George Magnus explains events in China: no collapse, but serious problems

Summary: Continuing our quest to understand events at the other pole of the world economy, today’s post by A-team economist George Magnus explains the 3 key things to know about current events in China.

Globe and China Flag

China’s economy: no collapse, but it’s serious, and so are the politics

By George Magnus, 1 September 2015
Reposted from his website with his generous permission

For the sake of clarity, repeat three things after me:

  1. China’s economy is not collapsing.
  2. What’s going on China is serious.
  3. Political tensions are making things worse.

(1)  China’s economy is not collapsing

People who have become China experts in the last few weeks, point to the sharp falls in power consumption and freight traffic – two of the three indicators in the now famed Li Keqiang index –- but these and other industrial indicators don’t tell us anything about what’s going on in the services or tertiary sector, which accounts for about half of the economy.

Even if producers are having a tough time at the moment, consumers of household goods and services and buyers of real estate haven’t gone to ground. Retail sales were still up by over 10% in July, and property sales registered pretty robust year on year increases of over 13% in the second quarter and 19% in July. The government is going to continue to support the economy with infrastructure spending, monetary easing, and fiscal and debt initiatives.

In August, even though the Caixin and NBS PMI data were down, some of the high frequency data could ‘look’ better in year-on-year terms, largely because of flattering base effects following from declines this time last year. The official data are likely to continue to show the economy growing around 6.5 – 6.8% in annual terms in the next few quarters.

(2) What’s going on China is serious

The economy is the fourth year of a structural slowdown that shows no signs of ending and is becoming increasingly insensitive to the government’s stimulus measures. This chart of the manufacturing, services and total PMI indices in August captures the situation well, and points specifically to the fact that the services component, which still shows expansion, isn’t doing enough to offset the decline in manufacturing.

Caisin China PMI for August 2015
Caisin China PMI for August 2015.

As the second half of 2015 unfolds, we should expect the services sector to weaken, largely as the drag from the financial sector (following the stock market plunge) permeates the economy. This could take around 0.5% off GDP growth. The contraction in heavy industry, including metals, chemicals, cement, and power generation, may already have tipped some provinces in the north-east and west of China into a ‘recession’, defined as growth below 4-5%. Manufacturing investment will remain weak not least as a consequence of persistent excess capacity, deflation and debt in the industrial part of the economy.

In spite of the summer recovery in property sales and prices, mostly in Tier 1 cities, and the implied erosion of the overhang of housing inventory, there is next to no prospect that the trend fall in real estate and construction investment will stop. Infrastructure spending and other policy easing stimuli in the first seven months of 2015 may have amounted to about 1.3% of GDP, and so even if we think the official growth data of about 7% are right – which is increasingly questionable – the underlying pace of economic expansion is a ‘high 5’ percent, not 7%.

This graph, showing the decomposition of fixed asset investment, shows that even though infrastructure investment, which is about a fifth, is holding up, it’s not enough to hold up the entire component. And this, after all, is the kernel of rebalancing: a fall in the investment rate that allows the consumption share of GDP to rise – but in the context, of course, of a slower overall growth rate.  {the x-axis runs from 2006 to 2015.}

China growth rates
X-axis runs from 2006 to 2015. Source: CEIC & UBS estimates.

We don’t know what’s really going on in the Chinese labour market, but the employment component of the PMI has been falling for several months and registered 48 in August, indicating a decline in employment levels. The International Jobs Report, published in January by the IMF in conjunction with the Economist Intelligence Unit estimated that China’s unemployment rate was nearer 6% than the 4% at which official data have been stuck for over a decade.

The data are an apparition anyway, because a large proportion of the urban population are migrants who do not have hukou, or urban registration entitling them to social benefits, and the registration for unemployment benfit is in any case thought to be low because the level of benefits is. Given what has happened to investment and construction this year, one could imagine that the unemployment rate has climbed since the end of 2014. This is way more important than GDP from a policy and political perspective, and the more policy is eased, the greater the concern will be about labour market conditions.

China bubble

(3) Political tensions are making things worse

What has really set the cat amongst the pigeons this summer is the juxtaposition of a weakening economy, and the cack-handed manner in which the authorities managed the mini-devaluation of the yuan and the frantic attempt and failure to prop up the stock market. I’ve written about this most recently in the Financial Times, and in the Times.

