Yuan SDR inclusion finally official

Everything has changed for the RMB, declares Business Insider. That is, for the long term:

In the long term, this means everything for China's economy. Here is Paul Mackel, HSBC's head of global EM markets FX research, on the long-term impact of the yuan becoming a reserve currency:

The significance of the RMB's SDR inclusion goes beyond the potential impact of inflows intoChina. It would encourage China to stick to a much needed financial and capital account liberalization. These would over time increase financial sophistication and improve the efficiency of capital allocation, facilitating the shift to a more consumption and service driven economy. It should give China confidence in making its exchange change rate even more market driven, which would free up its monetary policy. The SDR marks an important milestone of RMB internationalization.

But in the short term, as this article reiterates, the effects are muted:

Capital Economics states the matter clearly:

In practice, what determines whether central banks are willing to consider a currency a reserve asset is their confidence that they can sell that asset whenever needed into deep and liquid markets. Inclusion in the SDR basket could be taken as endorsement by the IMF that the renminbi and China’s financial markets meet this standard. But central banks are likely to come to their own judgement (as they have in their purchases of Australian and Canadian dollar reserves).

And of course, central banks worldwide have barely begun buying yuan-denominated debt directly; this largely symbolic decision doesn't change much on the ground in that regard.

The relatively high weighting of the yuan in the SDR - 10.92 percent versus 8.33 percent for the yen and 8.09 percent for the pound - is an acknowledgement of China's sheer size and heft, far more than its present status as an internationally used currency (still less than 3 percent of all global currency transactions and not even 1 percent excluding Hong Kong).

Quartz cites the RMB's chances of becoming a true reserve currency in the next 3 years at 0 percent, stressing that the recent increase in international yuan transactions has been driven by offshore speculation in Hong Kong. Still, the 1 in 50 estimate for the next 8 years seems too pessimistic considering Beijing's pledge to liberalize the capital account in 2020. I guess we'll have a better idea a year or two or now - at which point the yuan should be no higher than 6.8 or 6.9 to the dollar - just how much sway the reformers led by central bank (PBOC) governor Zhou Xiaochuan really have with Xi Jinping.

Still, this post is to mark another milestone in China's long march to integration with the global economy.

Meanwhile, there are finally some signs of life on the state-owned enterprise (SOE) reform front; I will be posting more about this in future.

The "Asiatic mode of production": imperial China as the world's principal example of "hydraulic despotism"

Previous: Marx's "Asiatic mode of production" in the context of China's rise: Introduction

Back when I was a freshman at New York University in late 1999, I did a term paper and presentation about China's water scarcity crisis for an ecology class; my professor expressed stunned disbelief when he asked me what percentage of Chinese agriculture is irrigation-based, and I answered about 70 percent. At the time, I didn't realize that this was an exceedingly high figure for such a massive country. Nor had I any inkling that mass irrigation itself is very peculiar to Eastern, i.e. Oriental economies; rainfall agriculture has historically predominated in the West.

Karl August Wittfogel's magnum opus, "Oriental Despotism", has uniquely contributed to the understanding of Chinese civilization as the world's principal example of "hydraulic despotism", which more or less means centralized bureaucratic administration of food production, notably through large-scale irrigation systems.

In fact, so distinctive and definitive is the water-controlling aspect of every large pre-industrial empire - notably China, India, Persia, and the entire succession of empires that have ruled the Fertile Crescent and Egypt - that for Wittfogel the term "hydraulic despotism" is synonymous with "Oriental despotism."

This reflects the obvious observation that these most successful instances of hydraulic despotism were of Asiatic, non-Western origin; just as telling, the only notable European adoption of this centralized hydraulic governance was via the Greco-Roman colonization of the eastern Mediterranean and Middle East in classical antiquity (circa 300 BC - 300 AD), which brought the longstanding hydraulic civilizations of the Nile and Tigris-Euphrates under their control, which lasted until the Eastern Roman (Byzantine) empire was pushed out of these regions by the Islamic Arabs in the late 600s.

Hydraulic despotism's poster child: imperial China

But China exceeded every other hydraulic empire in the combined measure of durability, size of territory controlled, and population administered. Needless to say, its distance and isolation from the other hydraulic empires contributed to the continuity of its contiguous core area of control; but scholars and historians have nonetheless found China singularly remarkable for its resilience as a politico-cultural unit through so many upheavals, be they internal revolutions or external invasions and even outright conquest at times by alien peoples.

It's not surprising, then, for Wittfogel to uncover the very deep origins of scaled irrigation agriculture and flood control in China: they apparently go back as far as the initial Xia and Shang dynasties of the second millennium BC along the middle to lower reaches of the Yellow river valley and the north China plain. Granted, this was actually later than similar developments in Egypt and Mesopotamia, but it appears that by the late Shang and early Zhou periods (circa 1200-800 BC), increasingly large and coordinated systems of irrigation and flood control infrastructure rivaled or exceeded those anywhere in the world, laying a formidable foundation for political centralization of an ever-growing magnitude. This was in the millennium before the first empire, Qin (221 BC).

