#274 Timing is Everything
China's Impossible Trinity, Imports Don't Reduce GDP, and an Escalation in Technopolitik
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Global Policy Watch #1: Not Stimulating Enough
Insights on global issues relevant to India
— RSJ
2024 is the year of the Dragon in China. Wood Dragon, to be precise, if one were to include the element (wood) in the animal sign. The year is supposed to be marked with growth, wisdom, abundance and positive change. With a little over three months remaining in the year, it has become clear to the policymakers that the reality of China's economic performance in 2024 is nowhere close to the promise of the Year of the Dragon. Much like most policy measures China has taken since 2020. GDP growth is projected to come below even the muted 5 per cent expected at the start of the year despite the growth boosts given during the year and a bit of the usual manipulation of the official statistics. The property market is moribund, with unsold real estate inventory weighing down the economy. Consumer confidence is still shot because of the general weak sentiment. China’s equity market is underperforming every other major market. Exports have grown, but the “China + 1” diversification of the global supply chain and the developed world's determination not to let China run away once again this time with its overcapacity has led to trade tensions and strong pushback to Chinese exports. Foreign capital flow has slowed to a trickle with the ongoing fear of a government crackdown on businesses using the specious pretext of an anti-corruption campaign driven by Xi Jinping since 2020. All of these lead inevitably to a long-term structural slowdown and a deflationary economy. Back in May, I had called this out (Edition #255: Back to 1930s):
“The familiar sceptre of the ‘lost decade’ of Japan in the 90s looms over China if it continues down this path. It is difficult to see Xi stepping back from a confrontation and finding ways to de-escalate the trade wars. There is a misplaced sense of being a victim of the US policies (shared with Russia) and an inflated view that their model of growth is better which will get in the way of any real breakthrough. And the worse China does on the economic front, the greater will be the desire to act politically to demonstrate strength to its domestic constituency. This can only go from bad to worse.”
Things have indeed gone from bad to worse since May. The Chinese Communist Party politburo had an unscheduled September meeting to discuss economic issues. There was a flurry of meetings between government and People’s Bank of China (PBoC) officials throughout the month. It all came together on Tuesday this week when a press conference saw the unprecedented coming together of People’s Bank of China Governor Pan Gongsheng, National Financial Regulatory Administration Minister Li Yunze and China Securities Regulatory Commission chair Wu Qing to announce a raft of monetary and fiscal measures to reflate the economy and revive animal spirits. An economic bazooka of sorts that’s useful to demystify a bit.
On the monetary front, the PBoC has cut the required reserve ratio for banks by 50 basis points. Reserve ratio is the capital kept aside by the bank for future contingencies, and a cut will likely free up about 1 trillion yuan ($140 billion) in capital that can be used to provide loans to borrowers. This was accompanied by a 20 bps cut in the benchmark interest rate on the seven-day reverse repo rate (the rate at which the central bank borrows money from commercial banks). A cut in reverse repo spurs banks to look for commercial uses of its excess funds rather than just parking it with the central bank.
For the property market there was a 50 bps cut on mortgage interest for the current borrowers in line with the Fed’s rate cut the previous week. Also, the PBoC reduced the minimum mortgage downpayment threshold for second homes from 25 per cent to 15 per cent. This is an important signal because Xi had gone after the second properties market by placing multiple onerous conditions to bring its growth down since he held it responsible for the property bubble built up. Also, PBoC tweaked terms for the facility that lends to state-owned enterprises for buying unsold inventory from property developers. The original plan that had $41 billion set aside to ‘digest’ unsold inventory through this mechanism did not see much offtake.
To revive the stock market, there was an announcement of a Rmb500 billion ($71 billion) fund to help fund houses, brokers and insurers to buy stocks. The PBoC also announced a new scheme under which commercial banks can borrow from it to lend to companies who want to conduct share buybacks. The stock markets responded positively to these announcements but my sense is any rally will be short-lived.
Will this ‘near’ bazooka work? I don’t see how. Curing for symptoms won’t let the ailment go away.
The underlying problems bedevilling China’s economy have been long in the making. The demand boost expected in the economy because of this will be meager. The property market is in a deep funk with bankruptcies of large real estate companies, an anti-corruption drive at the local government level, and a near halt on new construction activities. Real estate has been the primary driver of domestic growth, and it is also the main household asset for the Chinese. These minor concessions on rate cuts and second home purchase limits aren’t going to improve the risk appetite of the consumers. A much more targeted fiscal package to raise demand is needed that will spur consumers to stop worrying and saving, and start spending. This is a downward spiral that needs a ‘shock’ to change direction. Also, I’m not sure what rate cuts and liquidity boosts to the banking system will achieve when the underlying consumption sentiment and demand is weak. Who will the banks give that money to when consumers are trying to de-lever and don’t want any new loans? All that will happen is banks will buy more bonds in anticipation of more rate cuts. None of this will help the equity market.
