Despite being opaque, confusing and occasionally dysfunctional, the Chinese leadership has exhibited something close to genius in its ability to dodge financial bullets.
ChinaÆs unfashionable capital controls have once again (in the face of slumping equity markets in the rest of the region) proved to be highly effective in insulating China from the meltdown affecting other developing countries in the region (while the Shanghai A-share market was down 2% yesterday, it is still up 78% year-to-date).
"The capital controls are clearly binding at the margins. You have seen major sell-offs in other low-income countries around the region, but much less so in China," points out Jonathan Anderson, UBSÆ chief China economist. "It shows that under certain circumstances, capital controls are very effective."
Just as China avoided the worst of the devastation during the Asian financial crisis by being insulated from the withdrawal of international capital flows (thus managing to avoid a currency devaluation), the same has happened now.
Emerging markets are especially sensitive during times of doubt because of their higher risk profiles. So that means they usually get clobbered.
But China has largely escaped this fate. Even if China does see a slowdown in its export markets, its strong fiscal position and abundant domestic liquidity will help tide it over during a fallout.
Yet ChinaÆs incredible financial muscle is paradoxically not matched by an efficient financial system. ThatÆs lucky for the US, as itÆs ChinaÆs ramshackle financial system which is partly causing it to be locked in its low-price, high-cost export model.
ChinaÆs weak financial system means that it does not have the wherewithal to manage its money in an efficient way, so it essentially outsources its money to the US government.
In the short term, thatÆs good for the economy. Buying up US dollars keeps the renminbi low, and permits exports to flourish. The export earnings get changed to US dollars and spent on US securities û a virtual cycle, of sorts. It does, however, diminish the purchasing power of the Chinese, and hence their standard of living. To lower costs, it also encourages a disastrous mispricing of numerous inputs, especially environmental ones.
The export model came about at the end of the last crisis, according to Paul Cavey, Macquarie BankÆs China economist. ôAfter the last crisis in 1998, the Chinese government decided to stimulate the economy through massive infrastructure spending. This helped China become export-oriented, as it facilitated labour intensive industries,ö he points out.
The export model makes China vulnerable to how the rest of the world is performing economically û especially the US, its major export partner. Yet the US is also considered ChinaÆs prime geopolitical and ideological threat by some quarters of the leadership.
The export focus means China is locked in an infernal cycle of exports, profits, sterilisation and recycling of export earnings into US assets.
In the short term, itÆs worked. The huge sacrifices made by China in terms of its weak purchasing power, ruined environment and warped social framework have resulted in a mountain of cash. But a lot of that wealth is denominated in US dollar, a weakening asset class with a bleak outlook. And itÆs wealth that canÆt be spent domestically without endangering the export performance. In effect, China canÆt spend the fruits of its labour.
China will decide at some point that the wealth itÆs accumulating in US dollars is depreciating too rapidly for the accumulation of it to be worth the sacrifices. The leadership has always had an aversion to its dependence on export markets anyway, since they are not controllable.
At some stage, the leadership may decide it has sufficient resources to ægo it aloneÆ û that is, invest more domestically, and have a stronger domestic market. The easiest way to do this would be to accelerate the revaluation of the renminbi. This would essentially be a transfer of US purchasing power to China. And it would be a zero sum game. And all that forex could be converted into renminbi and used on health and education, two dreadfully under-funded areas in China.
ôHealth and education improvements would, in the long term, have a very beneficial effect on the economy," notes Cavey. "They would reduce the need for household saving and that would stimulate consumption."
With a stronger renminbi and more security, the Chinese could even start importing more from the US û although itÆs no longer quite clear what they would want to buy, other than some rather cool military equipment.
There are many signs this shift is already happening naturally. Foreign venture capitalists, for example, are moving away from unproven technology companies and buying stakes in traditional industries with a domestic focus. Local venture capital (VC) companies are following suit.
Interestingly, no VCs invest in export companies. öMargins are bad and costs are rising. Boto, the Hong Kong-listed Christmas tree manufacturer, also had a lot of problems a few years ago, which became well known û one of their rivals started dumping goods, which really hurt them. That, and other things, put investors off,ö says one VC investor in China.
The new breed of investee companies is increasingly being listed domestically - some eight companies have been domestically invested and listed in Shenzhen so far.
But a pre-requisite to a domestic focus would be a properly functioning financial system. With exquisite irony, the Wall Street banks are standing in long lines to teach the Chinese the tricks of sophisticated investing and financial management. Once Chinese houses clean their act up, they will be far more able to cope with the huge assets they have accumulated onshore.
Whether itÆs this downturn or the next one, watch out. Private equity specialists talk about 'keeping their power dryÆ, just as China is doing with its foreign exchange reserves. But however long the power stays dry, the purpose, at some point, is to use it.