The socioeconomic and sociopolitical dimension of extensive waterworks is quite striking. Wittfogel betrays a Western emphasis of concern for the obvious loss of personal autonomy that entailed participation in large constructions that necessitated top-down supervision - and concomitant coercion - of conscripted menial labor. From the Orientalist perspective, however, all this loss of freedom was a token price to pay for what back in those days was as great a miracle as would be chemically altering desert sand to make it fertile and arable today; it was part and parcel of Oriental society that bringing water to dry areas while simultaneously stopping destructive flooding was a quasi-divine, mythic undertaking that conferred an extraordinary legitimacy to its organizers and a strong implicit acceptance of hardship, toil, risk, and even abuse for the prize of a more habitable earth for one's posterity. Thus where the West sees the loss of individual rights, the East sees the foundation of generational stability in the formulation of a basic bond of respectful interdependence between ruler and subjects - the origins of the "mandate of heaven."

In any case, Wittfogel treats well the complex social-organizational aspects of the ancient hydraulic infrastructure projects. Not only labor, but also building materials, tools, supplies - and not least basic provisions for the workers themselves - had to be managed on an ever larger scale, demanding ever better coordination of interdependent or sequential sub-tasks that comprised the whole affair. Without doubt, as efficiencies and best practices accrued, the range, scope, and density of the hydraulic infrastructure all blossomed.

All this led to the rise of what Wittfogel calls the "agromanagerial" bureaucracy, the world's first true "apparatus" state - and, in fact, its only true apparatus state until the industrial era of modern Western bureaucracies (!). In all hydraulic empires, the power of the ruling sovereign became increasingly dependent on an elite group of these agricultural managers, whose principal task was to ensure proper irrigation; the efficacy of their administration was one and the same as the sovereign's own efficacy in enforcing his authority throughout the land, even as he sought various ways to curtail their inevitable political influence and ambition. The agromanagerial bureaucracy, then, is the very heart of hydraulic despotism: without it, even the sovereign himself is not so sovereign.

Wittfogel clearly lays out the enormous central power that naturally accrued to the organizers of the hydraulic infrastructure. With such a large and dispersed population dependent on irrigation, they pretty much ran the entire show; the fate of the people literally rested in their hands. The state became extraordinarily powerful; the society extraordinarily subservient. Through control of the nation's very lifeblood, the agromanagerial apparatus state naturally and easily performed such mass functions as censuses, land surveys and registrations, and - you're probably waiting for this one - universal taxation in such forms as surplus grain requisitions. Equally obvious, as Wittfogel points out, the universal conscription of labor and the organizational sophistication and discipline for large waterworks translated rather seamlessly into effective mobilization and supply of vast armies and the rapid construction of large defensive fortifications. The German Sinologist leaves little doubt: China's density and scale of hydraulic management was matched by its depth of study of the problems of warfare (including notably issues of logistics and supply), best exemplified by Sun Tzu's The Art of War.

China was actually a relative latecomer among the Asiatic hydraulic civilizations - it was, for instance, much later in entering the Iron Age than the Near East - but it more than made up for the slow start. By the Spring and Autumn period (771-476 BC), the ducal and other blood-vassal subdivisions of the Eastern Zhou crown had begun a process of consolidation into centralized territorial "hydro-states" in their own right. Fierce competition and warfare between these fledgling nations weeded out the weak from the strong, and a series of conquests and consolidations left only seven standing to confront each other in the Warring States period (475-221 BC), the twilight of pre-imperial China.

Thus, as Wittfogel observes, China, like other hydraulic civilizations, simply never had "feudalism" in the medieval Western European or Shogunate Japanese sense: the dukes and earls who ruled the large hereditary fiefdoms of the Eastern Zhou on behalf of their kin sovereign already had an agromanagerial bureaucracy they could rely on to run the regional and local administrations, with ever increasing experience and competence in the aforementioned agromanagerial functions. They thus did not have to parcel out land to lesser lords and nobles who would fray their central authority, but from early on such tracts were distributed as "office land" to state functionaries who, even if they did happen to be nobles, were completely beholden to their government service. By the time the fiefdoms reduced and consolidated into the Warring States, China had become a collection of just a handful of competing, increasingly absolute dictatorships. Unsurprisingly, this general period marked the zenith of Chinese societal and cultural development, including the Confucian philosophy - later peaks were attained through a combination of importation (i.e. Buddhism) and renewal or adaptation of the longstanding cultural base.

Again, we see the double-edged, East-West duality of this hydraulic civilizational expansion. On the one hand, by the 4th century BC the largest warring states of China could boast of cities and standing armies exceeding one million - figures that Western Europe would not match until the modern period. Such a boom of human life and activity was made possible by the agromanagerial bureaucracy of hydraulic despotism. On the other hand, the potential for further civilizational development and progress, particularly in the realm of ideas and systematic worldviews, was becoming increasingly constricted, even suffocated; the contrast between late pre-imperial China and its contemporary city-states of Greece, for instance, is quite glaring in light of the latter's strong advances in all manner of philosophy, reason, science and mathematics.

Perhaps China's fate was not inevitable even at this juncture, on the eve of Qin's ruthless campaign of conquest and unification in the 3rd century BC, which saw the western fringe state of the Chinese world push the limits of the agromanagerial model of governance to maximize economic and military power, merging this too with an outright barbarian mentality that had no qualms destroying much of the gentler and more universally humanitarian aspects of Chinese culture. But what's done is done...we are almost two and a quarter millenniums later, and the big question now is just how the world will deal with the new Oriental despotism of communist China - the new "Qin" - at a time when indicators abound that it is Western freedom and democracy which are in retreat, and the other Eastern autocracies of Russia and Islam look to Beijing as their guiding light.