The bottom line is that it is only possible to understand these economic, exchange rate and equity market developments in the context of the campaign waged by President Xi Jinping to bolster the Communist Party’s authority and control. Specifically, the anti-corruption campaign, and the effective displacement of government ministries by so-called ‘small leading groups’, which are Party agencies, which are anything but small.

The benign view is that to strengthen the Party, increase compliance among cadres in the Party and in SOEs and local governments, and get reforms going to correct the imbalances in the economy, Xi had to amass power and centralise it. There is little question that he and his senior colleagues understand they have to implement deep and meaningful economic reforms to unlock new sources of economic growth and productivity.

Xi Jinping
Xi Jinping. From Bloomberg.

The risk, as they know even better, is a loss of control. And they fear this more than anything. President Xi’s anti-corruption campaign is weeding out high profile Party misfits, but simultaneously stifling growth and initiative. It is also making an example of so called ‘tigers’ – top Party officials – but it is impossible to go after all the ‘flies’ – lower level officials, whose misdemeanours (or worse) have a real effect on peoples’ lives. Think only of the recent appalling chemicals explosion in Tianjn, where 11 local government and port officials have been accused of negligence and a beach of regulations, so far.

Xi has also substituted Party small leading groups for government institutions in broad areas of decision-making, undermining the authority of those charged with implementing reforms, and solidifying opposition among vested interests in the Party, SOEs and local governments. During the recent annual leaders’ get-away in the resort of Beidahe, State media reported that the government was facing resistance to reforms on an unimaginable scale. This expression of frustration was indicative not so much of the determination to press ahead regardless with market-oriented reforms and the creation of inclusive institutions, but of factional struggles and the influence in particular of retired leaders and senior Party officials.

To all intents and purposes, meaningful reforms of SOEs, and local government finance functions and structures, and a retreat of the State from the commanding heights to make way for the private sector and markets, had already run aground. So, the latest developments are not promising, and may imply that those most enthusiastic about reforms are now on the back foot.

This is what markets and commentators may finally have realised. In this context, though, I was amused to read a current piece by Mohamed El-Erian in the FT’s Exchange blog (“China needs to learn how to talk to markets“). Specifically the part where he says that as that China ‘engages further on the road of economic liberalisation and broader market-based reforms’, it will have no choice but to become ‘more sensitive to short-term market positioning’ and better at communicating policies and ‘managing market expectations’.

El-Erian is no intellectual slouch, and a very experienced investor, but this is a bit parallel universe. I’m sure he meant to say that China’s mini-devaluation and stock market management were bungled, damaged the credibility of policy-makers, and in future, they need to take more care. Yet, the idea that Chinese policy-makers simply ‘got it wrong’ out of haste or lack of thought doesn’t really square with what’s going on in China. And the notion that leaders will have no choice but to learn about markets and treat them with more respect as they advance with fortitude down the path of economic liberalisation is, to put it bluntly, other-worldly.

George Magnus


About the author

George Magnus is one of the West’s top economists.  After employment with Lloyds Bank International and Bank of America, he moved to the UK stockbroker Laurie Milbank with the Big Bang in the City of London in 1985, and then to S G Warburg in 1987 as head of fixed income research, and later Chief Economist. In 1995, he moved to UBS as the Chief Economist, based in London. In 2005, he was appointed Senior Economic Adviser, a position he held until going solo in 2012.

See his website, with links to his work. His books appear below.

For More Information

Please like us on Facebook, follow us on Twitter, and post your comments — because we value your participation. For more information see all posts about China, especially these…

Magnus has also written about the massive demographic changes that will shape the 21st century. For more about these see A rocky road lies ahead to a far smaller world population and Must our population grow to ensure prosperity?

Books by George Magnus

The Age of Aging: How Demographics are Changing the Global Economy and Our World.

The footprints of demographic change appear everywhere, and not just in economic and financial spaces. They can be found in the discussions and debates we have (and will have) about immigration, family structures, pensions and retirement, work and education, globalisation, religion in a secular world, secularism in religious countries and communities, and global security.

They can also be found in the heat of the current economic and financial turbulence. We are dealing with a cyclical slump in the economy, structural change in the way the world works, and a generational shift as the baby boomers begin to head off into retirement, and as Generation X steps up uncomfortably to fill the shoes that are better suited to the next internet generation.

Uprising: Will Emerging Markets Shape or Shake the World Economy.