The export problem isn’t going away soon either. China has gone down the path again of overinvestment and excess capacity, especially in the green energy and EV sectors. It has built capacity to service two-thirds of the current global demand in these areas. And it is building more. This is a bold bet on the future of energy, but more critically, it is a bolder bet on how the Western and emerging markets (like India) see China's export-oriented growth model. Unless Xi goes on a charm offensive, many of these markets won’t be open enough for taking in its excess capacity. The government debt burden will only continue to go up.
Also, the desire to prop up the stock market by giving cheap money to fund houses will only go that far. The long-term money and, therefore, stock market performance will depend on the view of China’s macros by analysts, the stability of its regulatory regime and how well it treats the private sector, foreign firms and entrepreneurs. Xi’s misguided actions in the past four years in this area will need a much longer period of assurance, support and stability before long-term money makes a beeline for its equity market.
Will there be more fiscal measures to back this stimulus further? This Reuters report suggests that:
“Reuters reported on Thursday that 1 trillion yuan due to be raised via special bonds will be used to increase subsidies for a consumer goods replacement programme and for business equipment upgrades. They will also be used to provide a monthly allowance of about 800 yuan, or $114, per child to all households with two or more children, excluding the first child. China aims to raise another 1 trillion yuan via a separate special debt issuance to help local governments tackle their debt problems.
Most of China's fiscal stimulus still goes into investment, but returns are dwindling and the spending has saddled local governments with $13 trillion in debt. The looming fiscal measures would mark a shift towards stimulating consumption, a direction Beijing has said for more than a decade that it wants to take but has made little progress on.
China's household spending is less than 40% of annual economic output, some 20 percentage points below the global average. Investment, by comparison, is 20 points above and has been fuelling more debt than growth.
The politburo also pledged to stabilise the troubled real estate market, saying the government should expand a white list of housing projects that can receive further financing and revitalise idle land. Shanghai and Shenzhen are seeking to scrap limits on the number of homes that Chinese can buy, Reuters reported. Beijing is also considering lifting similar restrictions across most areas of the city, but more gradually.”
Even these won’t be enough, in my opinion. We will continue to watch this space.
Looking at China’s economic issues at this time presents a fascinating contrast with India, where the central bank has kept liquidity really tight over the past two years, tried to dampen loan growth by increasing risk weights for banks for unsecured loans, and has signalled that credit growth cannot be higher than deposit growth in the banking system. These are all countercyclical measures to tame inflation, prevent the possibility of asset bubbles building up and keeping powder dry in case global macro gets worse. All of these will start impacting growth soon, if not already.
If China is a case of too little too late, maybe India is doing too much too early.
Anyway, going back to China. At the heart of their current predicament is a trilemma, brought upon it by Xi, that it is trying to manage:
It wants the party to remain dominant over the private sector and society, thereby, ‘managing’ the freedom it offers to market forces.
It needs growth to support the aspirations of its people and for the goal of ‘common prosperity’ that Xi has laid out. For this, it requires private capital, entrepreneurship, foreign investors and, importantly, free access to global markets.
It wants to be a superpower geopolitically, and it has a few goals to match those aspirations, namely, integration of Taiwan, territorial claims in the South China Sea region, global leadership in AI, EV and green energy transition, demonstrating the superiority of its political model, replacing US dollar with Yuan as the global reserve currency etc.
It can only achieve any two out of these three. But it wants them all.
Global Policy Watch #2: Just in Time → Just in Case → Just to be Safe
Insights on global issues relevant to India
— Pranay Kotasthane
“Are the West and China decoupling or merely derisking?” is a question that’s been doing the rounds in academic circles for many years now. My answer to this question has been that, at least in high-tech domains, the two groups are aggressively decoupling rather than mildly derisking. The primary reason being governments have internalised that winning the technological competition is central to geopolitical ascendency. The secondary reason is that no one knows how far they can push ahead with decoupling in this domain because many aspects of the current technological competition are poorly understood. This is in contrast to confrontations in the economic and military spheres where globalisation and nuclear weapons, respectively, mean that countries can push each other’s buttons only below a threshold. And so, we are witnessing high-tech decoupling along all these dimensions: machines, materials, talent, and values.
A fresh new chapter was added to this story of high-tech decoupling last week. The US Department of Commerce issued a notice prohibiting “the sale or import of certain connected vehicle systems designed, developed, manufactured, or supplied by entities with a sufficient nexus to the PRC or Russia.” The stated reason is that such systems collect “information about geographic areas or critical infrastructure and present opportunities for malicious actors to disrupt the operations of infrastructure or the vehicles themselves.” In other words, there is a potential risk of sabotage from these connected systems, and hence, they are being banned on national security grounds. Note that these restrictions would effectively make Chinese firms’ strategy of setting up car manufacturing facilities in third countries untenable.