The West - the only great civilization that arose and developed on a fundamentally non-hydromanagerial (non-agromanagerial) path of rainfall-based agriculture - may indeed have peaked by now in terms of hard military and economic power. But it has at least partly won the war of ideas; the Oriental despotism of today is not the worst of what it was in the 20th century under communism; at least some strands of Western thought and ideology seem too strong to be completely extinguished even in China or Russia should they truly turn culturally retrograde.

The next part of this series will treat the transition of hydraulic despotism from the pre-industrial era to its modern incarnation of totalitarian communism under Stalin and Mao, again referencing Wittfogel's great work.

Marx's "Asiatic mode of production" in the context of China's rise: Introduction

The "Asiatic mode of production", or more generally, "Oriental despotism", is an element of Marxist-Leninist thought that should be revisited today, in the early 21st century, in the context of communist China's dramatic rise to the forefront of the global economy.

Specifically, it will be argued here that the main continuity between imperial China and the People's Republic - namely, the all-pervasive bureaucratic apparatus state - is every bit as crucial to our understanding of modern China as the much more widely discussed discontinuity brought about by the communist revolution; in the final analysis, one can actually make the case that it is even more so.

As a start, China has been an empire since 221 BC, the date of its initial unification by one ruler, the first Qin emperor; indeed, the term "China" itself is derived from "Qin".

What is remarkable from a Western point of view is that practically all of the greatest innovations and developments in Chinese thought - notably the Confucian worldview - took root and matured around that date, that is, in the late pre-imperial (territorial states) and early imperial (especially Han dynasty) eras. In the subsequent two millenniums, Chinese civilization followed a very notable cyclical pattern of imperial rise, decline, and fall: while the dynasties varied in the degree of absolute political power they enjoyed as opposed to the civic strength of their subjects, their overall foundations for legitimacy were unmistakably little altered. In a nutshell, it boiled down to a so-called "mandate of heaven" of the reigning dynasty, based upon its ability to effectively administer and defend the imperial domain and thus preserve the exalted basic qualities of societal existence, namely stability and harmony.

In the modern age beginning around 1500, but especially since the industrial revolution about 1750, the stunningly rapid technological, socioeconomic, and ultimately political transformation of the West gave rise to an ever-increasing Western consciousness of the "otherness" of the East, i.e. the Orient, of which China among all the great eastern empires - notably Turkey, Persia, and India - appeared to be the representative par excellence. This otherness, in essence, was the apparently static and unchanging nature of Eastern society in stark contrast to the dynamism and progress of the West. Unsurprisingly, by the mid-1800s, as the industrial revolution accelerated to propel European Christian civilization into a position of unprecedented dominance over others, this awareness came to acquire an increasingly patronizing tone, and it would undergird the white man's imperialist colonization of most of the colored world in the closing decades of the 19th century and the early 20th.

It was in this context that Marx and Engels, among others, discussed what they termed the "Asiatic mode of production", or "Oriental despotism" per earlier Enlightenment terminology. Drawing from other Western thinkers, whether in their own day, such as John Stuart Mill, or from such earlier luminaries as Montesquieu and Hegel, they latched onto the central element of this peculiar form of non-Western autocracy: the seemingly all-powerful bureaucracy.

However, it was the 20th-century German Marxist/Sinologist-turned anti-communist, Karl August Wittfogel, who in 1957 published the definitive volume discussing this topic, "Oriental Despotism". Deeply disillusioned by the regressive autocratic retrenchment of both Stalinist Russia and Maoist China, Wittfogel laid the foundations for a systematic deconstruction of the pattern of continuity between Czarist Russia and the former and between imperial China and the latter; in doing so, he expounded upon the not insubstantial writings of the late 19th and early 20th century socialist thinkers - not least Marx, Engels, and Lenin themselves - to arrive at his critical conclusion that the entire theory of the "Asiatic mode of production" was deliberately abandoned by the Bolshevik revolutionary generation because it presented such a scathing indictment of the retrograde true nature of their supposedly progressive and scientific movement.

Today, as China is ruled by a party-state that continues to call itself communist but has obviously engaged in arguably the most blatant appropriation of public wealth for private interests in modern history, it behooves us to explore the possibility that, far from being an extraordinary deviation of the natural flow of human (specifically Chinese) affairs, it's more accurately a modern iteration of China's dynastic past of bureaucratic despotism.

What follows will be a multi-part critique on my own part of Wittfogel's aforementioned magnum opus on Oriental despotism.

Another flawed argument that Chinese communist rule is imploding

Minxin Pei's recent piece arguing that the CPC's rule in China is in its twilight recalls similar analyses earlier this year, perhaps most notably David Shambaugh's "The Coming Chinese Crack-up" in the Wall Street Journal back in March.

I disagree that the CPC is on the brink of collapse. I could be wrong, of course, but I'd like to point out that both Minxin Pei and David Shambaugh represent a strong strand of opinion that wishes, rather obviously, that the severe pressures apparently bearing on CPC rule will lead to a crisis that will give an opening for the reform and liberalization that have been absent since 1989; in this hope, they are misguided and have misread the meaning of the undeniable changes in the Xi Jinping era.

I think it's already obvious by now that the post-Tiananmen era - but more generally, what I call the "extended Deng Xiaoping era" (1978-2012) - has ended with the leadership of Xi Jinping. But this hasn't necessarily made the regime weaker and more brittle; or even if it has, China is so much wealthier now than back in the 1990s and even early 2000s that it makes the immediate threat of mass social unrest and revolution a rather distant prospect.

