China's Slowdown and Asian Growth

Wednesday, June 10, 2015
Carlos Barria/Reuters
Patrick Chovanec

Managing Director and Chief Strategist, Silvercrest Asset Management Group, LLC

Paul Francis Gruenwald

Managing Director and Chief Economist, Asia-Pacific, Standard & Poor’s Rating Services

Susan R. Weld

Executive Director, Law-Asia Leadership, Georgetown University Law Center

Patrick Chovanec, managing director and chief strategist at Silvercrest Asset Management Group, and Paul Francis Gruenwald, managing director and chief economist on the Asia-Pacific at Standard & Poor's Rating Services, join Georgetown University Law Center's Susan R. Weld to discuss the potential implications of varying growth rates in East Asian economies. The panelists focus particularly on the Chinese economy and comment extensively on Chinese President Xi Jinping's economic policies. They analyze how a slowdown in China's growth rate might affect other countries in the region.

WELD: Thank you for coming to today's event, in which Paul and Patrick are going to be talking to us about the influence and the importance of China's current economic posture with respect to the U.S. and other countries in East Asia.

My name is Susan Weld, and I guess I'm going to just introduce you two and have you take it away. And what I do is something quite different from what Patrick and Paul do. I'm a historian. I study early China history and thought, and there is a certain amount of diplomacy and some of the (ph) military studies in that period. I've done a bit of them but I'm going to pass off the-- (inaudible). Thank you very much.

So I didn't bring all my briefing papers with me. Do you have one?

CHOVANEC:  We can introduce ourselves.

WELD: Why don't you introduce yourselves. That would be great.

Sam, can you give me that.

CHOVANEC:  Do you want me to go ahead, or do you want to?

WELD: Patrick, you go first.

CHOVANEC:  OK. I'm Patrick Chovanec. I'm chief strategist and managing director at Silvercrest Asset Management in New York, where we manage about $18 billion on behalf of mainly wealthy families and some selected institutions on a global basis. So my role is a global one.

But before moving to New York about two years ago, I was a professor at Tsinghua (ph) University in Beijing, where I taught in their MBA program. And even before that I worked in private equity in China, investing in Chinese companies. I do have a background here in D.C. I was an aide back in the 1990s to John Boehner, who was not then speaker but obviously now is.

And in addition to my role at Silvercrest, I teach at Columbia University School of International and Public Affairs, a course called U.S.-China negotiation workshop, which is basically practical exercises in negotiations on economic, financial, business and geopolitical issues between the United States and China involving students from the U.S., China, Europe, which is a very interesting and enjoyable role.

WELD: And you also served as an officer in the U.S. Army and Reserves.

CHOVANEC: I did, yes. During a very peaceful time.

WELL: And then this is Paul Gruenwald, who is at Standard & Poor.

GRUENWALD:  Hi, everyone. My name is Paul Gruenwald. I'm the chief economist for Asia-Pacific at Standard & Poor's, also managing director. I'm based in Singapore so I'm here on an extended business trip. I do make it back to the U.S. several times a year.

My remit is to cover macro and financial for all of the Asia-Pacific region, and obviously China, being the biggest economy, gets the most attention. I also have a D.C. history. I worked for the IMF for about 16 years. The first half was Latin America, the second half was Asia. So we've been living in Asia for about 15 years. I ran the IMF office in Korea and then Hong Kong, and I did a stint with Australia New Zealand Bank five years as their chief economist for Asia as well.

I also taught at the school of International and Public Affairs, but I was an oppressed graduate student at the time and I think the quality of the faculty has improved since then, if Patrick's teaching a course there.

WELD:  I going to ask you, Patrick, to start off with giving us a little introduction to some of the issues which we are dealing with here.

CHOVANEC:  Sure. Well, the question here is how China's slowdown affects other countries in Asia and perhaps the global economy. And I think to adequately talk about that we need to talk a little bit about what is happening in China's economy, what kind of slowdown are we talking about. Is it a cyclical slowdown, where things will turn up in the next few quarters, or is it a more structural, long-term slowdown, and if so, what does that mean.

And I think that's an open debate, not just in markets where, you know, you will hear people say next quarter will be better. But also implicitly, even in higher quarters. I mean, the IMF is saying officially that China will hit 7 percent GDP growth this year,

Putting aside all the questions about the validity of Chinese statistics and reliability of Chinese statistics, in the first quarter of this year, quarter-on-quarter growth was 5.3 percent. Probably hasn't gotten better in the second quarter. So to get to 7 percent annual, that's going to require quite a rebound in the second half of the year. And the question is, is that in the cards.

I would argue that it's not. I would argue that what China is facing right now is a real structural change in its economy. And I'm not saying anything that Chinese officials, and even very high officials in their moments of candor, haven't said, which is that China is facing a structural adjustment from an export and investment-driven economy to a more consumption-driven economy.

And I think that that will be profoundly disruptive. I think that it involves not just a severe slowdown in some of the things that have been big growth drivers in the past, but really a very different kind of Chinese economy will emerge from this.

And let me very briefly try to explain what I mean by this shifting of the gears in the Chinese economy. China was very, very successful over the past decade or more, probably more than a decade, in adopting and pursuing what's called the export-led growth model, which was successful for Japan, for South Korea, for a number of Southeast Asian countries.

And the key to that model, which unfortunately the word export plays a premier role, and I think that's a little bit misleading because people then say, aha, it's net exports that drive growth in the export-led growth model. So it's exports minus imports have to be a large part of the economy.

