Magnus: China’s leaders must choose: political power for them, or economic growth for China

Summary: Today’s post by A-team economist George Magnus discusses China’s economic challenges, especially the clash between its political and economic transitions. These are among the major unknowns affecting the future of China, that other pole of the world economy, {1st of 2 posts today.}

Globe and China Flag

Will, or can China put change before control?

By George Magnus, 29 January 2016
Reposted from his website with his generous permission

One of John McDonnell’s economic advisory team, David Blanchflower, recently wrote in the New Statesman, “The new Labour leaders are not economists and are going to have to learn fast. They will have to accept the realities of capitalism and modern markets, like it or not.” He makes a fine point, and on reading it, I immediately thought that it could equally be made about China.

The leadership is no longer new, and for them the realities of capitalism and markets are not the same: they are prepared to incorporate market mechanisms and go along with western capitalism only to the extent that they, a) do not compromise the interests and primacy of the Chinese Communist Party; b) help the Party further Chinese economic and political power;  c) bolster the competitiveness and efficiency of state institutions. What the leadership does not want is a central role for markets and prices in the determination of the ownership, allocation and distribution of resources.

This much, if you did not know it before, has become evident to global audience in the seemingly parochial world of finance.

On the one hand, China has taken the initiative to set up the Asian Infrastructure Investment Bank under the umbrella of what President Xi Jinping has called the One Belt, One Road project, or to you and me, a 21st century Silk Road by land and by sea; and most recently won the IMF’s backing to include the Yuan in the so-called Special Drawing Right, the IMF’s accounting unit. We could also point to other initiatives to encourage greater use of the Yuan in the settlement and invoicing of trade, the denomination of international bonds, and the composition of central bank currency swaps; and to encourage foreign capital to come into Chinese financial markets.

China dragon
Image from Forbes.

Many analysts and researchers have been bowled over by these things, insisting that they constitute proof that China is on an unstoppable course of reform as it strides, altruistically, towards greater global prominence. If they do have substance, they are much more about the pursuit of power and influence than about changing the way the world economy works. It is not even clear that some of the headline-catching initiatives have the full backing of leading Chinese economic thinkers.

But the main thing the world has learned since last summer, is that when it comes to the relative microcosm of equity and foreign exchange markets, Chinese policy-making has become confused, contradictory and quite the antithesis of market-based reform. Most investors outside China aren’t involved and don’t worry too much about the Chinese stock market. But while everyone knows and cares about the Yuan, no one knows now what official policy is. And when you think about the possible causes and consequences of a Yuan devaluation, it is easy to see why.

Christine Lagarde told the Davos crowd the Chinese had a communications problem, but this goes a lot further than communications. It is about uncertainty at least, maybe even conflict that reaches into the bowels of public policy affecting not only the exchange rate but the wider reform and rebalancing agenda.

Forecasting China’s future

I was privileged to have been invited to participate in an excellent China conference last week at the Danish Institute for International Studies in Copenhagen. Several China specialists spoke, and many were in the large audience too. Amongst the things that struck me was the extent to which some prominent participants discussed reform and rebalancing without even referring China’s biggest economic problem of the moment, namely its passive attention (at best) to excessive credit creation and debt. And the extent to which many present had clearly swallowed the narrative, hook, line and sinker, that China is different, all pronouncements must be true, and all economic problems can be solved in the context of continued high growth. I do think nowadays that foreign thinking on China has changed from the hype we have been peddled for so long, but it may have some way to go if this was representative.

The always interesting Ambrose Evans-Pritchard said that hysteria about China has become ridiculous. I would agree that people, and policymakers in governments and central banks in the west, have been far too quick to assume China is going into the deep-freeze. It isn’t. But at the same time the likelihood of a more serious growth crunch between  2017-19, with or after a financial crisis reckoning that brings the funding of rapid credit creation and non-performing loans to a head is very likely scenario.

Looking at China’s present

The economy ended 2015 soft, but more stable as housing transactions and prices, at least in Tier 1 and Tier 2 cities, picked up a bit, responding to prior stimuli and easing of mortgage restrictions. Inventories of unsold houses and apartments have dropped but remain between 20-35 months of supply in most cities.

The economy will probably remain soft but relatively stable in the first quarter, and then in or by March’s National People’s Congress, there will most likely be a new round of fiscal stimulus, probably focused on infrastructure and tax cuts. If the exchange rate picture is stable, there may also be further reductions in interest rates and banks’ reserve requirement ratios, though these are hardly needed when credit creation is China’s numero uno problem.

So, an imminent economic collapse is unlikely, even if you think, as a few respectable forecasters now do, that growth in China has already lapsed to around 4% or so.