Granted, the evaporation of what Minxin Pei calls "elite unity" is troublesome for continued party rule. But this overstates the degree to which the elites were actually united during the Jiang Zemin (1993-2004) and Hu Jintao (2004-2012) eras to begin with. Whatever loss of unity at the apex of the CPC power structure has been a long time coming - and it has arguably been much worse at different points during the past decade than it is today, when Xi Jinping's single-handed authority seems rather impregnable, at least publicly.

True, there have reportedly been no fewer than 20 assassination attempts on Xi Jinping since he assumed office, most of which, it would appear, are connected to disgruntled or fearful officials caught in the crosshairs of the anti-corruption campaign. So yes, it goes without saying that discord within the party has potentially catastrophic consequences.

On the other hand, as Xi's power further entrenches and consolidates, much more than mere enmity, dread, or hatred of the top leader will be needed to mount any serious attempt to undermine, let alone overthrow him. As Xi locks down his control of the military and internal security apparatus - early this year, for instance, he apparently replaced his elite personal security detail with more reliable loyalists - his enemies must contend with slimmer and slimmer chances that they could seize power even if they do somehow eliminate Xi himself. This will alter all their calculations of risk and cost versus potential gain and reward with respect to any scheming to remove Xi, even as it heightens their awareness of the immediate danger to themselves should they be suspected of treason.

Even more significantly, in my opinion, the recent simultaneous crackdown by Xi against civil society, internal party liberals, and nongovernmental reform groups, far from being a sign of his regime's incoherence or paranoia, is probably itself a cunning CPC power play. It's Xi basically telling the party elite and even the rank-and-file apparatchiks, "I have every intention of keeping us in complete charge of the country, with no external limits on our authority; but that's exactly why you must support my harsh measures to clean up our own mess, because if you don't let me do it, you'll only empower those who hate all of us, clean or dirty alike."

Xi Jinping is no Jiang Zemin or Hu Jintao; neither is he a Deng or a Mao; he isn't many of the things that many of us wish he were. But if anything, he's an exceedingly gifted politician who has decades of practical knowledge of the actual (not merely theoretical) workings of power and statecraft. None of his prominent critics in the Chinese world have anything remotely rivaling the résumé he boasts in that regard.

That being said, at least for the time being, Xi also seems to be able to count on much popular support for his anti-corruption purge, as well. Coupled with his strong nationalism, this appeals to the very real element of jingoistic pride in Han supremacy that was strongly nurtured throughout the post-Tianamen era (1989-2012), and is now a driving societal force with increasing international significance in the post-post-Tiananmen (i.e. Xi Jinping) era.

And even here, he is cold, cunning, and patiently methodical, driven less by emotion than by colorless hard calculation: don't count on him to overreact stupidly to Western, American, and regional efforts to check Chinese assertiveness. Like any smart nationalist strongman, he'll wait until popular demands for aggressive coercion against foreigners reach such a boiling point that by the time he actually pulls the trigger, he can claim to have exercised remarkable restraint.

All of this, in my humble opinion, is more bad news for liberals, reformers, and Westerners fearful of China's rise than it is for the CPC itself.

China's response to ISIS and its own radical Islamist problem

China has censored social media discussion of the recent killing of one of its nationals by ISIS, apparently fearing too much discussion will make its inaction look bad to its own citizens. Meanwhile, it has reported killing 28 "terrorists" in Xinjiang that it claims were local Islamic radicals tied to a foreign extremist group, and took a swipe at Western "double standards" on terrorism even as it offered condolences for last week's Paris attacks.

How big is the radical Islamist problem in China, specifically Xinjiang? It's definitely worse than the official state media makes it out to be, and has become a chronic security issue since the big Urumqi riots in 2009, which now claims hundreds of lives annually. That being said, it's hard to think that this isn't a problem Beijing has largely brought upon itself. Its policies - jailing moderate activists, banning veils and headscarves, restricting Ramadan observances, and compelling Sinocentric education - are pretty much a wish-list for ISIS, Al Qaeda and other international jihadist groups to get young Uighurs to join their ranks. If anything, the minuscule number of Uighurs that have actually been seen with such groups in places like Syria and Afghanistan is an indication of the longstanding moderation of these Muslims.

Or, if China really messes things up with its heavy-handedness, this could be the early stages of something much worse: a far broader politicization of Islam in the Uighur population, including violent radicalization. That would be the opening for ISIS or Al Qaeda to actually establish themselves within Chinese borders.

The aspirant ISIS caliphate includes a good chunk of western China, including Xinjiang:

What does Xi Jinping's commemoration of Hu Yaobang mean?

Xi Jinping has lauded Hu Yaobang on the occasion of the 100th birthday of the famously fallen liberal party leader of the 1980s whose death in April 1989 triggered the Tiananmen protests. What does it mean?

Most likely, similar to his recent ploy in meeting President Ma of Taiwan, Xi is demonstrating ideological and political flexibility and practicality. The message he's sending to Chinese liberals is: "You don't have a monopoly on the legacy of our greatest reformers." Just like with the Ma meeting, he was telling Taiwanese: "Your fate ultimately lies with the Chinese world, not in drifting away from it."

