10 February 2016.

Part III: Finance for China’s New Economy

Economic development is plagued by up and downs and, as the Korean example shows, the downs are irrelevant for long-term success if dealt appropriately. How serious are then China’s financial troubles?

China will not export instability
In aggregate terms recently Martin Wolf showed how China’s total debt as percentage of gross domestic product (GDP) is short of 300 per cent similar to America and Germany, a level that compares favorably to Japan at over 500 per cent or the UK at about 450 per cent. Moreover, China’s ratio of financial assets to  GDP is 4.4 similar to America’s. What is interesting is where the similarities with the US end: Chinese banking assets represent three times total market value for just 0.5 times in the US. China’s indirect financial system might be less sophisticated in terms of capital allocation mechanisms, but it is probably more stable and manageable. Moreover, China will not export instability; its system has fewer financial risk transmission channels. Most foreign stakes are in the form of FDI, investments in fixed assets, not in FPI or foreign portfolio investments such as securities, fixed income obligations or structured products. Foreigners hold no Chinese government debt or derivatives like they hold American mortgage backed securities, Greek or Mexican paper. Japan has gotten away with its stratospheric debt levels because its paper is domestically held, so this otherwise acrophobic situation constitutes no major global risk. China will hardly be the direct cause of a global Minsky moment the Lehmann way.

Once the dust settles you still have real assets
While China’s non-performing loans might not endanger the global financial system they might still create havoc at home. Here Minsky’s questions to assess a debt bubble come in handy. “What is being financed?” and “What is the pivotal source of external financing?” We saw how China’s debt supports capacity in manufacturing, infrastructure and real estate, hence some of it can hardly be repaid. On the other hand, the pivotal source of financing is saving deposits, not collateralized debt obligations (CDOs) or synthetic derivatives, even in the extensive shadow economy. Hence leverage levels are contained and once the dust settles you still have real assets and are still the world’s factory.

What is essential is that China will have the choice not to subsidize financial firms to the extremes of zero interest rates and quantitative easing packages up the far reaches of the yield curve. Some economists secretly wish for a couple of years of low and even negative growth if it re-prices risk, accelerates creative destruction, reform and the liberation of assets from the old economy into the hands of new players. Today’s stock market troubles in China reflect the old economy’s struggles; about 55 per cent of the CSI 300 market capitalization is state owned enterprises (SOEs). Yes besides informal institutions, does China have an alterative financial system at all to support the new economy?

Partially, as the country is continuing to do what is has done best for the last thirty years: experiments.

More than traces of innovation
China's New Third Board (the National Equities Exchange and Quotations, or NEEQ) of mostly start-ups went from 25 titles in 2011 to 5,129 firms in 2015. According to China's Xinhua News Agency its market capitalization of USD 374 billion today is over four times that of 2014, with the index more than tripling in the last two years. Surely a speculative bubble; like Dot-com effervesce, one that will leave in its wake bankruptcies and a string of new firms that will propel the country, hopefully past the USD 17,000 barrier. Any foreign businessperson on a deep China dive sees more than traces of innovation. Social networks or payments systems like WeChat or Alipay are functionally much richer than Western equivalents. Shanzhai tinkerers are becoming unicorns; easy-to-fly drone-maker DJI or Xiaomi might just be the tip of the iceberg. Mindsets are changing to support technology faster than elsewhere and 12 per cent of China retail is already e-commerce; in the US and Europe the figure is about 8 per cent. The headline at wired.com after Alicloud’s victory at the GraySort competition was revealing: “China’s Alibaba Just Beat the US in a Global Machine Battle.”

The country already spends 2 per cent of its GDP on Research and development (R&D); whether at big data, DNA sequencing or renewable energies the marriage of Chinese scientific talent with business savvy and lateral thinking ought not to be underestimated in light of the coming Fourth Industrial Revolution. And where China’s innovation resources are yet insufficient it will employ shortcuts to fill the gaps. Sinochem’s 42 billion US-Dollar takeover bid for Syngenta is the outsourcing of the R&D innovation piece to Switzerland. As China takes strategic positions in the upstream segments of a business, knowledge density will be stimulated across all the Chinese parts of the value chain.

New business models are being conceived
China is one of the globe’s foremost spaces of tinkering and experimentation. Even the People’s Bank of China is mulling the creation of a national digital currency. Financial resources are heading towards the new economy; along this shift new business models are being conceived, much more aggressively than elsewhere. Of special interest are those in financetech, which might someday challenge even Wall Street. By the end of 2015 China had as much as USD 60 billion in P2P and 2,612 active lending platforms (notwithstanding the risks associated with disruptive models; eZubao collapse last month costing 900,000 investors about USD 7.6 billion). Money market funds are being distributed online by the likes Tencent and Alibaba. Yu’ebao has over USD 100 billion under management – beat that PayPal! Technology and services go hand in hand and here there news seem good: the Financial Times pointed to research by Goldman Sachs Asset Management showing that over the last decade services as a percentage of GDP rose from 40 per cent to 50 per cent.

A lift to global growth
In short, China’s future is to reinvent itself as new economy. The ultimate solution to the middle-income trap requires strong political leadership. In Mancur Olson’s terms, old dominant coalitions must be nudged; the old elites in energy, telecom or banking are to yield to more productive ones. Today’s lower growth and old economy troubles will not directly trigger a global financial crisis. Yet if the political leadership succeeds in reassembling economic elites, China will passage through middle-income. Such a movement will give a lift to global growth for decades to come.

What force could derail this shift? Once the People's Republic of China completes the transition to a consumption-based, services and innovation new economy with highly complex manufacturing clusters à la Germany or Korea, a future crisis in the Eurozone or Wall Street won’t matter all that much. Yet in todays 2016 Beijing’s main concern is not China, but precisely those areas beyond its influence. The lack of leadership in the West contrasts with China’s sense of purpose. Europe and the US forewent painful reforms opting for cheap money, an untenable general subsidy, and China senses payback time approaching. That is, a Minsky moment entirely of the West’s own making on the back of the artificial post-2008 financial system that Nassim Taleb of Black Swan fame would characterize as ‘Soviet-Harvard illusion’. Trying to pin the troubles brought about by political cowardice in advanced economies onto the challenges of a nation emerging at middle-income might not be entirely appropriate.

Picture: zanthia / photocase.de