And people will say, well, you know, in China recently, net exports have gone down from 8 percent to 2 percent of GDP, so obviously they have shifted away from that model. But really the export-led growth model is not just about net exports driving growth, contributing to GDP growth. It's really about drawing on external demand, gross exports to accelerate the process of domestic investment because if you're a poor country, you don't have that many—you don't have that much of a domestic consumption base, and so you can't justify that much investment because the market is not there. Whereas is if you can feed external demand, you can justify a lot faster pace of investment.

And so what happened, I would argue in the—in 2008 was, you know, the imbalance, the export-led growth model is very successful except that it relies on an imbalance, that if you're going to produce more than you consume somebody has to consume more than they produce.

And when you become—when you're an up and coming economy, that's not a problem, when you become the second largest economy in the world, it's very difficult for the rest of the world to absorb that. So beginning in 2008, it became clear that the consuming economies of the world, including the United States, could not afford to go into greater and greater debt to absorb that imbalance.

China's response to this was to double down on the investment component, for investment to replace the lost driver of external demand. As—if you think about that you've got—you're suppressing domestic consumption to channel all your resources into investment and production and you're making up the difference by selling abroad, once that driver goes away, you double down on investment, you're talking about a very imbalanced economy. So you're talking about driving growth through capacity expansion. But who's going to use that capacity? Who the end-user is going to be remains an open question.

So this is the adjustment that China faces, and I think that the reliance on investment to bridge that gap after—to essentially replace external demand with capacity creation has led to bad debt and a number of things that are going to—going to make this adjustment much more painful and much more difficult than it otherwise would be. So that—I try to lay that out just because I think it's important for us to understand or at least present my view about what is the slowdown that China is facing before we start to talk about what the implications are.

WELD: Can I ask you one thing, is this the kind of a slowdown that Nick Lardy talks about? Because he felt—he feels that China should have been driving towards this result as a way of solving its problem with an unbalanced economy.

CHOVANEC: Yes. Nick is certainly part of this conversation that we all have about where the Chinese economy has been and where it's going and I think we speak very much the same language in that respect.

And I think there's a—what you'll find is that there's a range of views among China watchers about how much China has been engaged in the process of making this adjustment versus resisting it. And I tend to be in the camp that while they know in their heads where they need to go, in reality there's been a lot of resistance to actually undertaking the kind of corrections that are necessary to get where they need to go.

WELD: The issue is really who is the "they" because I think there's different camps in this area as in others.

CHOVANEC: Well, what I mean by "they" is the—I mean, the Chinese government in terms of what they have actually done. What kind of reform steps have been undertaken.

So for instance a lot of people were very excited almost two years ago now when the third plenum met, of the central committee of the communist party met and the issued this document that listed a whole host of reforms, I'm thinking 60 or so that they were going to undertake which—and the guiding principle was that the market will be decisive.

And there was a lot of excitement and I think that some things have been done, some kind of nibbling around the edges, but I would argue not that much that has been game changing, largely because there's—I mean they want a correction without having a correction. They want to have a correction but they're afraid of the consequences of that for the financial system, for the property market, for the political implications of admitting a very serious slowdown in the economy. But I think that the longer it's put off, the more difficult that adjustment becomes.

WELD: Thank you so much. Now our second voice.

GRUENWALD: Yes, let me tell the same story but a slightly different tune maybe. I agree what Patrick said. I think it's correct to sort of characterize how we got here before we talk about, you know, where we're going.

So I think the slowdown in China really reflects two things. One is what I would call economic gravity. I mean it was bound to happen because, you know, when you're far behind it's easy to catch up and you integrate with the rest of the world and, you know, you sort of have big productivity gains and we saw this in Japan and then Korea, the tiger economies, Southeast Asia and all those countries had a period of double digit growth rates and eventually as they approached the technological frontier, it got more difficult to add value and productivity growth slowed.

So the fact that China is on a downward trend growth rate shouldn't be too surprising to everyone. But I think focusing on the post crisis period is important. I would just add one sort of big thing to what Patrick said is the role of debt. China used to be a relatively low debt economy. If you go to the onset of the global financial crisis, let's just pick a date, end of 2007, McKinsey put out a report recently that had China's all in debt GDP ratio of about 130 percent, 140 percent of GDP which sounds like a lot but in the grand scheme of things, it was relatively low. That's government banks, nonbanks, et cetera.

That ratio doubled over the last six years, and as Patrick said the legs go cut out of the growth story, the external demand disappeared, the authorities decided to double down on the growth story but you just have this huge surge of debt, and not only was it a surge of debt, the credit really wasn't allocated properly because there's a problem in China where if you're a lender, you can't really assess the credit quality of the borrower because there's this explicit or implicit government guarantee.

So, you know, I work for a credit rating agency now and we kind of tell this joke that markets without default are like religion without sin, you know, they don't really work properly. So, you know, they've got to the point now where they've got too much credit going to too many developers building too much stuff and they've kind of got themselves in an oversupply problem, and the economy's got such a high level of leverage, we're talking maybe 280 percent of GDP, on a par with US, Korea, and Australia, none of which would be considered a low debt economy.

The room for maneuver now has been very much constrained. So what we've seen in the last kind of year or so is, you know, President Xi Jinping and Premier Li Keqiang are very clearly trying to talk down the growth rate, talk down growth expectations. The target's no longer this sort of inviolable thing that we have to meet by throwing credit at the economy but, you know, the mindset is that, you know, you got to make the target and you have to pump up the credit if necessary to make the target.

So this transition now that I think we're in and, you know, the rules haven't changed, it's just, you know, the laws of economics always apply to China, they're just applying a bit more forcefully. Right now is—the challenge now is to find a path for the economy over the next couple of years where we kind of moderate the credit growth, we stabilize the credit to GDP ratios. But we have to shake up these excesses and I think that's part of the problem because, you know, the Chinese leadership does know what needs to be done but, you know, the (inaudible) edge of the abyss and look down and, you know, do they want defaults in the developer space? Do they want a pile of nonperforming loans?

