China's Transition - Installing Complexity

I'm off to China at the end of the week, and I've no doubt everyone will still be telling me that China's transition is underway. Certainly if you look at the Street's forecasts for China, you'll see everyone is dutifully sketching in the transition from investment & export led growth, to consumption-led growth, whilst the underlying growth rate and savings/investment balance barely skips a beat.

Let's hope so.

But I can't help noticing that in dealing with the challenges posed by China's current economic situation, the recourse to administrative measures in every way favours those parts of the economy which are most susceptible to state direction, which systematically making life difficult for China's freebooters and SMEs. Consider, for example, the choice to curb money supply growth by applying credit controls either directly (by raising reserve requirements, patrolling bank loan/deposit ratios, and directly discouraging lending into certain sectors), rather than by simply raising interest rates. What happens? Well, since the banking system isn't able or encouraged to price for risk, it'll simply lend to its 'safest' customers - the SOEs. The rest - that's the SMEs and the private sector - will soon learn not to bother applying for loans.  And so today the Chinese press tells us that kerb market rates in Guangdong, Zhejiang and Jiangsu are running at 10% a month.  When one part of the economy continues to misallocate, the other part gets squeezed hard.

It's not just money either - it's also electricity. China's got brownouts now, partly because of longstanding coal/electricity mispricing, but also partly owing to the powering-up of those energy-intensive industries which were shut down temporarily at the end of last year in order to meet environmental targets. And in Zhejiang, guess what?  When electricity is allocated, SOEs survive but private enterprises and SMEs are correspondingly  badly hit: enterprises using less than 2,000 kW per day have been shut down every other day since last year.

Now these sorts of policy choices and actions can in the short term mean targets (growth, inflation) will be hit. But by reinforcing an allocation of resources to that part of the economy which knows above all else how to invest big time now and worry about the end-market later,  the choices are surely not bringing forward the day when China's economy is driven by consumer demand, rather than the capex plans of the SOEs. Nor are they  likely to reverse the underlying downward trajectory of China's ROC and cashflows (see here).

As I've already observed, making the transition from exogenous growth models to endogenous growth models is damned hard, if only because the wild success of the financial repression/investment intensive and export-the-surplus model constantly reinforces precisely those lessons which ultimately need to be unlearned and discarded.

If the transition is to be made, all of us, investors, observers and policymakers, had better resign ourselves to a far greater complexity, and probably a far greater volatility, in the Chinese economy than we currently observe.  For, as the great Kevin Kelly says:

You can't install complexity. Networks are biased against large-scale drastic change. The only way to implement a large new system is to grow it. You can't install it. After the collapse of the Soviet Union, Russia tried to install capitalism, but this complex system couldn't be installed; it had to be grown. The network economy favors assembling large organizations from many smaller ones that keep their autonomy within the large. Networks, too, need to be grown, rather than installed. They need to accumulate over time. To grow a large network, one needs to start with a small network that works, then add more sophisticated nodes and levels to it. Every successful large system was once a successful small system.