What Wall Street Gets Wrong About

China
BY BILL POWELL 8/25/15 AT 12:48 PM

Volatile global markets got some respite from the latest blood-letting on Tuesday as bargain hunters nudged up Asian
and European stocks, though China, at the center of the rout, was smashed again. YVES HERMAN/REUTERS

FILED UNDER: Business

The number of people yammering on the TV networks who know next to

nothing about China has reached an all-time high. And for these mostly U.S.based Sinologist soothsayers, the verdict is in: China, the worlds great
growth story, is imploding. Its stock market continues to plummetdown
another 7.6 percent Tuesdayand its real economy slowing sharply. And
because China is the worlds second-largest economy, they say, and one of the
U.S.s largest trading partners, it's going to drag us down with them.
It's that simple.
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Here's how to think about whats gone on these last few weeks in the
markets. The proximate cause of the latest volatility was an
unexpected devaluation of Chinas currencythe renminbi (RMB)on
August 10 and 11. For over a decade, Chinas currency had either been
stable against the U.S. dollar, or appreciating steadily. That Beijing allowed the
RMB over the course of two trading days to sink by 3 percent came as a shock;
not because that is a significant devaluation but because of the global
environment in which it took place. Two major currencies (the euro and
the Japanese yen) and a whole host of minor ones (the Russian ruble,
the Brazilian real, etc.) have been sharply devalued over the past couple of
years. These devaluations have in turn intensified deflationary pressures in the
global economy, because goods and services in dollar terms have become less
expensive.
If Chinamanufacturer to the worldwere to join what appears to be the
beggar thy neighbor parade, and proceed to continue to weaken its currency in
order to help its flagging export sector, then that would be a matter of serious
concern. And indeed, thats how the markets evidently took the news.

Thats likely to be wrong. Beijing is in the process of trying to internationalize

its currency, albeit slowly; it eventually wants the RMB to be a
"reserve" currency, like the dollar, i.e., one that international trade is priced in,
and that foreign central banks hold as reserves. Toward that end, it wants to be
part of the International Monetary Funds special drawing rights schemea
supplementary stash of foreign exchange, to be used only in extremisthe IMF
declined to admit the RMB earlier this summer and said the currency needs to
be subject more to market forces. Indeed, at about 6.2 RMB to the dollar, most
economists believed the Chinese currency was slightly overvalued. The 3
percent devaluation was an adjustment that signaled the Peoples Bank of China
(Beijings Fed) was in fact going to allow the RMB to float a bit more.
The over-the-top-market reaction obviously took Beijing by surprise, and that to
a degree was Beijings fault. Whatever communication occurred between central
bank and finance officials in Beijing and other major cities around the world
Washington and Frankfurt most importantlywas clearly insufficient. The
battlefield clearly hadn't been prepared. Thats a combination of Beijings
inexperience on the world stage and its arrogance. The Chinese are not as
inclined to work closely with the U.S. and Europe as, say, the Japanese are.
Having said that, some of the rhetoric from Chinas trading partners was hard to
believe. Tokyos Minister of Finance Taro Aso won the chutzpah awardhow
do you say chutzpah in Japanese?when he decided to warn the world about
Beijings dangerous 3 percent devaluation. Earth to Aso: The yen is down 60
percent against the U.S. dollar since 2012!
So, amidst a tenuous global economic environment, the slight adjustment was a
bit of a shock; thats fair enough. But it does not mean that China is going down
the road of a Japan or Euro style full-bore devaluation. And that, make no
mistake, is a good thing.
In the immediate wake of the currency shock came a wave of fears about
Chinas overall economy slowing dramaticallyone that has obviously played a
role in the recent U.S. equity correction. To those of us who work here as
correspondentsparticularly for those like me, whove been here a long time