4% is plausible but if that indeed were the case, or even lower, would we not be seeing much stronger anecdotal evidence of a weak labour market? There are stories periodically in the South China Morning Post of Chinese migrant workers being told to go home early for the Chinese New Year holidays. Some are about workers being told not to return. The employment component diffusion index in the monthly manufacturing PMI is continuously below 50, ie employment is falling. The number of labour unrest incidents doubled to almost 2500 in 2015. These things are worrying, not least for the leadership. And so on.

At the same time, the idea that growth is 7%, when a barrage of indicators including profits, incomes and retail transactions are is falling or growing nowhere as high, looks increasingly suspect. Andrew Batson (China research director for Gavekal Dragonomics} says that China’s growth has slumped in Manchuria and other provinces where there is a concentration of old and heavy industry, and or exposure to the real estate sector that is now in decline, but still doing very nicely, thank you, elsewhere.

This reminds me of what far too many people said in the West in 2006-07, such as ‘It’s only the housing sector that’s overextended’, or ‘subprime loans are a miniscule proportion of bank assets’, or ‘it’s just sector-specific’. Yeah, right. What they missed was the rest of the iceberg of leverage and indebtedness, and how a a sudden interruption in funding, asset prices and growth exposed something that was systemic, not sector-specific.

China Rising.


This is what I think these optimistic analysts, and some cheerleaders, miss. China’s real estate downturn is the leading edge of something broader. Rebalancing is kind of happening by default, as the investment side of the economy falters, rather than by design of pro-household wealth transfers. Reform, including the newest focus on ‘supply side reforms’ that some erroneously liken to those of Thatcher and Reagan, will count for nothing if the government fails to lower the pace of debt accumulation or to allocate the costs of paying for bad debt to itself and to companies, including notably state enterprises. You can, and should if you have the time, read much more about this from the venerable Michael Pettis. Be warned, it’s 72 pages, but it’s nail on head stuff.

So, David Blanchflower scored a hole in one, I think, with his warning shot to Corbyn et al, and vital it is to the UK, of course. But China’s leaders and Xi, himself, need to get a grip on the economics of what they’re grappling with too, and they aren’t economists. They’re mostly engineers, who think about problems and solving them rather differently. Li Keqiang, the Premier, is a PhD economist and highly regarded in the international community, but his political position has been sidelined by Xi’s centralisation of power around himself and his creation of ‘small leading groups’, or large Party agencies that are usurping ministries, and the economic power and influence of the Premier, himself.

Meantime, watch the Yuan. Management of the Yuan may ostensibly lie in the hands of the economically sound  People’s Bank of China, but the strategy call lies with non-experts elsewhere. For now, things have quietened down. I discount the idea that the Yuan will be floated, because this would be to lose control.

The options are…

  1. A drip-feed depreciation against a strong US dollar, while keeping the basket value stable, the least contentious.
  2. Or a small 5-10% devaluation that only serves to trigger more capital flight and depreciation expectations.
  3. Or a large 20-40% devaluation that sets off financial instability in China and around the world.

We might get all three, in that sort of sequence, but if you twist my arm, I’d go for the limited  depreciation option, perhaps the second, but in any event accompanied by the tightening of exchange and capital controls, and the rollback of financial liberalisation. Control, after all, is the raison d’etre of the Party.

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.

Follow him on Twitter at @georgemagnus1. See his website, with links to his work. His books appear below.

For More Information

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?

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…

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.

Age of Aging
Available at Amazon.
Available at Amazon.

6 thoughts on “Magnus: China’s leaders must choose: political power for them, or economic growth for China”

  1. I started reading up on China’s economy after my first visit in 1967 and haven’t stopped. During that time I must have read thousands of articles like this one. Not a single one turned out to be right, yet writers continue to write them and Western readers hail their wisdom and inevitable realization.

    Why has nobody stopped to analyze this strange phenomenon? Thousands of utterly wrong opinions about an important matter. All disproven by observation, over decades.

    They’re all lazily written (e.g., ‘China’s biggest economic problem of the moment, namely its passive attention (at best) to excessive credit creation and debt’)* and completely void of understanding how China’s economy was designed and operated (hint: not like ours). I’m guessing they’re a form of “this can’t be happening”, a fervent wish/preayer that Western domination of the world economy is ending.

    Will the West will wake up to the fact that the Chinese specialize in everything – every aspect of human enterprise and endeavor – and bring twice as much intellectual firepower to bear on each area as the combined efforts of the West? In other words, the Chinese are eating our lunch.