These are subtle but politically astute moves for someone who has demonstrated a willingness to be tough and uncompromising on the fundamentals of CPC rule.

Perhaps Xi will one day reveal that he was privately sympathetic to the cause of political reform of both Hu and Hu's similarly disgraced successor, Zhao Ziyang, whose timidity during the 1989 Tiananmen crisis sealed the hardliners' triumph within the party before the June 4 crackdown. After all, his father had benefited so much from the bold reforms of the Deng era, which secured Xi Jinping's own political rise. Or maybe Xi wasn't too happy with his father when the elder Xi took a costly pro-Hu stance against the conservatives, effectively marginalizing himself within the council of "eight elders" that ruled China as the informal trustees of the revolution during Tiananmen.

Whatever the truth of the matter that can't be brought to the light yet, I encourage all Chinese liberals and China watchers hopeful of eventual political reform to grasp at the positive aspect of this commemoration of Hu by Xi: if we share a common figure of admiration and respect with Xi Jinping, that's a potential point of future accord.

Or to put it more bluntly, we should at least be thankful that the most powerful princeling of the current generation of leaders also happens to be the one most closely connected to the early reformers...considering how things nearly went awry with Bo Xilai, we shouldn't take this for granted.

What the yuan's SDR inclusion really means

A Financial Times piece lays out the true significance of the yuan's inclusion in the SDR, now all but a foregone conclusion. In essence, it says that this is indeed a watershed moment for the Chinese economy's global integration, even if the short-term effects appear muted.

Beijing's aspiration to dismantle capital controls by 2020 seems quite ambitious, but SDR inclusion strengthens the hand of those, led by PBOC governor Zhou Xiaochuan, who are officially committed to liberalization. On the other hand, it also raises the stakes: any major retrenchment from here on out will represent a severe breach of goodwill and trust, and that's assuming that the liberalization doesn't get bogged down to begin with.

Business Insider presents a Standard Chartered Bank matrix of how the different types of capital will be liberalized.

The CPC isn't in fact relinquishing control of China's finances; it's merely switching gears to do it with more efficient, repeatable processes, reducing the need for ad-hoc micromanaging. Further, it knows that an unfettered yuan is a requisite for the intensified regional trade and development competition that's heating up with the US in the Asia-Pacific.

Another assessment of China's GDP accuracy

Business Insider has published an analysis strongly suggesting that China is overstating its GDP growth, because its reported declines in imports, manufacturing, and investment (whether absolute decline or decline in growth) are too strongly decoupled from the overall GDP growth figure when compared against the lack of such decoupling in OECD economies (US, UK, Europe, and Japan).

However, a key paragraph is the following (my emphasis):

While there are considerable differences between China’s economy compared to other major OECD nations – the stage of economic development just for starters – the evidence uncovered by Artus suggests, in his opinion, that the government is overstating the true growth level of the economy.

Just one scratch below the surface, and this whole comparison between China and advanced OECD economies is completely unwarranted. $8,000 per capita GDP simply can't be compared to $40,000 or $50,000, can it? Might as well compare $8,000 to $4,000 or $5,000: in other words, between China now and China in 2011 or 2012, before its massive rebalancing began in earnest.

Let's take imports: they have been consistently down by double-digit percentages year-on-year, and a staggering 15 to 20 percent in recent months. But that's because of the crash - up to 50 percent in dollar terms - in commodity prices. No comparison with an economy like the US makes any sense.

Meanwhile, according to Bloomberg, despite a slowdown in 3Q, fixed asset investment growth is still up 10.3 percent on year through September (down rather slightly from 11.4 in 1H). This isn't anything remotely approaching a crash; neither is the slowdown of industrial production to 5.7 percent.

So the bears will always have their talking points; they'd just be a lot more credible if their assessments weren't so chronically full of holes, even if the official data is itself as patchy as they claim.

Yuan's SDR inclusion all but approved by IMF; gradual depreciation now the best outcome

IMF chief Christine Lagarde has given the yuan the go-ahead for inclusion in the SDR, paving the way for the RMB to join the dollar, euro, yen, and pound sterling in the international currency elite.

Days earlier, PBOC chief Zhou Xiaochuan delivered a sobering warning of what this actually means:

“To guard against and eliminating financial risks is a severe challenge for us in the next five years,” the Governor of the People’s Bank of China wrote in an article.

While it's true that Zhou has long been a godfather of reform in the communist hierarchy, it's still remarkable how strong this language is.

With the immediate danger of market and currency collapse seemingly contained, the decidedly uphill battle to open up the Chinese financial sector to global competition can finally begin. Beijing has precious little time to waste: it has been lucky and sufficiently adroit so far, but, as ever, it has no laurels to rest on and can't afford to mess this one up, not least because its monetary decisions now rival even Washington's, i.e. the Fed's, in global implications.

The most optimistic scenario is a gradual, smoothed-out depreciation over the next five years to a level of 7 to 8 RMB to the dollar. This will buy time for the wider global economy to readjust and retool in the wake of what Goldman Sachs has dubbed the "third wave" of the global financial crisis, by retaining high levels of liquidity in the real Chinese economy to support 6 to 7 percent real GDP growth per the 13th five-year plan.

For China, the desired end state is a 10 to 20 percent lower yuan that enables her to cement her position as the linchpin of the global manufacturing supply chain via the shifting of advanced component production from Japan and South Korea and the attendant increased automation of her vast plant. The three-way FTA with Tokyo and Seoul is the centerpiece of Beijing's strategy.