Do they want to come out—they want to come out the other side where, you know, as Patrick said the market plays a more decisive role but getting from A to B is very difficult for them because they put such a premium on stability. So one thing that could happen is, you know, we could be talking two years from now and Chinese growth could be let's say six-ish, a bit more sustainable, some of the excesses have been removed, but we still don't have the credit discipline in the economy because no one was really allowed to default and the banks don't know how to distinguish between different levels of credit and we still don't have a decisive role for the market.

We've got a little bit better run and less imbalanced planned economy and, you know, that's I think a big question for us going forward. Can they—you know, can they ease up a bit on the stability constraints so, you know, kind of let the market work and get a little bit of stress in the credit sector so the capital can be allocated more efficiently next time around, because if we don't fix that problem, we're going to be—we're going to face it again.

CHOVANEC: And I think one thing that's happened is that, you know, a lot of the levers that they used, the use of credit, is becoming less and less effective.

GRUENWALD: That's right.

CHOVANEC: So the returns to credit expansion that they simply pump more money in, what they get out of that is less and less GDP growth. And part of that is the fact that you're—they're trying to roll over more and more bad debt without it actually being recognized as bad debt by pretending to pay interest on it and that's eating up a big chunk of credit expansion and it—and some of it is simply that, you know, they've reached the limits of productive investment on some level.

So this really imposes some real constraints on their ability to sort of sustain and cover up some of these issues ,and I actually think that—you mentioned 6 percent. I mean that may be the official number at some point.

GRUENWALD: We're talking about forecasting the official number that was actually going on (inaudible).

CHOVANEC: The question—right. So the question—the question is, you know, how disruptive will this adjustment really be and I think (inaudible) proving to be more disruptive than that.

I mean you have now this year a lot of economists coming out and saying, okay, they say the growth number is something around 7 percent but in reality it's probably 3 percent or 4 percent and that's based upon things—looking at things like energy consumption and cargo, the rail cargo and things like that that would normally be indicators of economic growth, and they're all severely down. In fact, the import numbers I was just tweeting about yesterday and, you know, astonishingly down in terms of the imports that normally feed output in China of commodities.

So, you know, one of the—one of the key areas I think that they're concerned about is that—is that reining in credit—you know, in the past, all credit was controlled within the same banking system. And you—since you controlled all the actors, you know, you can sort of tell them what to do. What it—what happened really is starting in around the end of 2010, beginning of 2011 was an explosion in what's called the shadow banking system in China which is nonbank lending, investment products that are being sold to retail investors that invest in property, invest in the stock market, invest in infrastructure projects.

And so a lot of—a lot of his this debt that it was talking about is no longer really contained within a—reasonably transparent—reasonably directable state banking system and it's sort of floating out there in a pseudo market. And so what happens if you default on an investment product? Do people invest in new products? Well, if people aren't investing in new products, that they perceive risk which is exactly what you want them to do. You want them to say, "Okay, I want to assess the risk that this investment is not going to pay back."

That's what you want to inject but if you—if you do inject it, are you going to be able to roll over bad debt in a way that you want to? So, you know, the—I think one of the big constraints on economic reform in China is not just entrenched interests, a lot of people focus on entrench interest. It's also this issue of systemic risk and unknown systemic risk. If you—if I pull this string, if I tell for instance—if I'm China's bank regulators and I tell them as they've told them repeatedly, do not pool investment products, okay? Don't take the proceeds of new investors and pay it out to old investors as though that was a return on their investment, which is otherwise known as Ponzi scheme, don't do that.

Well they repeatedly told banks not to do that and they've repeatedly been ignored. Why? I think it's because the banks say, "Okay, we can do that but if we do that we're going to default on a bunch of products." "Okay. All right. Go ahead, you can do it for a while longer." So, you know, there's a reluctance to pull on that string of economic reform and of accountability because you don't know what the consequences will be.

GRUENWALD: And that's the—that's the abyss. Just for people in the room so you know the official nonperforming loan ratio in the Chinese banking sector is about 1.3 percent of assets. So it's extremely low.

And given that we've just come through a period of very fast credit growth and lack of credit discipline and transparency and lots of other stuff, you know, no one knows what the true number there is but one would suspect that would be a bit on the low side, it's obviously a lagging indicator.

Could I have one thing? Can we just go kind of freeform here or do you want to ask specific...

WELD: I have—I have a question which I'm interested in because I remember one of the first things I noticed when I first came in to this field, I was doing my PhD I guess in the '80s and there was a big, a local big man, you know how there used to be these big important people in local—regional areas.

And what he did was he set up his own bank. At that time, there was—the rules against doing that were not as clearly in places and he was arrested and taken off to jail. But it seemed to me he was so popular. All the local farmers loved this guy because he came and he helped them if they needed credit. Kind of the way it was in the '30s in the US. And I thought to myself, "Why step on that person?" And I kind of understand that a little bit now but I...

CHOVANEC: Well this is the interesting thing about the shadow banking sector in China which is—no, which is that if you had asked me about the shadow banking system five years ago I would have said, Well, it's not transparent and it's not regulated, but it serves this really important need and then actually there's a lot of accountability because if you lend your money on a private basis, you know, you have to assess credit risk because you may not get it back.

And so there was greater accountability in that way and it actually played a fairly healthy role, and it has a potential to play a healthy role in the economy. What happened though a few years ago was that the shadow banking channels, both old ones and new ones, became a conduit for the formal banking system to basically do an end run around attempts by the PBOC (ph), the central bank, to restrain credit expansion. And so essentially a lot of these channels got hijacked...