Uprising looks at the the world economy in the wake of the most destructive financial crisis since the 1930s and asks if the consensus view about the shift in global power to emerging markets generally, and to China particularly is as robust as it thinks it is. In Uprising, he explains the effects that the financial crisis is having on the major emerging markets, and why they will be as challenged and threatened as their richer, Western partners.

Available at Amazon.
Age of Aging
Available at Amazon.

23 thoughts on “George Magnus explains events in China: no collapse, but serious problems”

  1. The author knows nothing about the Chinese economy, its unique design and operation. This is a conventional Western attempt to demonstrate that, based on our Western models, China’s economy is in trouble. But The Economist has published 56 such ‘analyses’ since 1980 – all carefully buttressed and often written by ‘expert’ guest writers – and they’ve been as wrong and as ignorant as this one.
    Until we’re humble enough to study China’s actual, existing economy we will continue to be misinformed and, as a result, to fall further and further behind China.
    Hasten the day!

    1. Godfree,

      I have know Magnus for 20 years. He has traveled extensively in China, written about it, and — as as Chief Economist of one of the world’s major investment banks — had to have a high rate of accuracy in his forecasts.

      So you can say he is wrong. To say he “knows nothing about the Chinese economy” tells us more about you than him.

  2. Steve Keen notes that during the GFC China’s total private sector debt to GDP was about 100%. Not that high. Their response to the crisis was to tell banks to lend, thus expanding the money supply. Today private debt is about 180% of GDP. Keen estimates that over the next two years China will hit a private sector debt wall; a Minsky moment if you will, just as Japan did in the eighties, and we did in 2007, and for the same reason:
    Total private sector debt to GDP became too high.

    1. It was Keen and later Richard Vague who made the case that total private debt is empirically a powerful predictor of economic crises. Orthodox economists like Krugman still argue private debt does little to affect macroeconomic variables. This is a sad reality with serious policy implications explaining much about Japan’s and our policy errors. Time will tell if China screws their people to defend their bankers from the pain of failure followed by recapitalization. There are rumblings already that helicopter drops may begin soon. This would be dramatically bad for Chinese banks but good for the economy. We will soon see.

      1. Peter,

        Yes, but that theory is different than pointing out that China has a high debt load.

        Also, it is incorrect to say that the importance of private sector debt is a new insight. The key role of bank failures in economic depressions goes back to the 19th century (e.g., Bagehot’s Dictum, 1873), and today is a core part of Austrian economics.

  3. Just a couple of things FM. I agree that we’re unlikely to see a ‘collapse’ although there will be tensions. The analysis is good but there appear to be a few things not covered that perhaps make it less than comprehensive. One is capital flight out of the country, and I would be interested in your thoughts regarding this, although I know the Chinese government is trying to slow this with more capital controls. The other is the issue of Chinese households having over-leveraged themselves in the stock market based on false promise of free money with the bubble, and this has potential to impact social and political tensions.

    1. Over Moon,

      “but there appear to be a few things not covered that perhaps make it less than comprehensive”

      There are always things not covered.

      “I know the Chinese government is trying to slow this with more capital controls.”

      Nobody outside China has the data to do more than guess at current capital flows in and out of China. Doesn’t stop people from trying. Guessing about the future of these flows is difficult for well-established nations. IMO it’s almost impossible for outsiders to do so for China.

    2. Fabius Maximus, ok, and thanks for retrieving the comment.

      I would like to think logically we know that capital outflow is going to be significantly outwards for a while (whatever data has been available has suggested outflow starting at least half a year prior to the end of the market bubble), just as many of us logically knew that China would eventually run into trouble with an unsustainable debt bubble. I take the point about data, inc. quality of data; as well as an analysis being unable to cover everything.

      1. Moonbat,

        “we can argue about methodology”

        No we can’t because I won’t. I assume you’ve seen the reports about accuracy of China’s statistics. If you believe those numbers are reliable, well OK.

        If you’re not familiar with the calculation of capital flows, see this IIF guide. Given China’s level of corruption, their own government might not know all these numbers with adequate reliability. That’s a common problem in emerging nations, and was a major factor in the 1998 emerging nations crash.