As this CBS news report points out, it's too early to speak of Chinese consumers saving the global economy. Believe it or not, China still needs lots of investment in infrastructure and manufacturing capacity, largely because so much investment since the financial crisis has been wasted, and as anyone who's actually lived or worked in China can tell you, even the heavily utilized investments are often anything but optimal. If you just take the heavy industrial sector, especially in the north, you're talking tons of horribly inefficient, highly polluting excess capacity that's being shut down, consolidated, and/or recapitalized with new, i.e. greener investment. That's untold billions of dollars quarter after quarter.

All this also sheds additional light on the end of the one-child policy. A whole slew of articles, including in Financial Times and Fortune, have called it "too little, too late" in terms of the looming demographic crisis, i.e. rapid aging of the population and shrinking workforce; but the more optimistic view that I took in my own earlier post was echoed here in Forbes:

... But the government can’t explicitly or effectively make its people consume. The solution? Apparently, it’s to allow the existence of more people. That is, China is allowing married couples to have two children to increase consumption (and probably also investment). And this is going to work. ... 

So, there you have it. Need an economic stimulus plan that will actually work? Un-restrain the number of children the country can have. Wait. I guess this will only work in China. 

The declining labor force isn't the issue: the shortage of consumers is the real threat to China's economic future. Babies and young kids are excellent consumers - entire services and consumer goods sectors revolve around them well before they're old enough to contribute their own labor. So it makes perfect sense to have a mini-baby boom; it just behooves Beijing to make children less costly in real terms, by (among other things) getting its currency and monetary policy right to unleash enough liquidity that doesn't end up further inflating real estate.

In this respect, the government's nascent efforts to create a nationwide social safety net will also be crucial: young families will only spend more at present if they don't have to save so much for retirement on their own, though this whole topic of social security and healthcare is for another post.

Some thoughts about the US election 2016

As the 2016 US presidential election heats up here, now barely two and a half months away from the Iowa caucus, apparently there's much angst among Republican elites over the seemingly unabated ascendancy of such anti-establishment outsiders as Donald Trump and Ben Carson. But overall, the ball is still in the upstarts' court: they really have to keep convincing enough Americans that our country really is going down the tubes or on the precipice of Armageddon, in order to poll so well. Historically, it's always been a losing proposition to run on a platform of, "Things are so bad now that you need to look to me as a Messiah."

As in any modern US presidential election, the eventual winner is more a function of the prevailing state of our economy, than it is any referendum over a particular candidate or party's policy prescriptions and positions.

As such, the fringe right-wingers who have thrown in their lot behind a movement to lynch the Republican power elite will remain just that - a fringe - unless the general economic condition of the country as a whole truly deteriorates much, much further than its present state.

But if the Fed can hike rates, if even a token 25 basis points, and if China stabilizes in the short term, the entire narrative of the presidential election will have shifted subtly but substantially by the first primaries in late January.

Eventually, it will come out that Trump is actually 75 to 90 percent establishment in his leanings: he doesn't oppose big government per se, and at the end of the day most of his supporters won't have much problem switching to Marco Rubio or Jeb Bush.

Carson, meanwhile, is really little more than this year's version of Rick Santorum or Mike Huckabee: the pious preacher who soothes the wounded egos of fundamentalist middle Americans who wish we were back in the Fifties.

I'll record here what I've told others in person: this has always been Jeb's nomination to lose, no matter how low he polls.

Finally, I'll refer to my earlier post: Will China become more like us, or will we become more like them? When the haze of populist anger (fanned in no small part by demagogues on the radio waves) begins to clear, it should come out that most of the Republican base, believe it or not, can in fact live with the socialist monstrosity of Obamacare. After all, the US already runs a socialist welfare state of massive proportions - Social Security and Medicare - that has long acquired "untouchable" status with both parties. Thus it can be said that all the right-wing ranting about the evil of big government is 90-plus percent hot air, less than 10 percent actual substance. Even if Obamacare is amended or outright repealed, it will only happen with Republicans offering a better form of universal healthcare that flies in the face of the laughable notion (for the 21st century) of "small government."

We don't live in the Fifties anymore: those who clamor for that world are either lunatics or ignoramuses. No, our country won't go to hell because we have up to $200 trillion in future unfunded liabilities (Social Security and Medicare) which are set to increase with the ramp-up of Medicaid under Obamacare. All that the continued expansion of the welfare state will ensure - for sure - is that our labor market will continue to improve...yaay!

At long last, some signs of stability

Bloomberg reports that the Fed is now less worried about China in light of the recent upsurge of the Shanghai stock market and signs (albeit still patchy) of stabilization in the real Chinese economy. This would represent the greatest external hurdle to a long-awaited rate hike happening in December.

Bloomberg's overview of China in 3Q, as I've found out, indicates that mainstream opinion isn't nearly as gloomy as many headlines and stories suggested in August and September. Some highlights (my emphasis):

China’s economy slowed less than expected in the third quarter as a resilient service sector shrugged off the stock market crash and offset continued weakness in industry. Some will focus on the accuracy of the figures. Our GDP tracker averaged 6.6 percent in the third quarter, suggesting the official growth rate is not substantially exaggerated. Stronger credit expansion in the last few months is laying a foundation for short-term stabilization in growth — though further easing remains likely.