WELD: And there was no way for the regulators to...

CHOVANEC: Well they kind of—turned a blind eye because the alternative was to, an end to the investment boom that was driving economic growth. And so you knew it was bad but you sort of said, "Well, we'll fix that later and in the meantime just let it happen." Because nobody wants to say, "Well, I'm the one who turned the spigot off."

And so what happened was a lot of the distortions that exist within a formal banking system got carried over into the informal banking system. So for instance when somebody—to make that concrete, when somebody—the typical Chinese investor goes to buy an investment product whether it's offered by a trust or whether it's offered by the bank itself. I would challenge you to ask them, what is this invested in? What is the product that you just bought? What is the underlying asset? And you say, "Well, it's property."

Well what property projects? You know, the—are they good ones, are they bad ones, what do you think?" "Well it doesn't matter. It doesn't matter because the banks, this big state banks sold it to me, they're going stand behind it, they can't default." And if they default well they government's going to do it because they can't default. So now what you're doing is you're not assessing economic risk and you're not allocating capital based on economic risk, you're allocating capital based upon perceived political risk and a perception that everything is too big to fail. And that's where you get misallocation of capital and that's what I mean by the distortions of the formal banking system carrying over into the—into the nonbank investment sector.

GRUENWALD: Yes, I agree. The initial model was good so the banks in China adopted what they call the two balance sheet model and balance sheet number one is something we would all recognize. You know, you take deposits and make loans.

And, you know, because of the regulations on credit creation, the banks created this second balance sheet and, you know, I agree. Initially, it was quite healthy. One of the secrets of China over the last three or four decades, how have they been able to grow so quickly and not have a financial crisis and all this sort of stuff is financial repression. You know, they've kept the finance sector under tight lids and consumers haven't had many options, you can put it—just deposit it in a state bank and that's about it.

So when the banks created the second - well, balance sheet and started these wealth management products and you can do a little bit of fixed income, a little bit of commodities, a little bit of something else and bundle them together, get a higher return, that was initially a good idea and the banks themselves including the big four, five state banks were basically, you know, bundling assets and selling them to their clients and they have this implicit state guarantee.

But then the second generation's when everyone else got into the game and you started getting property and all this kind of stuff and the regulators got behind the curve and that was a big conduit for credit expansion. I want to mention one thing that we—I think—before we forget we should mention it. There's actually been a debt restructuring in China over the last couple of months. It was initially called a debt replacement. But what happened is you had local government financing vehicles. Local governments in China weren't allowed to issue bonds so they set up this off balance sheet entities, sound familiar?

And they were borrowing a lot from the banks and channeling into investment projects. Well, they were hitting a debt service wall this year. So the residual maturity were shrinking, the interest rate was relatively high and these are the guys who implement a lot of the state's investment plan and the system was in danger of getting kind of congested, right?

So the government comes along and says, well now the local governments can issue bonds themselves at a lower interest rate and a longer maturity. And that's going to kind of smooth the debt servicing profile. The problem is the banks who were lending on both sides of this balked, right? You're a bank and I'm getting paid soon and I'm getting a high interest rate and plan B is I'm going to get paid later and get a low interest rate, they didn't think that was a very good deal, right? That's obviously a debt service reduction and it's obviously a debt restructuring.

So what happened is the People's Bank came in last month and said, you know, "We'll buy those new bonds of you and give you some goodies on the side and we'll just sort of spread the—spread the pain around." So there's actually been enough credit and enough stress in the system and enough recognition that, you know, some of these debt service piles needed to be smoothed out there. We had a kind of very stealthy debt restructuring although I read in the, I think it was on Bloomberg this morning, that amount has been doubled now to 2 trillion yuan.

But this is I think is just another example of taking stability over a decisive role for the market because the market could have, you know, have taken that but the authorities kind of smoothed it in a (inaudible)

CHOVANEC: But what's interesting about that and...

WELD: We have to let the...

CHOVANEC: Yes. Well what's interesting about that, I'll just be very brief is that essentially the government, I would argue, the central bank has taken on the debt. I mean it hasn't really...

GRUENWALD: Like a policy bank, right?

CHOVANEC: The—it's all—it's going to go to the—to the—you know, to the balance sheet of the government. And this is—it reminds me a lot of what happened in Japan in the 1990s where they were—after the—after the bubbles crashed what happened was they opened the fiscal spigots and it went to socialized bad debt and it went to—and it went to public investment to replace collapsing private investment.

And it kept GDP from collapsing but what—but it did not maintain GDP growth at high rates and then also the effect was that it—Japan ended up with what, 200—you know, 20 percent.

GRUENWALD: They're way up the GDP.

CHOVANEC: So, you know, whether you—I mean China has the ability to socialize losses in a way that doesn't take place in a market economy.

Whether that's a good thing or a bad thing in terms of the incentives that it creates going forward, and also it's not a costless thing because the economic losses are real no matter how you account for them, right? So that's—so this is why there's this constricting effect on the Chinese economy.

WELD: Thank you.

CHOVANEC: I'm sorry.

WELD: I wanted to give you all a chance to raise your hand and say who you are and stand up and ask something of our two experts.

QUESTION: I'm Bob Distoni (ph) from the National Defense University—I'm sorry. I'm Bob Distoni (ph) from the National Defense University where I'm teaching very similar issues.

A famous economist once said that if something is not sustainable, it will end. What's going to happen here when the merry-go-round stops?

