Is the Chinese Game About Up?
Those of you who have subscribed to STRATFOR's Global Intelligence Update for a while, or who have perused our archives, know that we have been extremely negative about the Asian economy since 1996. Our predictions concerning Asia have come true, thus far, save for one. We have argued that the final Asian domino to fall would be China, and that the collapse of China's economy would signal the beginning of the second phase of the Asia saga, as the focus turned from economic disaster to the political consequences of that disaster. Those consequences would include both internal and regional political realignments that would redefine both East and Southeast Asian politics and the global system as well. Thus far, China has struggled successfully against this fate. Last week, its room for maneuver narrowed dramatically.
As with most events in the current Asian crisis, China's problem began with Japan. Japan's problems began when they reported that the Japanese economy had contracted in the last quarter. Japan's slide into recession was devastating news for the Japanese government and the permanent bureaucracy that controls the Bank of Japan. The BOJ had been holding interest rates at next to nothing. The reason had less to do with stimulating the Japanese economy than with providing Japan's ailing industries with enough cheap money to keep going. Low interest rates placed substantial pressure on the yen, as Japanese corporations unloaded yen in favor of other currencies. This weakened the yen, which is precisely what the BOJ was hoping for, since it reduced the cost of Japanese exports, thereby increasing exports and postponing the day of reckoning. Postponing the day of reckoning has become the sum total of Japanese economic policy.
The one bit of good news that was supposed to come out of all of this was that the Japanese economy would grow due to increased exports. Instead it contracted. There were two reasons for this contraction. First, Japanese exports into Southeast Asia were slashed due to that region's economic collapse. Second, the importer of last resort, the United States, is undergoing an unprecedented economic renaissance in both productivity and creativity. Japan, which has not been in a position to reinvest in its own economy due to economic problems going back to 1991, has an aging industrial plant that simply can't compete with American products, particularly in the American market. Although the Japanese continue to be able to compete on price, the vast difference in quality between Japanese and American products simply isn't there any longer. Moreover, the most dynamic sectors, such as software and biotech, are simply beyond Japan's capacity to dominate or even seriously compete in. Thus, its primary market, the United States, responds to low priced goods which have minimal, if any, profit margin, while Japan's secondary market, Southeast Asia, is unable to buy anything compared to what it purchased last year. The result: Japan is in a depression, dispensing with the circumlocution of "recession."
With this realization, Japanese and foreigners holding yen frantically sold them last week, driving the price down to levels that haven't been seen in seven years. This is not a temporary phenomenon. With interest rates at virtually zero, a contracting economy, difficulty in profitably penetrating the U.S. market, and a vanishing ASEAN market, who in their right mind would invest in Japan? Moreover, there are no obvious solutions. The Bank of Japan could raise interest rates to attract foreign investors, but higher interest rates would trigger a wave of bankruptcies among second tier companies that are barely holding on, in turn triggering a new banking crisis, and so on. Japan could stimulate the economy by encouraging domestic consumption, but that would cut the savings rate, destabilizing the banks once again. So, unless the United States decides to buy yen, there is little to raise its value. And the U.S. doesn't mind the weak yen, as it causes massive inflows of money into the United States, thus helping to maintain U.S. capital formation.
All of this puts China in the cross-hairs. The Chinese yuan and the Hong Kong dollar are the only major currencies that have not readjusted to the new Asian reality. It has been the absolute policy of the Chinese government not to devalue its currencies. But with the yen at 144 to the dollar, the pressure on the Chinese to devalue has become irresistible. The ASEAN collapse has already slashed Chinese exports. With the yen's collapse, what little market share Chinese exports to ASEAN retained is being destroyed by now cheaper Japanese goods. Moreover, with the Japanese forced into a price-based export surge into the U.S. market, they are in a position, along with the ASEAN countries, to place tremendous pressure on Chinese exports into the world's largest and most dynamic economy. Indeed, with the yuan unchanged and the yen down, the Japanese will be able to increase their exports to China itself.
Price had been one of the great advantages that China enjoyed in the global economy. Maintaining the value of its currencies at pre-collapse levels has effectively undermined that advantage. Thus the key question: Why have the Chinese remained so stubborn about maintaining the yuan and HK dollar at irrationally high levels? Why not devalue? Since an export-based economy has been a cornerstone of Chinese policy, resisting devaluation appears to be irrational in the extreme. Since the Chinese are rarely irrational, it is necessary to look beneath the surface for an answer.
The key, we believe, is the fragility of investment in China, including not only foreign investment but domestic Chinese investment as well. The focus here is on Hong Kong, which is the financial interface between China and the rest of the world. By holding the yuan steady and keeping the HK dollar pegged to the U.S. dollar, China has limited what it dreads the most: capital flight. One of the things that shattered ASEAN economies and which prevents Japan's economy from recovering is the constant flight of money to foreign economies, and particularly to the United States. China has already seen some of this. Its strategy has been to stem the tide by creating confidence in the markets. The key to maintaining confidence is to maintain the value of the yuan and the HK dollar. In order to maintain their value, it must maintain confidence. And so on, in an endless cycle.