On the issue of data reliability:

 As ever, there will be debates about the reliability of the data and claims that the official growth rate is exaggerated. There are some puzzles in the data — for example, the acceleration in services output given the collapse in the equity market. The GDP deflator, which some analysts argue is a channel for data distortions, fell to minus 0.7 percent from 0.1 percent in the second quarter. Without that drop, real growth would have been close to 6 percent. 

That said, we don’t think any of the alternatives to the official data tell a more compelling story. Widely used proxies like electricity output say more about the health of heavy industry than the economy as a whole. We note that tax revenue — representative of the whole economy and difficult to fake — is up 5.4 percent year on year in the nine months to September. Taken together with our monthly GDP tracker’s 6.6 percent reading for the third quarter, that gives us some comfort growth isn’t substantially exaggerated.

And of course, more experts are acknowledging that it may already be a moot point just how badly China has slowed down, because the broader global economy doesn't seem to be going to hell anyway. As the Fed hike article concludes:

For the world economy, that means worries about a near-term hard landing in China may be excessive, said Leon Berkelmans, a director at the Lowy Institute for International Policy in Sydney and a former economist at the Fed and Reserve Bank of Australia.

"Even if China is extremely sick right now, the lack of spillovers could be a positive story," he said.

More on that freight rail graph I posted the other day

More on this graph I posted the other day:



One can see that since January 2014, rail freight growth (red line) has been in negative territory, and especially deeply negative territory of roughly minus 10 percent for all of 2015, before plunging an utterly catastrophic 15 percent in the rocky month of August.

The frequently negative freight rail growth since mid-2012 is an indication of industrial overcapacity: a stunning four-fifths of freight rail in China is either coal (58%) or ores and metals (21.5%). This means that as the excess capacity has built up in recent years, the shipments of these bulk raw materials has at times fallen owing to stock buildups at factories and power plants. So no, minus 15 percent growth in rail freight doesn't mean real industrial output growth is negative; it just means a lot of raw material is still available to be processed before new shipments are needed.

So for the Gordon Chang's, Harry Dent's, Jim Chanos's, and others like the author who cited this graph the other day, a rather simple counterpoint: it's entirely possible that industrial output is still growing at 5 to 6 percent in China, as officially reported, without any productivity improvements at all, because rail shipments of bulk industrial cargo simply isn't reliably correlated with actual production and output anyway.

What does historic China-Taiwan meeting signify?

The landmark meeting between the leaders of China and Taiwan over the weekend will likely be remembered as a moment of recognition of new realities and the inevitability of history.
At a time of heightened (though still largey symbolic, IMHO) tensions over the South China Sea and unease over China's growing ascendancy in the region, this icebreaker between Xi Jinping and Ma Ying-jeou is a big positive for the world in its telegraphing of mutual flexibility in dealing with longstanding differences, with an outlook towards the future instead of dwelling on the past.
The heads of the Communist and Nationalist parties are affirming that whatever the lingering differences and enmity between them, that this is ultimately an internal Chinese affair. Their common opponent now is that sentiment on Taiwan - particularly strong at this juncture in its history - that the island's ultimate destiny can be something other than determined by its relationship with the mainland.
Only time will tell...the ideal scenario has always been that Taiwan would peacefully reconquer the mainland with its superior governance and institutions. But that is for the people of Taiwan to decide...may they find their calling in their leadership of the ultimate integration and reunification of China, whether as a Westphalian political entity or perhaps something looser, as the winds of 21st century history dictate.

Shocking contraction of rail freight: sign of much slower growth than reported, or amazing evidence of rebalancing?

An article points out the following shocking 15 percent decline in Chinese freight rail traffic in 2015 (red line):

Is this an indication of much lower GDP growth than the officially reported 6.9 percent for 3Q (and around 7 percent YTD), or of the amazing speed of rebalancing towards consumption and services? Most likely a combination of both: in China especially, such diametrically opposing phenomenon and trends seem to be the norm.

Meanwhile, the latest stronger-than-expected US jobs report has made a Fed rate hike in December probable, but uncertainties remain largely because of persistent soft inflation and inflation expectations.

Credit risk: the big unknown in an autarkic financial system

A fascinating analysis by Beijing University economics professor Christopher Balding notes that Chinese banks report nearly 4 times as much interest income from their outstanding loans as Chinese companies report in liabilities attributed to financial (i.e. interest) costs on their balance sheets. According to Professor Balding, this is a shocking indicator of the yawning gap between the official ratio of bad debt in the Chinese economy vice the actual figure.

China's nonperforming loan (NPL) problem has long been a big one: back on the eve of China's accession to the WTO in 2000-2001, the state banking system was widely recognized as insolvent, with NPLs believed to run at 25 to 40 percent of the total. The sheer size of the problem relative to national GDP at the time gave plenty of fodder to doomsayers like Gordon Chang to predict the inevitable collapse of the communist system within a decade.

Fifteen years later, with an economy ten times bigger, this fundamental problem lingers. Officially, the big four state banks - Bank of China (BOC), Industrial and Commercial Bank of China (ICBC), Agricultural Bank of China (ABC), and China Construction Bank (CCB) - have an NPL ratio of just 1 percent; Chinese financial markets price in a figure of 10 percent. In all likelihood, it is higher still, given that Chinese financial exchanges are still restrictive and closed compared with their Western counterparts.