CHOVANEC: In some ways, the merry-go-round is already stopping. You know, we're seeing in the economic data coming out of China what Xi Jinping would call a "new normal," you know, what I would call an extended hard landing where you may not have—you have signs of financial instability that are being dealt with on a case-by-case basis and brushed under the rug but you have a real slowing of the economy.

Since the topic here is supposedly how this affects the rest of the world, I think that's where it's really evident. I mean if you look at the price of iron ore which has fallen by two-thirds, and is below the level of—below the level of the cost of production for a lot of producers and a lot of the more marginal producers in Australia.

You know, if you were feeding China's investment bill over the past several years you really benefitted. If you were Australia selling iron ore, if you were Germany selling equipment, if you were the Japanese or the Koreans selling construction equipment you really were reaping a windfall, but that has dramatically changed. And how you're affected by China's slowdown depends a great deal on your stance relative to the Chinese economy.

This build-out of capacity over the past several years, it bid up the prices of inputs, whether it was equipment, or whether it was commodity industrial inputs. And it actually pushed down the price of outputs. So, you know, you had all this production capacity being created and going on to the world market.

The most obvious example, the most kind of dramatic example was in the solar sector where huge build-out in solar manufacturing capacity really devastated the solar industry around the world because the prices were pushed so low. And it actually drove the—I mean drove everybody else out of business, ultimately drove a lot of Chinese solar companies out of business.

But what we're seeing now is the exact opposite, which is that the—that there's downward pressure on commodity prices, all the things that we're feeding into China's investment boom.

And there's still over capacity, so that's all got to be worked out. Ultimately when that over capacity gets reined in or worked out maybe you see reflation in the—in the output sectors. But that's the effect, I think, it's having globally and it's very evident in markets.

GRUENWALD: Yes, I am a little bit less doomy and gloomy, although I agree with a lot of that stuff. I think we can take the analogy with Japan a little bit too far. I mean, we're not—China is not a country that's already been paved over and we're building bridges to nowhere, right.

The urbanization that started with Deng Xiaoping in 1979, we're about halfway done, maybe a bit more. China's urbanization ratio, which is the percentage of the population living in cities, it was about 19 percent in 1979. That (inaudible) started.

We just passed 50 and we're going to, you know, 70, 75 and we're adding more or less one percentage point per year. So, you know, do the math and we got a couple more decades to go.

We do need to get through this big over investment boom and sort of digest it all and hopefully resolve it and more to a more market oriented economy, but I do think—you know, there's still growth potential in the economy. We're not going to go back through the double digit days, but?

CHOVANEC: Yes, I know, I don't disagree with that at all. In fact there are lots of sectors in the Chinese economy, agriculture, logistics, healthcare, where there's huge room for productivity gains, consumer economy?


CHOVANEC: But what I would say is the driver is going to have to be different than the reliance on investment and external brand. It's going to have to be a more balanced economy.

GRUENWALD: Yes, I didn't—I didn't get to finish so I'm going to hog the stage for a second. The impact—we have a—we have kind of a global model we used for the impact of China's investment slowdown, so you can—you can sort of simulate them, very investment heavy deceleration of Chinese growth.

And the economy get hit hardest, well, straight off is Hong Kong and Taiwan because of the close links and everything. Korea is up there, Korea is—now is China's biggest trading partner, Australia as well, but some of the bigger sort of domestic ones.

Japan doesn't take a huge hit and neither does Indonesia or India in the Asia region. So it really depends which part is—as Steven (ph) said which part like (inaudible).


A protracted non-hard landing, I wouldn't call it soft landing?

CHOVANEC: And I call it a protracted hard landing. Yes.

WELD: You had a very important non stuck in there.

CHOVANEC: Yes, he had a non and I had no nons.

WELD: There is a gentleman here who is?

(UNKNOWN): An observation first and a question, the observation is you probably don't want your domestic, economic cycle to be moving parallel, perhaps to global (inaudible) cycle. That's what (inaudible)—maybe it was (inaudible).

The question, the current account surplus, the net exports in goods and services, would it have a mirror impact on the capital account surplus. Now if you wanted to just continue with the committee for the currency, whether you might define it from foreign policy perspective, official capital credencers (ph), or DFI (ph), to become very important and very interesting as far as your global economic presence is concerned.

What do you see in terms of the capital account movements? Thank you.

GRUENWALD: While, you're right, so far it's the—the way it's worked is there a big current account surplus and the counter-balance is a big accumulation of official reserves. And China doesn't want to do that anymore. It's sort of politically awkward to just keep piling up their money. And I think we're at $4.4 trillion or whatever the number is now.

I think rather than increasing our claims on the rest of the world by piling up reserves you've seen a movement toward more foreign direct investments. If you look across Asia, Japan used to be the big supplier of foreign direct investment, and everyone else was in that importer.

Korea switched over about five years ago to be a net exporter. And China is going to be not far behind. So they're really ramping up the outward FTI (ph).

Originally for a strategic you can almost—you know, so strategic issues, but more on, I think, on a commercial basis going forward. But they're going to have to loosen up some of the portfolio flows as well. There was an announcement last week, that I think for high net worth individuals they may be able to do selective portfolio outflows as well.

And in true Chinese fashion we're going to cross the river by feeling (ph) the stones so this is going to be a longish process. And I don't know if you want to add anything?

CHOVANEC: I think this actually raises some interesting questions about some of the initiatives that China has undertaken recently including the AAIB (ph).

It seems like the model that China would like to adopt that was—that Britain adopted in the 19th century and the United States adopted in the early 20th century, which was we will supply the goods and the capital. So we will run a trade surplus. We'll take the proceeds from that and we will reinvest it in the development of the world. And that's very much the model that China would like to adopt.