the reaction of both the markets and the commentariat has been nothing short of
depressing. Apparently, no one reads anything we write.
Since the government of President Xi Jinping and Prime Minister Li Keqiang
came to power in 2012, it has made it clear that the growth drivers of
the Chinese economyinvestment and exportsneeded to give way to
more consumption-led growth. Further, the partys platform
stated straightforwardly that market forces were to be "decisive" in
China going forward. That was a signal that the era of heavy loan growth
to state owned companies to build infrastructure was coming to a close. The
Chinese economy, as economists say, was going to undergo rebalancing.
That meant, as government acknowledged, that annual growth rates were going
to come down. The target for this year is 7 percent, down significantly from the
10 percent eraand one that Beijing may not even make.
A glance at economic history shows that when a sizable economy, like Chinas,
moves from one growth model to another, the shift is rarely painless. (See Brazil
in the 1960s, Korea and, most pointedly, Japan, more recently). As Beijingbased economist Michael Pettis points out repeatedly, rebalancing usually takes
longer, and is uglier, than the bureaucrats and mandarins would like. (See his
excellent book The Great Rebalancing.)
That Chinas economy has been slowingand may be slowing more rapidly
than most expectedseems to have shocked global equity markets in the last
week. Up to a point this is somewhat understandable. Chinas economic
managers gained a reputation, particularly after steadying their economy in the
wake of the global financial crisis, of having magical powers, not possessed in
capitals elsewhere. Actually, what they had was a lot of government money to
throw at the economy and, unlike in the U.S., a lot of jobs that actually were
shovel ready. (When the Chinese want to build infrastructure, they don't let
pesky environmental impact statements get in the way.)
That era is over, as Xi and Li have made clear. The transition to a more
consumer-led economy will take time, but it is occurring. Consumption

accounted for 60 percent of GDP in the first half of this year. This year, the
service sector and consumption will be bigger than the manufacturing and
construction sectorsthe third straight year that will be the case. Personal
income continues to grow at nearly 10 percent.
Why then, is Chinas stock market crashing? In part because it had gone
irrationally high last year: When the so called "A-share" market in China
companies that trade on China exchanges that for the most part only Chinese are
able to invest inbegan to crumble, it was 96 percent above its year ago levels.
The truth is, Chinas stock market is a speculative hothouse, and it is not
very indicative of where the economy is going. Only 7 percent of the urban
population own stocks, and 69 percent of them have less than the equivalent of
$15,000 in their accounts, according to Andy Rothman, senior investment
strategist at Matthews Asia. The bottom line: Do not assume that because its
stock market is cratering that China is going down the tubes.
But what about our stock market cratering because of slower China growth? Are
investors right to be concerned? Yes, up to a point. Corporate CEOs, like some
equity analysts, tend to fall in love with straight-line analysis, and during the
first decade of this century, when it came to Chinas economy, that straight line
was going upand only up. China would be the worlds largest market for
everything, and its growth would continue; so therefore, the U.S. Fortune 500,
and everyone else, invested like crazy in their China businesses.
Excessively so, in all likelihood, particularly if they were leveraged to the
industrial-infrastructure sectors. A friend serves on the board of two large U.S.
manufacturers, and he reports that their sales growth in China is 4 to 6 percent
this year. The problem is, they had planned for 8 to 10 percent growth. Partly as
a result, both companies are now losing money in Chinathe first time in over
a decade in which that has been true.
So some reaction in U.S. equity prices was understandable. But what we have
had is an overreactionarguably a big one. And thats why Apple CEO Tim
Cook took the unusual but wise step on August 24 to email CNBCs Jim Cramer

and say, hey everyone, at the moment our iPhone sales are actually growing
faster than we expected in China. Why would that be the case? Because urban
consumers in China have money, and they are still spending. And thats not
going to change appreciably anytime soon.
There are two other critical points to remember about China and its economy.
First, while the macro slowdown does hurt the bottom line of a lot of
multinational companies, the transition China is now makingfrom an
investment and export-led economy to a consumption driven economy,
is good for global economic growth. As Patrick Chovanec, managing director at
Silvercrest Asset Management in New York points out, "People talk about China
being a global growth driver, but in fact, by running chronic trade surpluses, it
has been a global growth de-river [by definition, if China was running surpluses
with the world, that was subtracting from growth everywhere else]. Now, by
propping up consumption in the face of an otherwise wrenching economic
adjustment, China can become a source of much-needed demand and a true
growth driver for the world economy. This is exactly correct, and after the
close on Tuesday, the PBOC announced further cuts in interest rates and in
the reserves Chinas banks have to maintain at the central bankpolicy steps it
hopes will increase cash in the economy, and thus consumption.
The darkest cloud in China remains debt, which has surged from an estimated
85 percent of GDP in 2008 to about 280 percent now. Thats debt held largely in
the hands of state-owned enterprises, the financing arms of local
governments and real estate developers. This means that there is virtually no
chance that the government can gin up massive credit growth again as a way to
spark the economy. The question is whether they can avoid an unexpected debt
crisisa massive bank run or large defaults in the so called shadow banking
sector. Neither is beyond the realm of possibility. But if over time, Chinas
growth slows, but debt issuance grows ever slower, the debt to GDP ratio
can begin to shrink.

Thats the best case for China: slowing growth, and the system getting a grip on
its debt problem. To be sure, that's not 10 percent growth forever and ever.
Those days are never returning. But it's not necessarily a crisisindeed, it's
what China and the world needs.