By now it should be apparent to everyone that so long as China's remains a closed and autarkic financial ecosystem, it simply doesn't have to play by the same rules as the recognized global norms. Hence it can pretty much cheat on a massive scale - as far as global conventions are concerned - when it comes to accounting for loan repayments (which would appear inflated on banks' income statements) or the actual writing off or restructuring of bad debt.

However, given the disproportionate contribution of financial services to China's overall GDP growth lately, it is now more important than ever to get the best possible grip on the PRC's financial health metrics, and if there are such massive discrepancies as this one noted by Professor Balding, it's important to somehow reconcile it.

The comment board for the aforementioned Financial Times piece zeroed in on the most obvious explanation: capitalization of interest payments. I added the latest post:

My thoughts:

1) Industrial and manufacturing firms have a strong tendency to capitalize interest on their major plant investments, just as real estate firms do so for construction. The post-crisis stimulus of 2009 saw overall investment approach 50 percent of GDP, meaning massive interest capitalizations across huge swathes of the economy over the last 6 years, read: massive under-reporting of financial expenses attributed to interest payments.

2) The Big 4 state banks' actual loans outstanding is probably significantly higher than reported, so the 7.8 percent interest income ratio is overstated. With a likely bad loan (NPL) ratio of 10 to 20 percent, that figure comes down to 6-6.5 percent. With aggressive revenue recognition of many "good" loans that are structured for lax repayment by the predominantly state-owned enterprise (SOE) borrowers, this figure can go down even further, maybe to about 5 percent.

3) Smaller (i.e. midsize) private firms aren't as likely to get sweetheart loans from the Big 4, so we need the interest income ratio for the banking sector as a whole, including breakdowns of the non-Big 4 state banks, municipal banks, private banks, etc.

4) The big cloud hanging over all this is shadow finance, which peaked around 2012-2013 but still plays a significant role in firms' debt structures which may or may not be reflected in their balance sheets.

At long last, China has unveiled its domestic commercial jetliner.

Meanwhile, as the US talks of at least two "freedom of navigation" patrols per quarter like the recent one by the USS Lassen, the PLA Navy Air Force is buzzing with increased patrol activity of its own over the South China Sea.

Beijing has apparently made the South China Sea the focal point of its assertive foreign policy: not only are its rivals there much smaller and weaker, in contrast to its spat with Japan over the Diaoyu/Senkaku islands in the East China Sea, but because practically all of Japan's energy imports first pass through the SCS before entering the ECS, control of the SCS serves the purpose of putting strategic pressure on Japan without directly confronting Japan's own boundaries, which China can't afford to do at a time when it needs close cooperation with Tokyo economically.

Tokyo for its part is clearly hedging heavily both ways, i.e. towards both Beijing and Washington. On the one hand, its economy needs to coordinate with Beijing and Seoul, as all three East Asian powers face the common threat of deflation against their export machines, and must kick-start the stalled trilateral free-trade talks so their economies work more efficiently in tandem to preserve East Asia's centrality to global manufacturing. On the other hand, Japan can't stand idly by as China gains the ability to choke off its lifeblood in the SCS, so along with Korea, it must uphold US efforts to preserve freedom of navigation there.

This comes as PBOC continues to support the yuan ahead of the IMF's crucial decision late this month whether to include the RMB in the SDR reserve currency basket along with the dollar, euro, pound sterling, and yen.

And finally, yet another article questioning the veracity of China's official GDP growth; the 6.5 percent annual target set for the 13th five-year plan (2016-2020) seems extremely rosy in light of some of the data series coming out of China lately.

When will US interest rates finally rise? When China's transition is on solid ground

An extremely politically incorrect fact of life, especially in a US election season, is that our economy is already to a large extent dictated by what happens in China: the simple fact that the Fed can't raise interest rates until the deflationary threat from China eases is a testimony to how our destiny is now so much more intimately tied to the communist empire than either our politicians or the general public have the capacity to understand or admit, means that the coming year until we elect the 45th president in November 2016 promises to be rhetorically very bumpy in Sino-US relations.

Fed Chairwoman Janet Yellen apparently keeps getting mixed signals about the economy from fundamental data, which isn't surprising given the same kind of mixed signals of strength versus softness in China's economy, as well: the official manufacturing PMI was still in contraction territory in for the month of October, a fortnight after official 3Q GDP growth topped expectations at 6.9 percent.

So long as China's transition isn't on firmly solid ground, the huge sword of Damocles that hangs over it - and the entire global economy - is a massive devaluation of the yuan (at least 10 percent). As I have previously noted, I think the real market-driven devaluation would be 30 percent or more if capital were truly allowed to flow freely in and out of China and the economy hit a real rough patch.

Such an outcome would be a death-knell for global GDP growth...it would also push back any Fed rate hike here by two to three full years.

The global economy relies increasingly on a communist-Leninist dictatorship to stabilize its prices, asset values, and growth prospects. Ironically, for all its evangelism of the virtues of free markets and trade, the West actually needs a very strictly regulated Chinese economy for at least several more years, because it's no more prepared for the wholesale deregulation of the Chinese system than it is for the total collapse of Assad's regime in Syria.

That doesn't mean Russia and China have much leverage over the West, either: if anything, in the grand scheme of things, they have even less.

This is truly a time when the big powers must act very cautiously and prudently and only in pursuit of their core interests; any excess adventurism based on hubris or an undue sense of victimization will be punished ruthlessly and efficiently.