Let’s try some more scenarios, but this time with your participation. My reasoning is this. Most economic and financial commentary is about telling the story of the past leading up to the present. So why not try to tell the story of the future? After all, that is what matters for investment and policy. Can’t do anything about the past. So I will have a crack, in this case on the fate of China’s financial system, which I consider the most crucial swing factor for the future of capitalism. But I would like you to have a go, too. We are often told about the wisdom of crowds in economic matters, so how about some wisdom of crowds in future economic matters? That is what the big corporations do, after all, when framing their strategy. It takes a bit of mental effort, but it does provide a map against which what actually transpires can be calibrated. So, here goes.
First, a bit of background. As with most developing countries, the vast bulk of China’s capital base is bank lending or other forms of more informal lending. The stock market has less than a 1,000 stocks and the bond market is only just starting. In America and Japan, corporate bonds are about two fifths of the capital base, equities are similar, and bank deposits are less. In China, corporate bonds barely exist, but there is movement. The People’s Bank of China (PBOC) issued a notice on 7 January 2009 removing the minimum threshold for bonds issued in the Chinese inter-bank market. This move allows unlisted enterprises greater access to the emerging corporate bond market and will be of particular benefit to many small to medium sized enterprises that previously were excluded from the bond market because of a RMB 500 million (US$73.2 million) minimum issue limit which had applied since 2004.
Colin Archer, Chairman, APEC International Investment Group Limited has recently said this:
Beijing finally lit the fuse. By announcing the launch of a new market for dollar-denominated bonds that are issued by non-financial firms, China has now taken a major step toward modernizing its capital markets. The move is very shrewd, for it brings about the confluence of highly complementary trends. For China-based companies that want to invest abroad or that want to buy foreign companies, product lines, or other assets, these new dollar-denominated bonds will make it possible to do these deals more easily, and at a much lower cost.
The banks hold 70% of SOE corporate bonds, and the banks are not moving in the right direction, as the book RedCapitalism comments:
The story of the past ten years suggests that China’s banks, despite their Fortune 500 ratings, are not even close to becoming internationally competitive. They simply do not operate like banks as understood in the developed world. Their years of protective isolation within the ‘system’ have produced institutions wholly reliant on government-orchestrated instruction and support. China’s banks are at the mercy of domestic political disputes and this emphasises their passive role in the economy. China’s banks have traditionally operated like public utilities. Zhu Rongji’s initial efforts to push the banks toward an international model has been stopped and the banks have reverted to their original role … it is the Party and not the market that runs its capital-allocation process … In China, political imperatives make significant internationalisation of the banks unlikely. The Big 4 banks form the very core of the Party’s political power: they work in a closed system with risk and valuation managed by political fiat.
Sounds not unlike Australia’s banks ….
I could go on, but let’s go to the scenarios.
China’s capital markets: Bear scenario.
The Chinese banks continue to revert or go backwards in terms of being modernised. This results in a two tiered economy: an increasingly moribund State Owned Enterprise sector and a rampant “bamboo capitalist” sector, based on private enterprise and informal lending channels. This causes considerable stresses in the system and multiple financial distortions. The Communist Party panics and starts to impose itself on the capital markets, outlawing more informal lending. It is not successful, spelling a serious loss of political power. Meanwhile, the asset bubble in the property market pops, causing havoc with the banks. The Communist Party has a one time only solution to boost the banks’ capital base — sell some of the property it owns — which recapitalises the banks but further dents confidence in property, the Chinese people’s preferred way of storing value (because bank deposits lose value in real terms). Confidence sags in China, slowing the economy’s stellar growth. This increases tensions in the rural regions, forcing more draconian responses from the Party. China experiences its first business cycle in modern times and economic growth falls to 6%. This has negative repercussions for the Australian economy and Australian dollar. Likelihood: 10%.
Muddle Through Scenario.
The Chinese government starts to get more aggressive about boosting the corporate bond market, speeding up the regulatory and institutional changes required. The take up is modest, but Chinese savers are offered an alternative to bank deposits, even if only in wholesale form. This is an important option when the inflated property market starts to come off, causing many Chinese investors to lose heavily. The Party finds ways to prop up the property market and uses the opportunity to relocate rural populations in the city with cheap housing, but Chinese learn about the perils of property investment. There is a reasonably rapid take up of corporate bonds and a growing maturity is introduced into the Chinese financial system. It also makes “bamboo capitalism” more transparent, giving firms the chance to go for either debt or equity rather than informal lending for their funding. But the excessive levels of investment remain and it is not until the yuan is floated that the Chinese system really starts to resemble a developed capitalist market. Likelihood: 80%.
Bull Scenario.
The Chinese government gets very aggressive and announces that it will look to accelerate the modernisation of the capital markets with a view to floating the yuan. As part of the process it invites foreign financial institutions in, who co-operate with their ears pinned back. It’s the biggest market opportunity they have ever seen, or will ever see. The yuan is floated a lot earlier than expected, creating investment cross currents. Capital comes in from developed economies into China in pursuit of higher returns than is available in their moribund economies. But capital also flows out of China as Chinese savers look to diversify their options and China’s pursuit of resource security heats up. China’s capital markets, unlike Japan’s, start to become subsumed in the global matrix. This removes some of the controls that the Party has over the economic levers, a situation that it struggles to deal with politically. It spells the end of the command economy in China, but goes a long way to revitalising global capitalism. Likelihood: 10%
OK, there’s my version of it. Lots of holes, but it gives you an idea.
I think in many ways this issue will decide the fate of the next phase of capitalism in the world — and certainly Australia’s economic direction. What do you think?