game isn’t restricted to the financial sector. Profits as a share of GDP from corporations – and not just the financial sector – reached historic highs during the bubble period, while relative wages slipped to all-time lows. Thus, the whole corporate sector was monetizing the bubble. And now, the U.S. corporate cash stash as a share of total assets is at a record high.
2) Money tends to be spent in the wrong way or overspent in a bubble. Economists call wrong spending “misallocation of resources,” which means the pie doesn’t expand as fast as it should. Overspending involves money that one thinks he has but actually doesn’t have. So when a bubble bursts, he’s chased by creditors.
These money factors amount to a hole in the economy that needs to be filled either through spending contraction or by increasing exports. Neither is easy. Cutting spending is, of course, unpleasant. Increasing exports is hard, too, because it requires devaluation. But unless domestic demand contracts, devaluation leads to inflation, erasing competitiveness gained by devaluation.
3) Capital destruction within the financial system is another factor that weighs down an economy for years after a bubble pops. The U.S. financial system reported losses of more than US$ 1 trillion during the crisis, creating a capital shortage that will restrict credit expansion for years to come. This is another headwind for the U.S. economy.
Action the U.S. government has taken so far shows it cannot resolve domestic problems. Americans consumed as much as US$ 3 trillion, or 20 percent of GDP, more than they could afford during the bubble. A retrenchment strategy would call for accepting a major downgrade in lifestyle. It would also require that consumption fall below the long-term sustainable level to regurgitate overspending of the past.
Long-term sustainability is possible if the U.S. trade deficit is small. Although the trade deficit was cut in half after the crisis, U.S. consumption probably is still above the long-term sustainable level. Moreover, export orders on the China side suggest U.S. retail sales have been picking up in the second quarter. This is good news for the short term but reflects the U.S. household sector’s reluctance to change an unaffordable habit. It seems pretty remote to expect consumers to regurgitate that US$ 3 trillion.
Ill-gotten bubble gains, if recovered, could help the economic recovery. So far, though, U.S. authorities have done very little to settle the score. U.S. government action looks suspiciously like a cover-up for wrongdoings during the bubble, and it’s a problem that the same people are in charge.
Not a single, significant player from Wall Street has gone to jail, despite mounting evidence of widespread fraud. Financial reform legislation has been delayed again and again. And the current reform bill includes so many measures contingent on studies that it would not bite for at least two years.
The Obama administration scored a major victory in passing the biggest healthcare reform bill in four decades. It will provide health insurance to 32 million people who are not insured today and cost US$ 1 trillion over 10 years. Obama will go down in history as a significant president just for this.
But its impact is mainly in the area of social justice, not efficiency. The U.S. economy’s biggest problem is skyrocketing healthcare costs, and the reform won’t reverse that. Even though the administration aimed to cut costs and expand insurance coverage, politicking forced it to give up the first goal, demonstrating again that the U.S. system can’t solve problems through cutbacks.
What sells politically is problem-solving through expansion, in which no one is hurt and a rising tide washes all problems away. The only way to achieve this goal is by expanding exports. This is why the administration wants to double exports in five years. But Europe and Japan are so depressed that the United States could hardly export ore goods there.
The Chinese economy is also too small to absorb much. Of course, if China doubles or triples its currency value as Japan did after the Plaza Accord in 1985, its economy would be big enough to support U.S. export growth. But is China in a position to accept that? I seriously doubt it.
Japan was a developed economy in 1985, and about one-third of China’s population lives in a developed economy, mainly in coastal cities. Two-thirds are living in a developing stage, and an overvalued currency would block their path to economic development.
The Democratic Party may lose a lot of votes for passing healthcare legislation, but blaming China for U.S. economic problems could win votes in the November mid-term elections. Thus, pressure on China’s currency value will skyrocket before November.
But as long as China remains calm, pressure will dissipate over time. The United States has been selectively imposing tariffs on Chinese products over the past few months. Nothing will change in the near future, and a massive, across-the-board tariff on Chinese products is unlikely.
Most Chinese exports to the United States are designed, owned and sold by major U.S. corporations. IPhones, Nike sneakers, and HP PCs are good examples. A massive tariff would hit their profits and trigger a stock market collapse. It would bring down the U.S. economy and trigger a double-dip.
The U.S. government doesn’t have the courage to prosecute people who caused the bubble and brought down the economy, fearing negative economic consequences. Neither will it have the guts to do something against Chinese exports that would surely bring down its economy.
What the government can do is impose tariffs on Chinese products that are commodities still produced in the United States. Chemical and metal products fall into this category. But even if Chinese exports of these products are fully blocked, the impact would be limited, since China doesn’t have to depend on exports as in the past.
A labor “shortage” is now emerging as a major turning point in China’s development. Wages will likely rise faster than GDP for years to come, which is the best news for growing domestic demand.
Low wages due to a labor surplus depressed China’s consumption development, but the labor market is now turning to an advantage for workers. An unlimited labor supply is a thing of the past. Consider, for example, that rural schools across the country are closing because they’re running out of students.
Another factor is that multinationals now rooted in China’s consumer market are increasingly relying on China for profits. This trend is strengthening China’s global bargaining power. Moreover, global stock markets will become more dependent on China’s economic performance.
For the United States, then, hurting China would be like hurting oneself. Time is on China’s side. China can wait out U.S. protectionism.
The global economy has shown signs of recovery, but it’s still not stable. The bursting of the credit bubble has been followed by even greater growth for two, separate bubbles – the U.S. Treasury market and China’s land market.
What to do? Cooling the land bubble would make the Chinese economy less vulnerable to any shock from U.S. protectionism. So interest rates should be raised as soon as possible.
Many analysts argue that raising interest rates would increase currency appreciation pressure. This argument is normally correct. But a great deal of hot money is already in China, chasing a bubble rather than paying interest. If China raises interest rates, hot money may exit for fear of a bubble burst, and appreciation pressure on the yuan may ease rather than strengthen.
China’s land bubble is vast and has far-reaching consequences for the country’s future. The bubble may spread to farmland in coming years, creating new complications. The bubble’s existence has been widely acknowledged, but no clear measures have been taken to control it, proving that powerful interests are behind it.
The bubble makes China vulnerable to shock. If trade friction with the United States drags on, hot money may leave en masse for fear of an economic collapse. And it may make the collapse self-fulfilling.
To strengthen China’s position in the coming conflict with the United States, taming the land bubble is a must. Trade friction with the United States will command headlines and attention from policymakers. But China’s main challenges are internal. How to divide the pie created by economic development is critical to the country’s future. Many argue growth will solve all problems. I’m not sure about that.
Asset bubbles in China are mainly for taxing the middle class, and they stunt growth. No modern economy can be stable without a big, healthy middle class. As long as China’s middle class is vibrant and growing, external challenges cannot derail economic development. So the answer to China’s problems lies within. International confrontation offers no solutions.