  4. Indeed. So you have the Austrian school that teaches a narrative about credit expansion leading to mal investment that ends in a crack up boom or bubble that eventually busts and ends in tears. But the Austrians have no analytic framework. They just have a narrative about credit expansion leading to excess followed by collapse. Also Austrian schoolers don’t view banks as the source of the crisis, they blame central bank policy, especially central bank complicity in monetizing fiscal deficits, a behavior some Austrians argue would be impossible with gold backed money.
    It was Keynes who introduced a more analytic framework which focused on aggregate demand and it’s importance in causing crises. It is fair to say that Austrian schoolers have a loose but valid grasp of credit cycles but no analytic theory of money and how it is created. Indeed they argue new money should not be created and prices should continually fall. Keynesians believe new money (and thus new demand) is created by deficit spending and money should be so created if evidence suggests there is not enough money (to deal with random shocks) to support stable demand.
    It was Minsky who first described a plausible way that capitalism might be intrinsically unstable and thus prone to periodic crises requiring neither profligate credit expansion by foolish governments and central banks (Austrian) or random shocks (Keynes) which depress aggregate demand and require fiscal deficits by government to restore equilibrium.
    Minsky described a plausible cycle where banks expand the money supply by lending (Keynesians believe only deficit spending can alter the money supply) which causes asset price inflation which justifies more lending and more inflation and so on until debt saturation halts the credit expansion. Once halted the cycle reverses. Asset prices fall triggering defaults causing banks to stop lending causing asset prices to fall and so on. Because Minsky’s approach was essentially Keynesian with the role of bank lending correctly identified as adding to aggregate demand by effectively increasing income, it was possible for Steve Keen to build an analytic model of Minsky’s instability hypothesis. Without Keynes’ analytic framework this is impossible. The Austrian school credit cycle narrative is not sufficient.
    So Krugman is wrong because he doesn’t understand Minsky. The Austrian school is wrong because they understand that credit is money but little else. Minsky was right but died before computing power existed to crunch the model that Keen built on Minsky’s work. And Steve Keen is right. It’s actually a very hopefull and exciting time. China has interesting policy options supported and suggested by these new theories and the ability to execute same which we cannot. We cannot because our finance sector is too powerful and our policy advisors are too parochial. I hope they do. And if they do I hope it works and they kick our ass economically. We deserve it.

    1. Peter,

      “So Krugman is wrong because he doesn’t understand Minsky.”

      Your self esteem is greater than your knowledge of economics. I doubt you have read much — if any — of Krugman’s books, and certainly none of his professional literature. Rest assured, he understands Minsky’s work far more than you ever will, by a very large margin.

  5. I stand by my statement. If Krugman understood Minsky he would abandon loanable funds. He has not done so, in fact he has doubled down, proposing a torturous intellectual patch to equilibrium orthodoxy wherein patient lenders contrast with non patient lenders in a liquidity trap situation as an explanation for how banks might play a subtle role. For this reason to me he is intellectually bankrupt. Loanable funds is a risible construct. Sorry but it is, your bluster not withstanding. Are you familiar with the loanable funds assumption, it’s logical equivalence to ISLM, and the absurdity of both as explained by Keen?

  6. In my life as a physicist I have seen a few paradigm upheavals up front and personal. I have seen an old guard resist new thinking unsuccessfully. I have seen the new methods win over the old as young talent arrives and must choose between the new and the old. More and more, the struggle even in physics is not resolved by data and experiment, but rather by intellectual rigor and by elegance of the competing theories. Yes, physics today is much like economics at least in that regard, finally unmoored from experiment, now increasingly an aesthetic as well as an intellectual endeavor. But to get here at least physics has passed through significant and impressive mathematical milestones:
    linear operators, linear systems of governing equations, routine inversion of those operators and the matrices that describe those equations, and finally the early introduction of nonlinearity, the amazement at how complex this makes everything, the realization that nonlinear systems can have almost infinite complexity, resulting in chaos theory, stability theory, and perturbation method, which lead directly to quantum mechanics, the statistical wave equation, and culminated in the strange but apparently true idea that everything is waves.
    By comparison it is fair to say that economics, in terms of mathematics and analysis, has not kept up with physics. Forgive me but I have to say when I read Krugman and compare him to Keen, as a math physicist who has paid his dues, I have to say Krugman looks to me like a baby playing with a razor blade. I hope he doesn’t hurt himself, and it’s painfull to watch. By comparison I’m impressed by Keen.

