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“The political object is the goal, war is the means of reaching it, and the means can never be considered in isolation from their purposes.”

Carl von Clausewitz

Commentary & Analysis

China’s Third Plenary says “Market Reform”…depends on your definition of reform I guess.

It is interesting watching the PR machine inside and the dupes in the financial press outside of China spin the Third Plenary Session.  “Gee, it is momentous market reform and the markets are reacting positively to this great news,” seems the spin.

This is an example of what I am talking about, from

“Many contend that the reform path of ‘comprehensively deepening reform’ identified during the Third Plenum, which constitutes a continuation of the spirit of reform that dates back to the 1980s, will strengthen China’s market economy system, transcend economic reform, and promote the overall development of China’s future.”

Say what?

  1. It seems the primary goal was to transfer political power and economic control of the economy away from local governments and to the center.  I guess centralizing power must be considered free-market reform under the catch-all rubric of “improving socialism with Chinese characteristics.”
  2. Centralizing more power means the largest State Owned Enterprises (SOEs) will increase their market dominance over small SOE’s and truly private enterprises.
  3. Lip service was paid to reforming the hukou system, but given the costs to the central government near-term; don’t expect this to change the tide of relatively low consumer demand as a function of total Chinese GDP.

There was very little in the way of liberalizing markets (government controls most of the stocks listed on the exchange and has their “political officer” snitch embedded in all of them); or transferring wealth from the government (and SOEs) back to households.  Granted removing the ability of local governments to steal land from farmers (continuation of the anti-corruption campaign by Xi) is a step in the right direction.  There was more emphasis on increasing China’s global influence (and defense), as expected from a rising world power.  But from an economic perspective, other than lip-service to the idea of a governing model predicated on socialism that attempts to react to market signals, not much seems to have changed.

But the confident emphasis on the Chinese way [explicitly] as the most viable way forward now that the West has failed [implicitly] is a powerful takeaway from the session and one that screams “conflict on a lot of fronts may be dead ahead.”

The reality remains.  China’s economy is seriously imbalanced in terms of export/investment versus domestic demand and a growing debt problem part and parcel to keep the export/investment model viable in a slow growth world.  It suggests more conflict on the global trade scene [did anyone notice the US recorded largest deficit on record with China in the recent trade report?]  And will this session do much to stem China’s growing bad debt problem?  Implicitly, it may…but, the problem won’t go away.

“Ray Chan, of the South China Morning Post, for example, had an interesting article last Saturday that made this point. He starts off the article by warning that the rapid growth in credit in China has uneasy parallels with rapid credit growth in the US before the 2007 crisis,” according to

Parallels between the United States and China have started to look more ominous after several years of rampant credit growth and the emergence of an increasingly uncontrollable and unsustainable shadow banking system. China’s massive foreign reserves could, however, be the last tool in the bag for its bank-centric financial system if no timely regulations are implemented.

With the memory of the collapse of Lehman Brothers in 2008 still fresh, investors are fretting over the growth of thinly regulated shadow banking activity. Trusts, entrusted loans and bank acceptance bills shot up sharply to a record 294 billion yuan (HK$370 billion) last month. According to Moody’s Analytics, China’s core shadow banking products, which are often opaque and subject to little or no regulation, almost doubled to 20.5 trillion yuan last year from 11.7 trillion yuan in 2010. The US firm excludes entrusted loans and trust loans as they own underlying assets.

The article continues:

China’s credit situation is somewhat different, though, as it has a high saving rate and massive foreign reserves. Mervyn Davies, a former head of Standard Chartered and British government minister, said: ‘China is very rich in reserves … At the end of the day, the [Chinese] banks do need recapitalising, which is not a huge challenge to them because the government can recapitalise the banks.’

So, is the reality of preparing for a bad debt crisis at the heart of why so-called “market reform” isn’t really about market reform but more about controlling the narrative?

“I agree that China is in a very different position than the US, but this isn’t necessarily a good thing. The main relevant difference is that because all the banks are perceived to be guaranteed by the central government, and Chinese households have a limited number of ways to save outside the banking system, it is unlikely that China will experience a system-wide bank run as long as the credibility of the guarantee survives,and runs on individual banks can be resolved by regulatory fiat (banks that receive deposits will be forced to lend to banks that lose deposits). We are not likely to see a Lehman-style crisis,” says Pettis.

Now of course, many believe this debt situation, if it really becomes a problem, will be papered over by the Peoples Bank of China (PBoC).  After all, they have massive reserves to do the job.

But Michael Pettis makes a brilliant point about these reserves; likely something the Central Politburo Standing Committee knew about before the Third Plenary Session got underway:

“…the amount of reserves are almost wholly irrelevant, because this argument seems to be reviving, it makes sense, I think, to repeat why central bank reserves cannot in any way help China resolve the crisis. I will leave aside the problems of whether the reserves are transferred in the form of foreign currency, in which case it does little to satisfy domestic RMB-denominated funding needs, or in RMB, in which case the PBoC must stop buying dollars in order to hold down the value of the RMB and in fact must sell dollars, which would cause the value of the RMB to soar, thereby wiping out the export sector in China.

“A much more important objection is that the idea that reserves can be used to clean up the banks (or anything else, for that matter) is based on a misunderstanding about how the reserves were accumulated in the first place. There seems to be a still-widespread perception that PBoC reserves represent a hoard of unencumbered savings that the PBoC has somehow managed to collect.

“But of course they are not. The PBoC has been forced to buy the reserves as a function of its intervention to manage the value of the RMB. And as they were forced to buy the reserves, the PBoC had to fund the purchases, which it did by borrowing RMB in the domestic market.

“This means that the foreign currency reserves are simply the asset side of a balance sheet against which there are liabilities. What is more, remember that the RMB has appreciated by more than 30% since July, 2005, so that the value of the assets has dropped in RMB terms even as the value of the liabilities has remained the same, and this has been exacerbated by the lower interest rate the PBoC currently earns on its assets than the interest rate it pays on much of its liabilities.

“…  the net effect of using the reserves to recapitalize the banks is identical to having the central government borrow money to recapitalize the banks.”

It seems financial repression of Chinese savings will continue in earnest (just as it is almost everywhere else).  This means the imbalances inside the Chinese economy will likely get worse unless global aggregate demand starts to increase soon.  Just yesterday, the OECD announced it was lowering its global growth forecast yet again.

I think “socialism with Chinese characteristics” will be interesting to watch in the months ahead.  The outcome may not match the pre-game hype.