These rules mark an important shift in technology geopolitics. Hitherto, the stated reason for export controls on advanced chips was their potential end-use in military applications, while the restrictions on telecom equipment from China stemmed from a fear of sabotage of a critical nationwide system. The connected car systems ban is then an escalation, as it brings consumer products technology into its ambit. Interestingly, the reasons given for banning connected car systems also apply to imported smartphones and laptops. Will they face similar restrictions as well?
Regardless, note the scope creep: cars are now considered ‘critical infrastructure’, and connected vehicle technologies have become a national security threat.
During COVID-19, the stated reason for decoupling was resilience. The narrative was that global supply chains have sacrificed resilience in the search for higher efficiency, and some balance needs to be restored. Thus came the argument that the “just in time” management strategy must be replaced by “just in case”.
The connected car technologies ban, and the fallout of Israel’s pager attacks mean that even a “just in case” strategy is not enough. It’s now being replaced by a “just to be safe” strategy where every connection with the adversary is seen as a risk vector worth eliminating. Given that technological means for addressing hardware tampering exist, resorting to an outright ban suggests that high-tech decoupling and market denial are well and truly in play.
Matsyanyaaya: Do Imports Reduce GDP?
Big fish eating small fish = Foreign Policy in action
— Pranay Kotasthane
In public policy, axioms must be reaffirmed every generation. Otherwise, they get buried under layers of contemporary urgencies and narratives. That’s what seems to be happening with respect to the thinking in America on trade.
The Trump campaign’s tirade against trade would make you think that he is hoping to be the president of an impoverished, post-colonial country that’s still recovering from the trauma of colonial terms of trade. In recent speeches, he’s claimed that “Tariffs are the greatest thing ever invented”, and has repeatedly insisted that only foreign companies pay up for high tariffs; American citizens don’t.
That these falsities have political mileage in a country with the world’s best thinkers and academics underlines that every generation is condemned to rediscover many economic and policy axioms. Just as today’s India is yet to rediscover the benefits of pluralism and tolerance, today’s America needs convincing that freer trade and immigration are its core strengths.
The underlying reason for the allergy towards trade seems to be a mistaken belief that imports reduce GDP. The more the imports, the lesser the domestic production. Hence, more tariffs would decrease imports and increase domestic production, so the logic goes. Isn’t it also backed by this mathematical identity taught in high school economics?
GDP = C + I + G + (X-M)Where C stands for consumption, I for investment, G for government expenditure, X for exports, and M for imports.
This intuitively makes us feel that the higher the imports (M), the lesser the GDP.
However, this is incorrect.
GDP only measures domestic production, so imports (goods produced outside the economy) should not matter at all. So what’s it doing in the domestic production equation, then?
As it turns out, the equation is such only for accounting reasons. Here’s the explanation:
Some of the spending (which is counted as C, I, and G) is spent on imported goods. As such, the value of imports must be subtracted to ensure that only spending on domestic goods is measured in GDP. For example, $30,000 spent on an imported car is counted as a personal consumption expenditure (C), but then the $30,000 is subtracted as an import (M) to ensure that only the value of domestic production is counted. As such, the imports variable (M) functions as an accounting variable rather than an expenditure variable. To be clear, the purchase of domestic goods and services increases GDP because it increases domestic production, but the purchase of imported goods and services has no direct impact on GDP.
So, more imports do not reduce GDP. It’s only an accounting artefact because of which imports feature in the GDP equation. This truth needs to be rediscovered yet again.
Meanwhile, if you prefer a longer explanation, Noah Smith’s post from yesterday does a great job. Now, who’s going to explain this to Trump?
HomeWork
Reading and listening recommendations on public policy matters
[Post] We have a systematic analysis of developments in the India-US technology partnership over the past couple of years here.
[Paper] A useful paper on the Delimitation debate from the folks at Vidhi Centre for Legal Policy.
[Video] Jeffrey Ding’s provocative book Technology and the Rise of Great Powers contends that technological diffusion impacts national power more than innovation and that China is far behind the US on this count. This video summarises the key arguments quite well. Do not miss.
[Podcast] A Puliyabaazi on the security implications of the pager and walkie-talkie explosions.
Thanks, Pranay. Have been following your substack for a recent while but have been an avid reader of your writing through other mediums, amazing stuff.
My observation (negative lens on purpose): National governments are fundamentally hedging for the outside-in risks and are myopic in their view. We live in a world where governments are creating trust/trade barriers and yet are standing together on a forum to committ to a decarbonised future. The contrast is evident. Why should anyone trust, invest, pledge in propelling a globalised common goals for Net Zero and SDGs when the reality is that geopolitics and powerplay trumps the narrative almost always.
There can never be a global common goal. The goal is what the global elite recognises and ensures the minions follow.