The challenge comes where in those situations—in the 19th century, in the early 20th century we were in a fundamentally supply constrained global economy, in which because Britain was the only industrialized country, everybody had yet to be industrialized because the world was recovering from World War I and World War II, and it needed to rebuild itself, capital was intensely desired, right. Now it's the build-out capacity.

We're now living in a demand constraint global economy. One in which a lot of countries have developed and they're all looking for customers. And a world which is awashed in capital looking for somewhere to go. I mean, people are paying the Germans to take their money, right.

So, does that model work in a demand and constrained global economy or what is—or I would argue what is needed is actually Chinese demand, and not Chinese capital. So, how China uses—I would argue that China is actually in a good position right now to use its foreign exchange reserves as a cushion for its domestic and economic adjustment.

So, you know, you produce more and you've consumed it for years, you can actually afford to consume more than you can produce. You can run trade deficits. And the fact that you are undergoing this real and difficult economic adjustment doesn't have to hit your quality of life. And they can afford to do that.

That's good news, and it's also good news for the global economy because it means opening up global demand. But the track—the track that they seem be on is to try export capital and not export demand.

QUESTION: Jay Singh (ph) with the Voice of America.

I went to an event, a lunch event of the report, it's called the IFF (ph) China report, 2015, yesterday at the SAIS (ph). It's very interesting.

A lot of questions regarding that report, but I just want to focus on a couple of things. One is that it claims that this report is trying to unveil the longer term strategy of Chinese leadership and the Chinese economic like transformation of the model, the development model or so.

And it claims that China's economy, the model, the economic growth model has successfully transformed it from the export led, like growth model to the service industry led growth model. That's one thing.

And regarding the AIIB (ph) and "One Belt, One Road," and it has a simple chart, is that OK. China is the manufacturing base, and along the road in Central Asia, those countries, they are going to put a lot of money on there like the building up the infrastructures. And eventually to Europe, that will be the consumers, OK.

So, I just want to—it's kind of like contradictory to me, and so, I just want to have your ideas and opinions on this. They claim that they interviewed 20-plus leaders like policy makers, high-ranked officials in China, so they came out with this report.

CHOVANEC: So they think the adjustment is over, it's accomplished. Sort of

GRUENWALD: Give them the famous, give them the famous--

CHOVANEC: We're at the beginning of the adjustment, not the end of the adjustment. And, you know, I think there is a desire to sort of declare that mission accomplished, but I don't—I don't think that's accurate.

GRUENWALD: Yes. I mean, one statistic that really stands out in China is if you look at the ratio of private consumption to GDP—and, you know, the way I learned economics is that, you know, consumption is sort of the ultimate aim in everything, including the growth rate falls out of that.

In an average OECD economy consumers get about two-thirds of the economic pie. In emerging Asia the average is about 55, 60 percent and the last time I looked in China it was 37.

There may be some measurement issues there. It could be a bit higher, but just showing how the economy is designed, it's kind of built for speed, right. You invest a lot of stuff and you grow really fast and investment has an abnormally large portion of GDP. So I think what we've been discussing up here is, you know, getting—moving away from that model where investment plays the lead role in getting the prices and incentives right, and moving toward a more consumption-led economy.

But this is early days. That is a hard number to move. The consumption is share of your GDP and getting it up into the 50s, which is probably where it should be for a country of China's per capita GDP, that's a long slog, that ain't going to happen in the next maybe, you know, decade. Decade would be a good ambitious timeframe. I don't think we'll get there in 10 years.

CHOVANEC: By the way it's not saying that China's economic model—I'm not—I don't think either, which is saying that China's economic model have failed.

GRUENWALD: No, no, no.

CHOVANEC: It's actually that China is—that China's export led growth model has succeeded to the point where it's outgrown it. And China's size actually means that it's outgrown it at a much earlier stage than development, than other countries.

When China became the second largest economy in the world, passing Japan, it had 10 times the population, so it had one to tenth the per capita GDP. That means that China reached Japan's global impact and the limits of the export led growth model at a much earlier stage in its development path and that brings with it challenges.

So it's China's success that has changed the game going forward. And the things that will take China forward are not the same things that have taken it to this point.

WELD: Will they be able to think up kinds of economic models?

GRUENWALD:  Well, they don't need--

WELD: Ahead of us in a sense.

GRUENWALD: Yes, no—well, China has this great advantage and I really think it's underplayed. They started the development process very, very late. So, you know, again, when Deng Xiaoping was premier and this was the late '70s they could see what happened in Latin America, right. You have the import substitution model with big fiscal and external deficits and that didn't turn out too well.

And then they looked at Eastern Europe and saw the big bang, fast liberalization of the financial sector. That didn't turn out too well. Then—the crisis in 1997 and '98 where you had these currency and maturity mismatches.

So they're very pragmatic guys, and I agree, they're very smart. And they pay attention to what goes on in the rest of the world. So they're finding a path through that ensures the stability and, you know, ensures that they stay in power and all that stuff. But I don't think they need to reinvent anything. They're just going to—they are going to take the bits that work and don't work.

But I think some of the fundamentals about getting the economy more geared toward consumption and letting prices and markets play a bigger role, those are—they should be non-negotiable. They're not going to be able to do it without doing that.

WELD: I am very simple minded. The last I was in China I took a long bus trip down in the Yangtze River and all the way from Shanghai through to the hinterlands. And it didn't look like a very prosperous country at that time in those places.

So, anyway—yes, this gentleman in the--

WILLIAMSON: Irving Williamson, U.S. International Trade Commission. You talked about the impact on China's imports, of also this gradual evolution. What is the risk that they'll go back to—not go back let's say, but to continue to sort of maybe pump out exports or increase imports.

