Loose Caboose

February 28, 2008

By The Diplomat

Economic decoupling may be a dubious thesis, but there is some finance decoupling between China and the West. China’s financial structure is still emerging from its communist origins. It is far less integrated into the global structure than its commercial system. To the extent that this protects the country from some of the West’s excesses like securitisation and derivatives trade, this is probably entirely beneficial. But the need to develop a more modern financial structure remains paramount, especially as China will only have one chance to do it before the country’s population ages.

Superficially, the currencies of America and China are coupled; the yuan is still fixed against the US dollar. But in terms of financial development they are a long way apart. The yuan is fixed because China’s financial system is still not yet developed enough to float. This protects Chinese exporters from the effect of a falling greenback; they will not be priced out of the American market, but it is a mark of how different their stage of development is.

China is the opposite of America in terms of fiscal prudence. Whereas America is sucking in about $800 billion, or two thirds of the world’s excess savings, China has amassed almost $US1.5 trillion in foreign exchange reserves.

The underpinning of the banking systems in the two countries is very different. If American banks start to get into problems on their capital adequacy, as is now happening, it is perilous. Some US banks are starting to borrow from the Federal Reserve to bolster their funds, a trend that signals danger to the whole system. China’s banks, although often near insolvency, are backed by the Chinese government, which still has massive land holdings throughout the country that can be sold off if necessary.

The capital markets are very unalike. China is only starting to develop bond markets, and its equity markets are immature. Much is being done with securities regulation and the stockbroking industry to establish a Western-style financial system, but there is a long way to go. One bright sign, however, is the recent sharp rise in profits of state owned enterprises (SOEs), which have been growing at about 50 per cent. This will help deepen the capital base. It may eventually lead to the creation of a social safety net, the absence of which is a big factor influencing China’s high savings rate. As a portion of the SOE’s profits go into a national social security fund, ordinary Chinese might feel it is safer to spend.

Even the much-touted high levels of foreign direct investment (FDI) into China are very unlike Western countries’ FDI. China’s Ministry of Commerce claims that foreign direct investment rose 13.6 per cent to $US74.7 billion last year. But the figure is inflated by mainland Chinese money being sent through offshore tax havens to take advantage of tax incentives for foreign investors. According to the Department of Foreign Investment Administration, investments channelled through havens such as the British Virgin Islands, Cayman Islands, Mauritius and Samoa jumped 37 per cent last year to account for more than a quarter of all the flows. When FDI from Hong Kong is added in, it is estimated that as much as two thirds of FDI is Chinese mainlanders pursuing tax minimisation.

For Australia, which heavily depends on China’s growth continuing, the prospects do not seem as troubling as it would be if the country depended on American growth. Most Australian economists agree that Australia will take some time to be affected by the American downturn. The demand for energy in China will remain, and with such a high proportion of the economy devoted to investment, the surge in demand for minerals is likely to continue. And even if there is a short term easing in commodity prices, the underlying supply and demand patterns suggest it will be only temporary.

The more interesting question is which strategy China will employ in the face of American economic weakness? The openness of the Chinese economy has not been principally designed to attract Western capital, but to instigate a massive technology and knowledge transfer. It has been spectacularly successful.
China now has to develop its own global firms, and start to diversify the investment of its massive financial reserves. The Chinese government has currently purchased about $US800 billion in US Treasury bonds. What will it do with its fast growing foreign exchange reserves? As Western financial institutions increasingly struggle to husband sufficient capital, the prospect for some strategic investments looms.