Roubini Looks at China

By John Ballard

RGE's Wednesday Note is reproduced here without specific permission, so if this post gets deleted that will be the reason. I don't anticipate any problems because the links mostly lead to blind alleys for anyone not a paid subscriber, and RGE should be very happy to have free marketing.

Like most people, I am mystified at how well an ostensibly Communist country succeeds at capitalism.  But my puzzlement with China is nothing compared with the wholesale blind ignorance on display in America. James Fallows, who spent a year in China producing an impressive series in The Atlantic, issued this warning almost a year ago.

Is America going to hell? After a year of economic calamity that many fear has sent us into irreversible decline, the author finds reassurance in the peculiarly American cycle of crisis and renewal, and in the continuing strength of the forces that have made the country great: our university system, our receptiveness to immigration, our culture of innovation. In most significant ways, the U.S. remains the envy of the world. But here�s the alarming problem: our governing system is old and broken and dysfunctional. Fixing it�without resorting to a constitutional convention or a coup�is the key to securing the nation�s future.

That's not hyperbole. That's reality. If the midterm elections did nothing else, it underscored the willingness of the electorate to be led by unseen forces, unable to discern truth from fiction and eager to believe any ego-stroking promise.

ABC's most recent attempt to wake the country up, although chopped up into sound bites (ironically delivered through a storm of commercial advertisements, oblivious to the content of the message being funded) should be a wake-up call, it is instead competing with an ever more interesting narrative about Bristol Palin. When the same interests that own Fox News also control the London Times and Wall Street Journal the neologism "videocracy" begins to make sense. We point and giggle at Sara Palin, as with the Tea Party, at our peril. The possibility of an American Berlusconi is not far away. (Or maybe he is already here.) After all, the political fortunes of Arnold Schwartzenegger and Jesse Ventura are well-known. And do we need to be reminded of Al Franken? Or Ronald Reagan?

Roubini is pretty dry by comparison. But most informed prose (think law, science, medicine, forensics) tends to make dull reading.

In March we observed that a long-term political cycle centered on China's power transfer in 2012 was trumping the short-term cycle that would normally see monetary policy control transferred to Party technocrats. Now the "short cycle"�aimed at curbing inflationary pressures and asset bubbles�is set to overtake the "long cycle"�aimed at allowing Party leaders to shore up their power. In "The Long and Short of It: China's Political Economy Is Shifting," we update our model of China's political economy and examine possible implications for future tightening measures. The bottom line: China appears to be entering a more serious tightening phase, though inflation is still likely to increase in 2011.

We see two broad political cycles driving China's monetary policy. The long cycle is a contest between Chinese Communist Party (CCP) factions for the seven seats that will open up on the Politburo Standing Committee in 2012. In the meantime, faction leaders�Party officials who often hold government positions as well�will seek to demonstrate the relative strength of their following. Since this depends on a tangled web of unofficial political allegiances and therefore is difficult to gauge, each leader must demonstrate the size and strength of the faction behind him/her by steering funds to cadres in local leadership positions through the state-owned banking sector. This highlights their political sway and promotes growth in their regions, all the while fueling inflation.

The short cycle, as laid out by Northwestern Assistant Professor Victor Shih in his 2007 book, is the escape hatch. When inflationary pressures and/or asset bubbles begin to threaten social stability, the CCP leaders with large regional factions ("generalists") temporarily hand monetary policy control over to cadres with narrower support centered in government ministries�"technocrats," to borrow Shih's terminology. This is a credible signal to other cadres that lending growth must be curtailed because the handover comes at a cost to the heads of the generalist factions: the loss of their ability to steer funds to cadres within their faction. The generalists are willing to pay this price because they are confident that when the inflationary pressures dissipate, they will be able to regain control.

With inflation increasing at an annualized 8.7% m/m pace in October and money supply and credit growth well in excess of government targets, the centralized technocrats are beginning to assert their authority. This should lead to a curtailment of credit in 2011, which will pull down fixed-asset investment and GDP growth as well. The short cycle will subside once technocratic dominance of monetary policy effectively chokes off inflationary pressures and growth looks vulnerable, likely in late 2011 or early 2012.

We also believe there have been shifts in the factional balance of power that could have implications for the timing of the transition to the short cycle. Vice Premier Li Keqiang appears to have increased his influence over the "populist" faction headed by President Hu Jintao, and Vice President Xi Jinping has all but ensured his takeover of Hu's positions at the 2012 CCP Congress, which would return the "princeling" faction to power. With Xi's and Li's power bases seemingly strengthened, the risks of maintaining expansionary credit policies would outweigh the benefits. Rather than jockeying with each other for position within the 18th Standing Committee, Xi and Li are likely to work together to choke off funds to competing factions.

A shift to tighter credit and fiscal conditions should result, beyond the removal of the stimulus measures imposed in 2008. We also expect the technocrats to take advantage of their temporary hold on power to try to push through additional financial sector reforms that will make it more difficult for the generalists to manipulate credit decisions at the local branches of the state-owned banks. This is likely to start with additional asymmetrical rate hikes to narrow the gap between lending and borrowing costs and may also mean higher required reserve ratios for banks in the coming months.

The Central Economic Work Conference in early December should signal an end to the "moderately loose" monetary policy that has allowed the long cycle to dominate the short since late 2008. There will likely be little commentary about renminbi (RMB) flexibility at the conference; nevertheless, we expect that technocratic control of China's monetary policy should marginally increase the rate of RMB appreciation against the USD. Although there is some debate among the technocrats as to the benefits of a stronger RMB, we assume their median position is slightly more favorable to appreciation than that of the generalist factions.

Having watched the last five presidents allow banking and financial interests to call all the shots regarding both fiscal and monetary policy -- with bipartisan cowardice and submission  -- I have come to the conclusion it is they, the ones we call banksters, who are the American Taliban. No, they are not as coarse at their counterparts in Afghanistan, FATA or Pakistan, but they wield power to control large populations in much the same way.  Chopping off jobs and homes is not as bloody as actual decapitation, but the impact on those who watch may be even more frightening. Unlike victims of the financial situation in America, victims of the Taliban in Asia know who their perpetrators are and how they operate.

Tyrannies like the one in China operate differently from representative democracies. That much we know. We even send our children away to fight and die for the principles we hold dear. But as a nation we are no less resistant to extremism than any other population, whether oppressed or free. If history teaches no other lesson it is that tragic feature of society: sometimes it seems better to die than change. "Change we can believe in" turns out to be a terrible deception because we do not believe in change except for others.

Roubini, Soros and a few others seem to be fighting fire with fire, but as an old guy in retirement with no expertise in high finance I have no way to know for certain. China's "two cycles" approach coupled with monetary policy see-saw of generalists and technocrats seems to be generating impressive results. And Roubini's explanation strikes me as good as any. China's leaders don't have the luxury of waiting for popular support for national policies. But neither do they have the handicap of a culture that puts individualism ahead of collective progress. Their highest value seems to be pragmatism. As Deng Xiaoping famously said "It doesn't matter what color the cat is as long as it catches mice."