So what are your forecasts for China's exports and what does that mean for their trade relations with neighbors and trading partners?

CHOVANEC: I think there is a strong temptation to try to shore up the existing model. And it's actually prevailed in practice over the past six years.

I will credit them though that they haven't given into the temptation to try to devalue the renminbi, which would be, you know, a real step back in terms of trying to shore up a model that's reached its sell-by date.

And I think that it is partially a reflection of the PBOC's recognition that that would really be a setback of the rebalancing of the Chinese economy. So, you know, they deserve credit in that respect. But I do think that there is an ever-present temptation to try to say, OK, let's pump out more.

I think the greatest constraint on that is its ineffectiveness. Its decreasing effectiveness, that you just get less and less every time you try to inject more money into the Chinese economy. It doesn't get the result that you—that you think. And it doesn't successfully prop up the old model.

GRUENWALD: Yes, I totally agree and they can't control what goes on in the rest of the world, right? If you've got an export based model you need foreign demand and they've been waiting for a long time for the U.S. to recover and the U.S. has been kind of starting and stopping. And, you know, that plus all the debt and what I would call the lessening efficiency of credit in generating growth, I think.

You know they understand that they need to move, but it's hard, it's a political decision for them as well.

WELD: The gentleman at the back row there. Could you say your name as you speak?

QUESTION: (Inaudible) Agency. Actually the economy slowdown, the Chinese government is paying close attention to innovation and entrepreneurship in emerging industries like IT, e-commerce and high-tech.

And I wonder if you could elaborate more about this structured change of the Chinese economy. And another interesting question is as the economy slows down but the Chinese stock market it still is high.

As you know in the past few years we had 10 percent growth in the stock market and it performed well. So, how do—how do you understand and could you comment on this issue? Thanks.

CHOVANEC: Don't get me started on the Chinese stock market right now.

GRUENWALD: I was going to say don't touch the Chinese stock market.

CHOVANEC: You know, so, innovation, let's talk about innovation first. There is huge room for—people in China are incredibly innovative, that can work for the system or it can work against the system in some ways.

But, you know, to me I think that the greatest failing—and Premier Wen recognized it near the end of his term, of the efforts to simulate innovation have been that they've been top-down and they have been plan-based.

And in fact if you look at, you know, not just the U.S. economy but, you know, innovative economies around the world—real innovation tends to be not according to plan. And it tends to be outside the box. And I think there's lots of room for that in China. But when you—when there is the definition—all too often I see entrepreneurs telling me in China, well, we're doing this and it's part of the five-year plan, and these are the designated areas.

And so, they're basically jumping on the gravy train and that's how you get this capacity buildout in solar that was completely unsustainable. And it really didn't generate innovation. It was—it was a capacity buildout of existing technology, because everybody wants to jump on a gravy train, you know, to seek rents rather than actually innovating.

So I think there's plenty of room for innovation. It's just that - it's going to be bottom up. And there's got to be a greater room for the—for the private sector to make that happen.

GRUENWALD: And the financing has to be there, right? Part of the problem when you have big state banks and big state enterprises and you're trying to slow down credit growth, is the credit starts to get rationed, and so, you're giving it to your favorite safe customers.

And China has, what, two private, purely private banks now. They're quite small but they need to get a lot more kind of venture and risk capital into the—into the system. And, you know, that's not the way that the economy is designed, so we'll have to see.

But I agree, that's an area where I think China has a lot of potential if they can steer their resources towards that sector and get productivity growth going again and it's stalled over the last half decade or so.

CHOVANEC: If you really want to know what I think about the stock market just Google my name and foreign policy and China. And in Foreign Policy magazine I have an article that was about a month ago, two months ago, that was saying why I thought it was a bubble and why I thought it was dangerous and not going to achieve the results that the Chinese government wanted out of it, but I won't bore everybody by doing stock market analysis here.

QUESTION: Hi, Allison Milly (ph) of Compton Group.

The drive—China's drive for resources and commodities really shaped a lot of its foreign policy over the last decade or so. I'm wondering how you think the slowdown will affect their relationships. Africa in particular comes to mind, but worldwide.

GRUENWALD: I'm not sure if we have—we don't have any data points for that one, right, because we came in and we sort of, you know, sort of captured a big chunk of the continent for resource reasons and other ones.

You know, I think it's very interesting. You know, Australia is obviously not a developing country but, you know, we mentioned it already. Iron ore prices have fallen by about half or two thirds. The volumes have kind of—have kind of held up, but these countries all got, in terms of trade shock, and, you know, if they thought this was a big party and they spent all this stuff and borrowed based on the expectations of future prices, that could be—that could be a problem.

But the Chinese are also famous long thinkers. You would suspect that if they've got sort of, you know, preferred clients that they wanted to continue to deal with, maybe that's part of the outward FTI, and that type of strategy as well.

But, I think, you know, this sort of bounce-back on the terms of trade or something that a lot of people weren't expecting so quickly. And, you know, it's not going to last forever and China is going to sort of settle back into a slower growth path. But we ain't going back to where we were, you know, before the crisis when prices were considered, you know?

CHOVANEC: Yes, an interesting question. I don't always subscribe to the idea that the Chinese are really long-term thinkers because the short term response generally in China to any kind of fall in the price of commodities, even though it was generated by a fall in Chinese demand is the double down and a buy up of a lot of that commodity.

So you'll see, you know, they're stock piling oil, they're stock piling iron ore, and they're stock piling whatever. There was also in the news recently, Fortescue (ph) is a company in Australia that has really—it's iron ore producer that has really thrived on the export of iron ore to China, but it has relatively higher cost base than everybody else, and they're below probably their cost base.

