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For more than two decades the Chinese Communist party has offered the masses an unwritten social contract — we will manage the country and allow you to get rich, as long as you stay out of politics.
Rapidly rising living standards and a bureaucracy that was remarkably successful at achieving high rates of growth left most ordinary citizens convinced this was a pretty good deal.
Most foreign investors in the country have been similarly impressed by the competence of Chinese technocrats and their ability to manage an increasingly complex economy that is now the world’s largest, at least in purchasing power terms.
But a stock market crash and a series of policy mis-steps over the summer have left many investors questioning their faith in the infallibility of the mandarins in Beijing.
Meanwhile, the relentless slowdown in the broader Chinese economy that has been under way for the last few years appears to be worsening, and deep-seated problems in the real estate, manufacturing and financial sectors are becoming more acute.
As recently as two years ago, many Chinese officials were still confidently predicting that the economy would continue to expand at a steady rate of 8 per cent for at least two more decades.
But China will grow at its slowest annual pace in a quarter of a century this year as the Communist Party struggles to achieve its full-year target of “around 7 per cent” growth in GDP. According to official statistics, the economy expanded 6.9 per cent in the third quarter from a year earlier, after growing by 7 per cent in the first half.
Tao Wang, the chief China economist at UBS, predicts growth will slow to 6.2 per cent next year and 5.8 per cent in 2017.
“Downside risks [to these forecasts] will probably come mainly from a deeper and more prolonged property destocking process and a greater knock-on effect on the industrial sector, and to a lesser extent, from insufficient policy support to temper the downturn,” she says. “Either could aggravate the negative feedback loop in weak real activity, worsening deflationary pressures and increasing debt burdens; all against a backdrop of higher capital outflows and financial market volatility.”
Investors are unlikely to see any relief from China’s enormous export sector, which is struggling with weak global demand, rising environmental and labour costs and a strengthening renminbi.
At the start of 2015, the government set a target of 6 per cent expansion in total trade, but in the first 10 months of the year China’s trade with the rest of the world shrank 8 per cent from the same period a year earlier.
Woes in the export sector were one reason for the Chinese government’s decision to devalue the renminbi on August 11, according to people familiar with the matter. But the shocked reaction of global markets and the abrupt volte-face that followed that decision probably did more to harm Chinese leaders’ reputation for economic competence than anything else.
“The devaluation was clearly a policy mis-step,” says Derek Scissors, a resident scholar at the American Enterprise Institute in Washington DC. “It seems they were completely oblivious to the downside risk and how the rest of the world would react.”
In fact, global investors had already been losing confidence in the Chinese authorities for some time.
Around the middle of 2014 it became clear that the government had decided to encourage speculation in the country’s vast, but poorly regulated, equity market. By attaching its imprimatur to a bubble the government believed it could engineer a giant debt-for-equity swap as companies sold shares to pay off some of the crushing debt that was harder to service as growth slowed.
As the benchmark Shanghai index soared in early 2015 the People’s Daily, the official mouthpiece of the Communist Party, crowed in a front page editorial that this was only the start of a multiyear bull market. But barely two months later the bubble burst and prices of equities, that had been driven upwards by a flood of newly sanctioned margin trading, started to plummet.
Beijing’s knee jerk reaction was a massive state-sponsored rescue effort to buy stocks and stop the price falls. When that did not work the government banned large shareholders from selling any stocks. The market kept falling and eventually the “national team” of state-backed stock-buying funds abandoned their attempts to prop up prices — but not before they had spent more than $200bn trying to support the market.
“This was a huge hit to the government’s credibility and it just got worse with the failed devaluation attempt,” said one market participant with close ties to top financial regulators.
On August 11, the day the People’s Bank of China — China’s central bank — announced its devaluation, several of the PBOC’s most senior officials were on holiday and had to be recalled, according to several people with knowledge of the matter. These people said the PBOC had proposed the move as just one possible policy option and did not expect the central leadership to adopt it so promptly. At first glance the announcement appeared to be a master stroke.
In addition to a small “one-off” devaluation of less than 1 per cent against the US dollar, the PBOC also said it would now allow the market to play a much bigger role in setting the exchange rate — a reform the IMF and many other institutions had been urging for years.
That meant Beijing could devalue the currency to help struggling exporters while also appearing to be complying with IMF demands. Theoretically, this would not lead to competitive devaluations from other countries and China would not be accused of following a mercantilist policy. Over the next few days investors pushed the value of the renminbi down by close to 5 per cent, as Beijing had hoped.
But outside China’s borders global markets and regional Asian currencies were collapsing as investors worried about a currency war amid fears the Chinese economy was in much worse trouble than anyone had thought.
Within days the PBOC reversed itself and announced it was heavily intervening in the market, essentially to re-peg the renminbi to the dollar to try to calm panicky markets and trading partners. “The government was very surprised by the strength of the international reaction,” said one senior adviser to the Chinese leadership. “But once it feels it has sufficiently stabilised the market then we will see some more devaluation.”
If this prediction is correct it will have a vast impact on global companies and investors operating in or coming to China.
For years, the ever-rising value of the renminbi was as certain and stable as the Communist Party’s social contract with its citizens and that meant a one-way bet and an extra attraction for foreign investors pouring into renminbi assets.
Investors looking for a bright spot in China have pointed to resilience in consumption and service sectors, which have held up even as growth in investment, construction, manufacturing and heavy industries has plummeted. The government has encouraged this optimism by pledging to shift the Chinese growth model from investment and construction to consumption and services.
But in unpublished recent remarks to visiting foreign dignitaries, even China’s outspoken finance minister, Lou Jiwei, forecast four or five years of much lower growth as the economy digests massive industrial overcapacity, as well as excessive debt levels that are still rising. He also warned that he expects “labour pains” as unemployment rises.
“Although employment and consumption have stayed resilient so far, we expect both to face increasing headwinds in 2016 and 2017,” says Ms Wang. “Going forward, as investment and GDP growth continue to slow, employment and wage growth may soften further.”
As growth slows and debt piles up the government’s unwritten contract with the masses — and with global investors — is looking increasingly strained.