    * How China’s integrated economy works:

    China’s debt:
    China’s debt fragilities are over-stated. They don’t threaten the model. In real life, corporate net debt is near zero, private savings are $3 trillion, foreign reserves $4 trillion. The proof is in the numbers. Not just headline growth, but stable and low inflation, strong wage growth and rising tax revenue. China’sDebt to GDP ratio is the best in the world, according to the World Bank’s figures. While Japan struggles with a 390% debt load and no growth and the US grapples with a 290% load and little growth, China’s 209% and 7% growth is functionally negligible.
    Chart .

    Bad Loans: China’s Banking Regulatory Commission says that the trend of rising bad loans, or non-performing loans, is within expectations, and overall risk is under control. Official data showed non-performing loan ratio at China’s commercial banks rose to some 1.6 percent at the end of September, while loan-loss provision coverage ratio, the ratio of provisions held to gross non-performing loans, stood at some 168 percent. The total of NPLs across Europe is about 1 trillion euros ($1.1 trillion), equivalent to the size of Spain’s annual gross domestic product (GDP) and 7.3 percent of the EU’s GDP. Non-performing loans (NPL) across Europe’s major banks averaged 5.6 percent at the end of June, down from 6.1 percent at the start of the year. But that compares with an average of less than 3 percent in the United States.

    Public sector: From 2010 to 2014, the growth pace of the public sector’s net assets averaged 8.6 percent, according to the finance research institute under the People’s Bank of China, the central bank. Total net assets of China’s public sector, including government executive departments and state-owned enterprises, was 113.8 trillion yuan (US$17.2 trillion) by the end of 2014. The research also showed that the debt risk of the public sector is under control, with debt growth dropping from 26.6 percent in 2011 to 13.2 percent in 2014.

    ROI of China’s government debt: The St Louis Federal Reserve estimates that the multiplier on Chinese government spending is two. In other words, the economy is creating surplus capital to replace that which is destroyed. Finally, there’s exports, which validate internal data: China is taking global market share and prices are falling even as wages and currency rise. What’s happening externally is surely happening internally. A couple of suggestive data points: Is Government Spending a Free Lunch? — Evidence from China – Federal Reserve Bank of St. Louis Working Paper. Xin Wang and Yi Wen: Perhaps even more exceptional is China’s extensive use of government spending as a major policy tool to stimulate the economy over the past three decades. Our analysis supports the large multiplier found in China but also suggests that government spending may not necessarily be a free lunch despite the large multiplier. We show that (i) government spending in China Granger-causes output and investment booms as well as inflation, and (ii) it has a multiplier close to (or larger than) three.

    A final thought about the imperialistic tone of the above article: “China’s leaders and Xi, himself, need to get a grip on the economics of what they’re grappling with too, and they aren’t economists. They’re mostly engineers, who think about problems and solving them rather differently. Li Keqiang, the Premier, is a PhD economist and highly regarded in the international community”.
    Has the author not noticed that China’s engineers have worked miracles with their economy (raising 700 million from poverty while simultaneously creating a billionaire every month), and that American economists have destroyed ours?

  2. Richard Vague is worth reading in regard to China. According to Vague crises occur reliably when total private sector debt grows significantly faster than GDP in a run up to the crisis. This certainly applies to China whose private debt to GDP ratio has exploded over the past seven years. Private debt to GDP is well above 300%. Another harbinger of crisis as per Steve Keen. Time will tell but Vague especially makes a strong case for impending crisis in China.

    1. Peter,

      Yes and no (as usual in economics). High levels of private debt can cause a “crisis” a term too vague for use. More accurately, it can cause a recession. It is unlikely to cause anything worse — such as debt deflation leading to a depression — unless the banks are substantially affected.

      This makes China’s situation complex to interpret. Much of the debt is on State-owned Enterprises (SOE). Are these private or pubic entities with respect to debt? If the latter, then in a crisis the government can fold them onto its balance sheet — as the US did with the Government-sponsored enterprises (e.g., FNMA) during the mortgage bust. Ditto for the banks, where there is are precedents for the government socializing their bad debts.

      You can easily tell the real China experts from the faux ones: the faux ones give confident, often grandiosely so, predictions. The real ones, like Magnus, are much more cautious.

      1. I too admire Magnus. I would love to hear his take on the growing meme of heterodox economists that private debt is important because, strictly speaking, banks do not simply intermediate between savers and borrowers, but rather can and do create new money when they lend. This, they say, is what we got wrong in 2008, what Japan got wrong in 1992, and it is what China may get wrong starting about now.
        This is their interpretation of Minsky, that money supply expands thru bank lending before a crisis and money disappears the same way during a banking crisis.

  3. Pingback: The Dragon that Blows Bubbles | al fin next level

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.

Scroll to Top
%d bloggers like this: