3 Sep 2015
China Crisis: The Great rebalancing or the next recession? By Nigel Wilson
"China built 50 airports while we agonised over one runway."
Today's economic dislocation began back in the Reagan years, when the rich Western economies effectively decided to outsource investment and manufacturing to China and the Asian Tigers. The West consumed, under-invested and indulged in billions of dollars of share buybacks while China and the developing countries of Asia saved and invested. Emerging market productivity soared whilst Western productivity flattened.
Rich westerners have consistently bought Chinese manufactured goods and paid for them in dollars. Many of those dollars were reinvested in Western government debt and now increasingly in real assets including London property – allowing the cycle to continue. The wealth generated in China was used to over-invest in infrastructure, as it was in the US and UK in the 19th Century. China built 50 airports while we agonised over one runway.
Occasionally this process got out of hand – the scale and quality of Western indebtedness versus Chinese investment was a contributory factor to the Great Financial Crisis of 2008.
But the direction of travel in the West has been consistent. Capital expenditure as a share of GDP has fallen, current account deficits have risen, corporations have piled up cash and share buybacks have soared.
Market obsession with fed watching
Analysing trade data has become unfashionable since markets became obsessed with Fed-watching. The focus was on interest rates: "little i" as opposed to the "Big I" Investment. But it was no surprise that the immediate trigger for August's falls was a poor set of trade data from China and a corrective, but modest, 3% devaluation of the Remnimbi - an "Economics 1.01" textbook response. Global trade is not growing.
Our challenges are complex. China needs to become a more consumer-driven economy to grow into its new infrastructure. We in the West need to do the opposite: investing in infrastructure, and physical and intellectual capital to improve productivity and put our growth back onto a more solid footing.
In an interconnected world of open economies and global capital flows this will be bumpy and will require constructive collaboration and co-ordination amongst the major economies. We know that the Chinese government can no longer simply "order" a switch from investment to consumption.
The zero everywhere world
We are living in a ‘zero everywhere' world, so policymakers have to make key decisions as real growth, inflation, productivity, trade growth and interest rates are all trending towards zero. Many commodity prices – oil, iron, copper - have fallen by 40% or more and deflation is a threat. Governments, corporates and regulators have to work more closely together to reverse these long term trends – at present they do not.
The Quantitative Easing miracle cure was applied early in the US, but more slowly elsewhere. In America, it was rightly used as a defensive, emergency medicine, alongside the rapid recapitalisation of banks, to get the economy back on its feet. Elsewhere it became a way of life: central bank balance sheets have ballooned by over $10 trillion. Too much is expected of QE – in Japan, the Eurozone and now China – it cannot become a substitute for real economic activity.
Recent collapses in commodity, currency and equity markets don't signal a straightforward re-run of the last Global Financial Crisis, but are evidence of the need for a co-ordinated structural correction at a global level.
Fortunately there are some measures that can be taken to smooth the transition:
1. Invest in the UK and end short-termism
First, we need to increase our own investment in the UK. That means taking a longer-term view than the City has come to expect. So investors, like Legal & General, should de-emphasise quarterly reporting by the companies we invest in. Instead of short-term share-price fixes like buybacks and mega-mergers, we should be supporting genuine investment plans which deliver returns over many years, not months. It also means investing more in our infrastructure – road, rail, healthcare, energy and housing. Interest rates have never been so low, money has never been so abundant, yet so little of it has been invested in growth. Money needs to be put to constructive use: Jean-Claude Juncker has the right idea on this with the European Commission's €350 billion stimulus plan, and we too need to accelerate George Osborne's Northern Powerhouse plan from concept to a reality.
This in turn means supporting a gradual shift from tax-favoured debt to equity. Funding with debt – and globally there is $200 trillion of it at present - means extracting a rent from future economic activity: borrowing from our children. Equity finances growth in the present, and creates upside for future generations. We need to use equity more to grow our small-cap companies from start-ups to grown-ups. There are many exciting sectors - including healthcare diagnostics, graphene, 3D-printing, big data analytics and modular housing. I wholly support the efforts of the London Stock Exchange, for example through its outstanding Elite programme, to deliver this.
2. Britain can be a great exporting nation again
Second, we need to become once again a great exporting nation – and without entering a series of competitive devaluations. I am encouraged to see high-profile trade missions, but our trade infrastructure lags far behind many of our competitors, notably Germany. A real drive for export credits and trade finance would be a good start, plus we need to punch our weight at international trade fairs, rather than settling for the small stall in the corner, too often sitting in the shadow of the German pavilion.
3. New asset classes to grow real economic value
Third, a critical effect of QE was to push up the price of existing assets including traded equity, bonds and commercial property. We need to build new asset classes – aggregated small company financings, private rental housing, specialist accommodation for retirees and students, and local infrastructure and regeneration funds – to grow real economic value.
I hope we see co-ordinated and constructive G20 policies to meet the global rebalancing challenge, the rebuilding of an equity culture in the West and more consumerist economies in Asia. But we cannot simply go on as before: the UK can help by becoming an investing economy; we need to start now.