Has China ever had a leader as powerful as Xi Jinping? Many think not.
Not only does the “Red Emperor” have power, but he is also shouldering the massive burden of completing certain major projects: transforming the Chinese economic model and managing the structural weakening of the country’s growth potential, fighting corruption, opening up capital flows and controlling debt, which has skyrocketed since 2008. All these obstacles and pitfalls stand in the way of the Chinese president and could at any time cause a backlash from the Communist Party apparatus—some members have been lurking in the shadows and could be quick to take aim at the all-powerful Xi.
Against this backdrop, the volatility in recent months of the Chinese stock exchanges (Shanghai index falling 30% in just a few weeks) is a warning shot that should be closely monitored for any number of reasons. First, because it takes the wind out of the sails of proponents of the Chinese model and its amazing ability to ride out the consequences of economic and financial shocks. If they are to be believed, China had discovered the alternative model to the defective market system, some sort of enlightened state control. Recent weeks have dealt a serious, if not fatal, blow to this absurd idea, proving that the Anglo-Saxon model is not alone in exhibiting the defects of overleverage and wild speculation. Some may cheer—somewhat prematurely, in our view—the Beijing authorities’ swift action to slow the market crash. The measures it took, namely injecting liquidity, suspending sales by large shareholders and delisting shares outright, all significantly limited the market’s ability to function properly and shook traders’ confidence. These traders now know that market forces are capricious, which is never good news if the aim is to build long-term trust in the financial system.
The Chinese authorities will have to pay a price beyond the amounts spent to prop up the market in June and July and on a much broader front over time. The inclusion of Chinese stocks in the MSCI indices, the liberalisation of capital flows and the addition of the renminbi to the IMF’s SDR (special drawing rights) basket will certainly be postponed. That’s what could undermine Xi Jinping’s status and the strengthening of China’s global leadership.
The recent Chinese stock market crash also, if not above all, reflects the fundamental dilemma China has faced for several years: that of dealing with two irreconcilable problems through the repeated use of monetary tools. The massive post-2008 fiscal stimulus supported the Chinese economy (10-11% growth) at the cost of a rapid rise in debt, which now stands at 250% of GDP. The need to control this debt, which resulted from the real estate bubble and the weakening of local government finances, is what has led Beijing to tighten the monetary policy screws since 2012. It did so at the cost of a “collapse” in economic growth, which is now approaching 7%. And that is the squaring of the circle for Xi Jinping and his allies in a nutshell. It is in fact the need to support the economy—a slowdown could have caused social unrest—that has led Beijing to yield ground on interest rates since the end of 2014, thereby helping to fuel the Chinese stock market “bubble” for two or three quarters. It is, in some ways, a vicious circle!
The financial shock on the Chinese market at the beginning of the summer is clearly far from insignificant. It once again exposes the weaknesses of the Chinese model, and it clearly has some. It shows how difficult it is to manage economic and financial problems, a particularly arduous task given the inevitable transformation of the economy from externally driven expansion to a business climate dominated by domestic components. This explains why Beijing has been actively stabilising its currency against the dollar for several months, despite the reduction in foreign exchange reserves. In addition, the desire to have the renminbi added to the SDR basket certainly has something to do with the Bank of China’s stabilising action.
Which raises the question of Beijing’s larger role on the international economic and financial stage and within the Bretton Woods institutions themselves, which will require the full convertibility of its currency and thus the free movement of capital. The recent events on the Chinese stock market have understandably dashed the hopes of those who were the most optimistic about the timing of these major decisions, which must nevertheless be made.
Some consider Xi Jinping to be too powerful and his personal power to be incompatible with the collective leadership the Chinese Communist Party is accustomed to. He has major challenges to address. Financial instability and the recent stock market crash are making his job even more difficult and his margin of error even narrower. The interventionist solution has calmed things down, at least temporarily. But make no mistake, this is by no means a definitive solution. The march toward liberalisation will have to resume at some point. We believe that China remains a major structural risk for the world economy in the next 24 to 36 months. While we may be pleased that the recent GDP figures fuel hopes of a stabilising economy, we do not believe the China issue has been resolved. Quite the contrary.
François Savary - Chief Strategist - Banca REYL