And they've run into some financial difficulties. And there was talk about Baosteel and a whole bunch of other Chinese companies going in and buying them to lock in cheap iron ore, which is questionable, why would you need the locked in cheap iron ore if it's already cheap. And why would you want to buy the asset if it's cheap unless you thought it was going up?

There is this tendency to double down on resources when you would think that you would not want to double down on—and try to even not want to double down on resources, but that's the short-term response.

The long-term response may be that, you know, it is not as attractive as it was. If you think that, you know, you're—if you think your consumption of iron ore is going to double in the next 10 years, well, you might want to go out and secure sources of iron ore.  If you don't think it's going to—it's going to, that may be a very different picture. And the effect on global prices and everything else may be a very different kind of proposition.

GRUENWALD: Yes, but the trade pattern is a little bit different. So if you look at, you know, just—you know, Australia and New Zealand recently—well, you know, they've been trading with the Japanese and the Koreans for much longer than the Chinese.

And the Japanese and Koreans just want to trade. And the Chinese want to come in and buy the assets. So you see that repeatedly. It's not just in Asia and (inaudible), they go in Africa—and maybe that's part of the mercantilist behavior. But there's something about, you know, the psyche that they have to own the asset and they sort of—they don't want to, you know—even if it's not a good long-term investment, just the fact that they own it and they can secure it, that's definitely part of the driver, and the FTI (ph). And I don't think that's going to change hugely in the?

WELD: Yes, but the innovation comes in with how to use those?

CHOVANEC: Well, this is an interesting question because, you know, I used to teach American Business History at Tsinghua. And one of the things that I would discuss very early on is that the United States historically was always a resource rich, and I mean land rich, resource rich country, and labor constrained. So you had to import labor, right, and to fill up the country and use those resources.

China has traditionally been labor rich, although there may be more constrains on that than there were in the past—and resource poor.

In the United States technology was mainly aimed at addressing that issue, which was labor saving technology. You know, it's a scarce resource then you invented labor saving technology.

In China the tendency is to adopt labor saving technology because that's seen as higher technology, but in fact China's constraint may be that it needs—it needs to develop technology that's resource—that actually uses resources more efficiently?

WELD:  That's innovation?

CHOVANEC: So maybe a very different kind of innovation, but I haven't heard that conversation take place, at least explicitly.

WELD: Yes?

QUESTION: Hi, Taseem Pasha (ph) with the Department of Treasury. I have two questions both for you Paul and Patrick.

The first one being do you anticipate with China's desire to manage its slowdown any moves when it comes to currency policy. It has made commitments to half the R&B (ph), be exposed to market forces more and more. And I was wondering what you think of—how this slowdown is going to impact that in the coming future.

The second question is about the part of the GDP we have maybe not discussed so far which is government spending. How do you anticipate China using that lever to impact the GDP income in the future?

CHOVANEC: I'm sorry, what was the last question?

GRUENWALD: Fiscal policy.

CHOVANEC: Fiscal policy?

GRUENWALD: Yes, yes, that's right. Well, I can those in reverse order, Patrick, you can just jump in.

Asia governments aren't as active on fiscal policy as governments in the rest of the world, so China has been running, I think, a modest fiscal deficit of, you know, one to two percent of GDP. They certainly haven't come out and said we're going to ramp up fiscal spending in response to the slowdown.

The public balance sheet is actually one of the strengths in China. So we talked earlier about absorbing some of the excess debt from the local government. They like that as a source of stability along with the good balance sheets of the big four or five state banks. So I don't expect any kind of, you know, huge and loosening, you know, caves in (ph) style of listening of fiscal policy.

Exchange rate, they have been sort of gradually widening the band. I think it's plus or minus two right now. I think historically when things get a bit dicey with the Chinese growth story, they'll kind of buckle down and be a bit tighter on the exchange rate management. And then when things are going better they'll widen the band a bit.

There's a couple of reasons to do that. One is they're gradually opening up the capital account. They want to show the IMF that they're good, global citizens and get into the SDR (ph) (inaudible), so there's probably a couple of different reasons that they do that. But everything is going to be gradual, right. It's just not in the—in the model to do both things.

So, I suspect we, you know, get some gradual widening of the band, but I don't think any big fiscal stimulus is in order. They're sort of targeting things like SME in these preferred sectors, but not opening the fiscal tops (ph).

CHOVANEC: One could argue that China is a credit boom (ph), and some people did argue this at that time. It's essentially fiscal spending in disguise because it's going to be backed ultimately by—you know, if there are losses, if the money is going to come back then it will—then the government will absorb it, whether explicitly or implicitly.

And so, you know, the use of the government balance sheet, it doesn't have to be in the kind of clear spending way that we do, and they use the government sheet to drive the investment through, you know, through the banks et cetera. So, you know, there has been a use of fiscal policy in a sense.  

On the renminbi—you know, the challenge for U.S. policy makers is that in the past they could say, well, we want a strong renminbi for rebalancing, right, both in the United States and in China. And we want a market based renminbi. And you were arguing for the same thing.

Well, now because the capital outflow is from China there's downward pressure on the renminbi. And so, if you let the renminbi float it will probably go down. Now that—so now you've got to choose.

You could say, well, do we want a strong renminbi for rebalancing and therefore you should essentially reverse your past intervention by supporting renminbi when you kept it instead of keeping—you kept it down in the past and now you need to support it, and you use your reserve to do that or do you want just the market base floating renminbi.

I mean I would actually argue that you want the former. But to have a meaningfully market based renminbi you've got to unwind those FX reserves to a reasonable level.

WELD: You know, we sorrowfully come to the end of our time. Thank you so much.

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