Two weeks ago we participated in investor meetings at the Spring IMF Meetings in DC. One of the key concerns expressed by investors was a possible hard landing in China. By now this is a repetitive subject in our writings, but what concerns us as much as a hard landing is the apparently generalized view of the Chinese economy as a centrally planned economy that can be managed at will (thus the Atari reference). Most discussions about the hard landing scenario for the Chinese economy were apparently pacified with the argument that the authorities will continue to manage to produce the economic results they set themselves to achieve. We believe this is naïve, and sets markets up for a sequence of shocks from economic disappointments coming from Chinese data, not unlike the recent bout of volatility.

Investors as well as officials from multilateral institutions such as the IMF seem to believe that the Chinese authorities will achieve the targets they set themselves, while managing current challenges and put in motion the recently announced ambitious reform plan. Let us review a concise (and potentially superficial) list of challenges:
– Convergence: we have said this many times before, but growth rates in the 8-12% area are not sustainable, and high growth economies eventually converge to more normal secular rates below 5%. Some do it with a drastic change and crisis, others more smoothly. But it is now clear that China is not going back to growing more, but it is in a path to grow less. This transition presents multiple challenges. The one we can understand is that of market perceptions, which expect China to continue to post high rates of growth, in the 7-8% area. We believe this has risks.
– Inducing rebalancing of the economy, away from investment and exports into higher consumption. China’s economy has the lowest share of household income (thus consumption) of almost any other economy you might compare it, by far. In the last decade the growth model exacerbated the cross-subsidy of capital by households. Pushing for a change of that requires household income (therefore consumption) to grow much faster than the economy. There are arithmetic constraints and economic constraints to workers income growth. Many believe that it requires lower GDP growth.
– “Quality growth” is a phrase we heard in Washington as an objective of the current reform effort. Better growth is most likely the result of a freer resource allocation, which requires less central planning and relying more on market forces, which goes against the ‘Atari’ view of China that markets seem to prefer, relying on the government’s fine tuning to deliver what is forecast.
– Controlling credit growth: many argue there has been a credit bubble in China. The fact is the government is clearly trying to reduce the pace of growth of credit, while minimizing the persistent local liquidity shortages and volatility in local money market rates.
– Managing the elimination of moral hazard in savings vehicles: China’s savings outside of the banking system, in the so-called ‘shadow banking’ reached almost USD 1.9 trillion in March. Since last year the underlying assets of some of those Trusts went into serious trouble, and early this year a few of those vehicles were to default and underwent a type of bailout in different guises. Investors have not lost anything commensurate to the loss in the underlying asset. The government is clearly managing the process to slowly eliminate moral hazard without causing a panic with respect to financial instruments.
– The capital account is gradually being opened, which together with the previous points would present a challenge in most countries, except for the level of reserves in China, as well as the kind of controls still in place.
– The exchange rate has changed trajectory, after years of secular slow appreciation the government has decided to show it is no longer a one-way bet. When asked about CNY convertibility, G7 officials said that 2-3 years would be too soon.
– Anti-corruption campaign: clearly the new government (since 2013) has started a serious campaign to reduce the economic impact of corruption. This is a tremendously challenging task in such a large economy with such a sizable presence of the public sector through state-owned companies.
– The environmental effort is part of the reform process, and the government appears to place serious hopes in the green sector as a source of growth taking the slack of inefficient sectors that would shrink as reforms introduce more competition in the economy.
– Foreign policy is a challenge, as China steps up to accept its size and relevance in the world. As a speaker said in Washington, China is going through its Monroe Doctrine moment, flexing its muscles in the region. We believe the Monroe Doctrine applies with difficulty to today’s Asia, as there are other sizable powers in Japan, India, and let us not forget Russia. This was not the case in early 19^th century Americas.

The list could go on and on (even without touching on the potential for a political transition to democracy). The issue is that markets accept the central government can engineer a smooth convergence process, with growth in the 7.5% area for a couple of years, while managing all those internal challenges while fending off potential exogenous shocks (e.g. higher G7 rates, commodity prices swings, geopolitics, etc.). Recent events are a good example. Economic data in China has disappointed since the beginning of this year, and we believe it is a key factor in the poor performance in markets this year, not to mention the volatility in the last 2-3 weeks. However, most forecasters believe that the government’s recent focus to accelerate infrastructure spending will be enough to bring the economy back to the 7.5% growth pace it set its aim at.

We have a somewhat more skeptical view of central planning, especially in the face of so many serious challenges and a great number of different objectives. We remain convinced that China is the single most important source of volatility in markets in the coming years, as its reforms and convergence are historical and cyclopean in nature. The nature of the challenges and risks naturally push observers to wishful thinking. This is why we continue to write about this, and spend so much time monitoring.