James Fallows, writing in the Atlantic, has produced a fascinating piece on China’s fund. I have covered the emerging sovereign wealth funds several times already (1 2 3 4 5 6 7), however, Fallows’ piece is one of the more economically literate I have seen on the subject.
Most writers presume that the so-called “export-lead growth strategy” has something to do with economic growth because of its name. But naming something incorrectly does not prove cause and effect. I drank a dozen beers before getting in my car and called it the “beer-lead safe driving strategy”, that would not make it so. In terms of its actual effects it should be called the “export subsidization savings-wasting strategy”. Fallows does a great job of explaining how the currency peg generates more investment in export sectors at the expense of a lower standard of living for Chinese consumers:
- Any economist will say that Americans have been living better than they should–which is by definition the case when a nation’s total consumption is greater than its total production, as America’s now is. Economists will also point out that, despite the glitter of China’s big cities and the rise of its billionaire class, China’s people have been living far worse than they could. That’s what it means when a nation consumes only half of what it produces, as China does.
- Some Chinese people are rich, but China as a whole is unbelievably short on many of the things that qualify countries as fully developed. Shanghai has about the same climate as Washington, D.C.–and its public schools have no heating. (Go to a classroom when it’s cold, and you’ll see 40 children, all in their winter jackets, their breath forming clouds in the air.) Beijing is more like Boston. On winter nights, thousands of people mass along the curbsides of major thoroughfares, enduring long waits and fighting their way onto hopelessly overcrowded public buses that then spend hours stuck on jammed roads. And these are the showcase cities! In rural Gansu province, I have seen schools where 18 junior-high-school girls share a single dormitory room, sleeping shoulder to shoulder, sardine-style.
The accumulation of reserves is a form of “forced savings”, as Fallows explains:
- China’s savings rate is a staggering 50 percent, which is probably unprecedented in any country in peacetime. This doesn’t mean that the average family is saving half of its earnings–though the personal savings rate in China is also very high. Much of China’s national income is “saved” almost invisibly and kept in the form of foreign assets.
The forced savings is implemented through the fixed currency exchange rate. When exporters receive dollars by selling products to Americans, they take the dollars to their local bank, which must “surrender” them to the Chinese central bank for a quantity of Chinese currency based on the fixed exchange rate. Because the fixed rate is lower than the market rate would be, the Chinese central bank over time accumulates dollars. These dollars have accumulated to the tune of over $1 trillion. After suffering negative real returns year after year as treasury yields were lower than the rate of depreciation of the dollar, some of the central planners have decided to “invest” a portion of their reserves in stocks. The first part of the article tells the story of how the state investment fund has lost $1 billion on the Blackstone IPO.
The article shows that the capital allocation process is not economically driven at all; on the contrary, it has become entirely has become totally politicized. A career communist party bureaucrat who “has never bought a share of stock, never bought a car, never bought a house.” was put in charge of investing the fund. Every purchase they make is decoded semiotically as some kind of signal to the rest of the world about Chinese geopolitical intentions:
- Foreign observers also suggest that, even after exposure to the Lou Dobbs clips, the Chinese financial leadership may not yet fully grasp how suspicious other countries are likely to be of China’s financial intentions, for reasons both fair and unfair. The unfair reason is all-purpose nervousness about any new rising power. “They need to understand, and they don’t, that everything they do will be seen as political,” a financier with extensive experience in both China and America told me. “Whatever they buy, whatever they say, whatever they do will be seen as China Inc.”
Fallows, however, does not question that China’s economic activity is real growth (and also believes that economic growth causes inflation). In fact, economic growth has nothing to do with inflation (which is a monetary phenomenon — real growth causes falling prices):
- Neither government likes to draw attention to this arrangement, because it has been so convenient on both sides. For China, it has helped the regime guide development in the way it would like–and keep the domestic economy’s growth rate from crossing the thin line that separates “unbelievably fast” from “uncontrollably inflationary.”
Not only Fallows, but almost the entire economic media believes that China is growing by 8-12% per year because their measured GDP is growing at that rate. GDP as Reisman explains, overweights consumption spending relative to production spending.
Real economic growth consists of the expansion of an integrated capital structure that is consistent with consumer preferences. A credit-driven boom also causes aggregates to increase. The cannot be distinguished from a credit-driven burst of activity entirely through the measurement of aggregates.
Lots of spending can be generated and aggregates boosted by pumping credit into an economy. This activity can go on for a while until it becomes clear that certain sectors of the capital structure are not economically rational. But until that point, the aggregate spending statistics look fine. What I suspect is happening in China is some combination of real growth and a credit-driven frenzy of mal-investment.
Their real economic growth in terms of creating an integrated capital structure consistent with consumer preferences is probably much lower than the reported GDP number would indicate. A lot of their “export-driven investment” is economically irrational because the currency peg encourages the development of an export industry for which there is not true (i.e. funded) demand, and because the forced savings resulting from the currency peg is “invested” by central planners who will largely waste it.