The cycle, in the end, depends on reality, but the reality has a psychological component. China has tried to create a reality of a robust economy immune to the problems faced by the rest of Asia. Part of this strategy has been political. Clinton's upcoming visit to China is a crucial link in this process. Clinton, in a speech before the National Geographic Society this weekend, explained that good relations with China are critical because, after all, China has maintained a 10 percent growth rate, on average, for the past 20 years. In other words, China is a powerful economy that needs to be treated with respect. Apart from the geopolitical benefits of this viewpoint, Clinton reinforces the psychology China is trying desperately to maintain.
But the premise of Clinton's assertion is that a high growth rate denotes power. In fact, there is no necessary correlation between growth and health. Anyone willing to sell below cost will have a high growth rate, until he goes bankrupt. That is what happened to Japan. China's high growth rate does not mean that it has had profitable growth. Japan's problem, prefacing China's by about 8 years, was that it had magnificent growth, but the lowest rate of return on capital in the industrial world. The result was short term growth rates that were astronomical, followed by economic collapse.
Consider: The rest of Asia has had a massive economic collapse. Yet the Chinese are claiming that they will be able to achieve 8 percent growth in 1998, just as they had before. That seems to be an impossible feat. Now, all Chinese economic statistics are to be taken with a grain of salt, but we believe that China will achieve 8 percent growth in production in 1998. The reason can be found in an example cited by China's Xinhua News Agency on May 25. Xinhua reported: "Despite growing demand for nice suit from the nouveaux riches men, the domestic supply of suit has far outstripped the market demand, today's China Daily quoted the China National Garment Association as saying. According to Chen Ling, an association official, China last year turned out more than 10 billion suits, half of which were exported, but only 13 million suits were sold in domestic market. As more and more suits are stockpiled in the warehouses, production costs of many enterprises are growing rapidly, which has led to the rising price of suits, she pointed out."
In other words, the Chinese have FIVE BILLION suits sitting in their warehouses, priced beyond the reach of the Chinese market. They are also saying that they sold five billion suits last year, without selling more than a few million in China. We have confirmed this figure from other sources, but we still find it absolutely astounding. Indeed, we have to believe that this number is exaggerated. Either way it is bad news for China. If the number is correct, then it means that the garment industry has produced itself to oblivion. If the number is lower and there are only, for example, five million suits in warehouses, it still means that they are overproducing. It also means that Chinese economic statistics, like Chinese suits, are not always made of the finest fabric.
It is in this context that we should take the report by the Chinese State Statistics Bureau last week that production in China rose by about 8 percent over the same period last year, and nearly 1 percent over the previous month. China is producing and, if need be, it can sell what it produces. What is not clear is that it can sell what it produces at a profit, or if it can even break even. In other words, the Chinese are suffering from the Japanese disease, in which growth has psychological value at the same time as it undermines economic well being. Thus, the Chinese are trying to hold up the yuan and Hong Kong dollar to maintain the illusion that they can escape the Asian disease. Their theory s that, if enough people believe that China is invulnerable, there will be no capital flight. If there is no capital flight, eventually there will be an inflow of capital. If there is an inflow of capital, everyone will forget about the old suits sitting in warehouses.
The key to this is psychological. The Chinese are desperately trying to portray themselves as the equals of the United States in dealing with the crisis. George Bush was in China last week announcing that the Asian crisis will be short-lived. Clinton is heading there next with the same message. Both are creating an aura that is absolutely essential to China's well-being: that China is a vibrant, functioning economy, that can work with the United States in reviving Asia. The Chinese have indeed played this brilliantly.
Unfortunately for them, the yen collapsed last week. China is overpriced, overproducing and over the barrel. The lowered yen has created overwhelming pressure to devalue. The psychological game cuts both ways. Having worked to create the illusion of invincibility, devaluation will reveal that the emperor has no clothes. The Chinese began a campaign last week placing the blame for the yen's rise on Japan and demanding that the U.S. do something about it. Thus, China's next ploy will be to portray devaluation as a defensive measure against American indifference and Japanese predatory behavior. But it will be a feeble ploy, officially believed only by those Western banking houses that have led their clients into disastrous investments in China.
We believe that the Chinese game is about up. The next question, as in Indonesia, will be political. What will economic contraction mean to China's domestic and foreign policies? That is an interesting question, to be posed after this one: What will Japan's economic collapse mean for its domestic and foreign policies?
Stratfor System's Red Alert, June 15, 1998 |
