Stimulus and Protectionism

“Whenever someone starts talking about 'fair competition' or indeed, about 'fairness' in general, it is time to keep a sharp eye on your wallet, for it is about to be picked.”

― Murray N. Rothbard

The global economy has been struggling, to say the least, since the Global Financial Crises of 2008. When the financial crises occurred US and Europe started a process of monetary stimulus, an experiment with ‘zero bound’. The Chinese saw demand destruction like never before, 25% of their exports vanished and 25m migrant workers had to come back home. This prospect of instability made Chinese government embark on an unprecedented fixed asset expansion program to maintain demand and employment. This were funded by bank loans, by the same banks controlled by the government.

Gross Capital Formation (US$ bn)	2000	2008	2015	2008-2015	CAGR 2000 – 2015	CAGR 2000 - 2008	CAGR 2008 – 2015
China	367	1,127	4,553	22,074	18.3%	15.0%	22.1%
US	2,077	3,233	3,299	24,109	3.1%	5.7%	0.3%
Euro Area	1,599	2,603	2,588	22,365	3.3%	6.3%	-0.1%
Japan	1,022	988	1,042	8,657	0.1%	-0.4%	0.8%
World	7,266	12,427	19,215	128,038	6.7%	6.9%	6.4%
% of World
China	5%	9%	24%	17%

Source: World Bank

While this expansion was taking place, it is interesting to see how household final consumption shaped up during the same period.

Household Final Consumption (US$ bn)	2000	2008	2015	2008-2015	CAGR 2000 – 2015	CAGR 2000 - 2008	CAGR 2008 – 2015
China	568	1,660	4,251	23,295	14.4%	14.4%	14.4%
US	6,792	10,014	12,284	87,311	4.0%	5.0%	3.0%
Euro Area	3,673	7,833	6,367	58,226	3.7%	9.9%	-2.9%
Japan	2,674	2,826	2,416	24,479	-0.7%	0.7%	-2.2%
World	20,203	36,446	42,608	3,25,058	5.1%	7.7%	2.3%
% of World
China	3%	5%	10%	7%

Source: World Bank

So, the critical questions anyone would ask:

• Why are the Chinese who have only 7% of Household Final Consumption spending 17% of the Global Capital Formation post 2008?
• Why has global demand not expanded at a faster pace despite so much central bank stimulus globally with Capital Formation expanding 6% but demand only 2%?

When the Global Financial Crises struck, the Chinese government seeing the retrenchment of demand embarked on massive capital asset formation, the fixed asset formation expanded faster than before 2008 to the point where it spending more than Euro a rea or US. This capital expansion did rescue the global economy initially. The expansion had two elements. The first was in capacity building in different industries (a significant proportion was related to construction) to the extent there is overcapacity in excess of 30% in sectors like iron and steel, glass, cement, aluminium, solar panel, and power generation equipment. China exports US$2.3trn worth of goods around the world with electronic equipment and machinery making up almost half of it. By some estimates, Chinese has the capability to export another US$2trn globally given its overcapacity. The second part is in property, China has invested since 1998 more than 15% of GDP in property or something like 40% of Gross Capital Formation. By 2025, they plan to move 600m people to urban centres, like building all the cities of Europe in less than a generation. Property investment creates income for local provinces and municipalities (it is also their main source) which then use this income to for their pet expansion programs, industry incentivisation and employment generation programs. Thus, increasing property prices every year helps not only the wealth effect of the populace but also ensures larger and larger availability of money for the provincial governments. Politics is intricately linked to economics.

While this was happening at one end of the globe, the other end was busy providing financial stimulus. But this created no jobs as Chinese overcapacity swallowed whatever excess demand that was created at whatever price. Of course, demand growth was impacted by declining population and aging. With lack of jobs, there could never be any meaningful and sustainable expansion in consumption. The financial stimulus consequently, instead of working in its traditional ways helped expand financial asset prices – stocks, bonds, property, wine, art or fur. We have, therefore, seen inequality grow across the globe.

We've used up a lot of bullets. And we talk about stimulus. But the truth is, we're running a federal deficit that's 9 percent of GDP. That is stimulative as all get out. It's more stimulative than any policy we've followed since World War II.  - Warren Buffett

China may propound itself to be virtue of free market world. It is hardly for the reason of political stability (e.g. global media or internet access), overcapacity and local capability development in key industries. For example, as Dr Balding points out:

• An average Chinese tariff rate of 3.4% compared to the US rate of 2.6%. China maintains a 9.9% average rate for other WTO members while the US has a 2.5% weighted average for WTO members;
• China maintains a long “negatives” list of industries in which foreigners simply cannot invest. This includes such high tech national security industries as cotton.  Even now, most investors require a Chinese joint venture partner and are simply prohibited from having a wholly owned Chinese subsidiary;
• China continues to restrict international capital flows despite joining the IMF SDR and promoting RMB internationalization.  Excluding flows within China controlled territory, the RMB ranks below the Danish krone for international payments and transactions.   

This brings us to today’s fork:

• The Chinese desperately want access to the global markets especially the US (>25% of global demand) while keeping its demand to itself to sustain industry and employment;
• One Belt One Road is as much an economic manifestation of this as it is geopolitical;
• Investment is done with Chinese money and conditionality’s such that the construction activities are taken up by Chinese companies (nothing unusual here, JICA or EXIM does the similar);
• The monies lent unless it gives an adequate economic return may leave high levels of debt in emerging countries i.e. Venezuela where the decline in oil prices have put US$18bn of China financing at risk or like Sri Lanka where high levels of debt have resulted in 80% of a port being handed over to China; 
• Given the deterioration of the Chinese economy (overcapacity and high levels of debt), Chinese people are sending their savings abroad parking in real estate or acquiring companies at high valuations, this is putting pressure on the RMB (devaluation expectations run as high as 30-40% if the central bank stops intervening):
• Almost till 2013, China had bought US$ to maintain the low value of the currency but now despite the massive current account surplus the outflow is unprecedented causing continuous haemorrhaging of the currency reserves;
• Politicians globally, whether they understand this or are just seeing implications in their home markets, are responding with rising protectionist sentiment in Europe and the US, Trump is just an extreme version of this sentiment.

It is clear that this will not end well. Low rates have created a world of high debt and overvaluation, retracement of both is detrimental for economic progress and the overcapacity China has created may take over a decade to clear out. Continuing issues of Eurozone and Middle-East and global aging make things only worse. None of the parties involved seem to be able or willing to normalize their paths on their own, which likely means a crisis that sparks the adjustment.

Take your pick…