  7. Sorting through the gobledygook and preening egotism spewed by the various commenters, it seems likely that FM is once again doing the economic equivalent of reading Aeschylus to a cage full of hyenas.
    I especially enjoy comments in which the Nobel laureate Paul Krugman is denigrated, viz.: “If Krugman understood anything about Minsky he would abandon loanable funds.” This is the equivalent, in a physics thread, of the phrase “If Einstein understood anything about physics…” and indicates that we need read the commenter’s blovations no further.
    FM’s points seem simple:
    [1] The Chinese economy is extremely opaque and highly corrupt. The Chinese central government itself probably does not have knowledge of many crucial numbers, e.g., capital flows out of the country (lots of black market cash gets smuggled out), real durable goods production (are the numbers fake to cover up embezzlement,are they faked as occurred regularly in the USSR to please the politburo, or is so much of the real GDP buried in an invisible corrupt economy that the real numbers don’t show up?), real services industry numbers (do the numbers account for bribes, control fraud by privileged party insiders, etc.?) and so on.
    [2] The Chinese economy is a strange mix of central control and private enterprise, with all the biggest “private” Chinese companies actually run by privileged party insiders with their own agendas.
    [3] Much of the Chinese workforce seems undocumented, with hundreds of millions of migrant rural peasants moving into and out of the coastal industrial zones without the correct papers and consequently working “off the books.”
    Given this, it seems extremely hard to determine exactly what’s going on in China.
    My questions are:
    A) Is the current Chinese leadership actually trying to root out corruption, or are they simply conducting a purge of disloyal members of the Central Committee under the familiar disguise of attacking bribery and thievery? To what extent is the pushback against the alleged anti-corruption effort an actual blacklash by thieves, and to what extent is it a political struggle twixt two conflicting groups inside the Central Committee?
    B) How does the Chinese leadership plan to handle the crucial transition from low-skill manufacturing to high-skill high-value-added tech and services industries? It seems that this transition is playing a part in the slowdown. See “The Change in China’s economy,” East Asia Forum, February 2015.

    During the past three decades, two traditional drivers — exports and investment — underpinned China’s strong economic growth. Now both of these drivers have lost their umph. Manufacturing industries that produce investment goods are suffering from high overcapacity rates that average between 30–40 per cent. At the same time, manufacturing firms that make labour-intensive goods are rapidly losing competitiveness due to rising wages and other costs. The latter problem is popularly summarised as the middle-income trap. Industries need to upgrade in order to stay competitive.

    C) What contribution does the tremendous real estate and construction bubble in China play in all this? China apparently has multiple city-sized shopping malls which stand empty, created in order to artificially sustain the construction industry and prop up inflated property values — see “China’s Ghost Cities in 2014” in Business Insider, June 2014. This seems reminiscent of the pre-2008 subprime real estate bubble in the West.

      1. Peter,

        I is nice to see you provide info from experts, rather than spouting about what you don’t understand. However, you are confused about how science works. To see known science (aka consensus or agreed upon) you look in textbooks. To see the frontiers you look at research.

        Two important things to know about research:

        (1) Papers are published about disagreements among scientists. Questions that attract many papers are the cutting edge in that field.

        (2) Most of research is wrong, to some extent. It’s common for laypeople to point to a single paper and yell “truth” — others are “committing malpractice”. That’s silly. (This is one practice in the quite mad public discussion of climate change).

        It’s not baseball. Cheering for your team just shows that you don’t understand.

  8. That’s a good point. There is right now a fairly heated debate among physicists about the recent development that theory on the frontiers is hopelessly untestable by experiment. To test the current hypotheses would require particle beam energies that are quite possibly permanently out of reach. For this reason resort is being made to non experimental selection criteria. Is the new theory simple? Is its derivation elegant? Lacking experiment, what else are we to do?
    A very similar conundrum has vexed economists for a long time. They too cannot perform controlled experiments. They too ask, “So how do we choose a winning paradigm?”.
    My suggestion is to borrow from the physicists. Who shows the most intellectual rigor? Who does his math right? Who achieves interesting results, especially interesting predictions, even though untestable predictions, from their analysis? Dare I say it: Is it cool?
    I think the work Steve Keen is doing is mind blowingly cool, the way that symmetry is cool. The way that quantum mechanics is cool. Thank you for pointing out this important aspect of human behavior. None of us escapes this truth of our human condition. We make a lot of important decisions this way because there is no other objective criterion.

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