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Last week, China's leadership—including President, the Politburo, the CSRC, and the PBoC—clearly 1) announced a reflationary barrage of fiscal and monetary policies and 2) made statements in support of free markets as a big step to end the deflationary deleveraging and to stimulate creative productivity. That happened at the same time as 3) Chinese assets were (and still are) very cheap, so it was a combustible combination of influences that set the markets on fire. It was a big week. In fact, I think that it was such a big week that it could go down in the market-economic history books as comparable to the week Mario Draghi said that he and the ECB would "do whatever it takes,” if China’s policymakers, in fact, do what it takes, which will require a lot more than what was announced.
I will now be more specific.
What a Beautiful Deleveraging Looks Like
In my 55 years as a global macro investor, I have seen, traded through, and studied many big debt crises (48 are covered in my book, “Principles for Navigating Big Debt Crises.”) It is that perspective that leads me to believe that China is at a fork in the road and can either:
a) deal with its debt crisis well by engineering "a beautiful deleveraging," which acceptably reduces debt burdens or spreads them out so China won't have a debt crisis and will be energized to be productive.
or,
b) deal with the debt crisis in a way that causes it to drag on, leading to an economic and psychological malaise like Japan experienced (until Abe and Kuroda shifted policies).
In a nutshell, it all depends on whether Chinese policymakers do or don't simultaneously a) restructure bad debts (thus eliminating zombie conditions of their institutions) and b) lower interest rates below inflation and nominal growth rates, or, if that proves impossible, monetize debt to get the rates below the inflation and nominal growth rates while weakening the currency to devalue the debt.
More specifically, for China's policymakers to engineer a "beautiful deleveraging," they have to lower debt burdens by simultaneously.
a) doing debt restructurings that clean the bad debts out of the system (which is deflationary) while also.
b) creating money and credit (which is stimulative and inflationary) in a balanced way so that debt service burdens are reduced and there is neither unacceptable deflation nor unacceptable inflation.
This beautiful deleveraging can only be done in countries that have most of their bad debts denominated in their own currencies and have most of the debtors and creditors as their own citizens, which is the case for China. Doing a deleveraging in this way not only reduces debts without triggering either unacceptable deflation or unacceptable inflation, but it also allows viable businesses to get back to business unencumbered by their old debts and it eliminates the "pushing on a string" problem of having scared people, companies, and other entities holding cash in safe banks and government debt assets. It does this by making cash a poorly performing asset class relative to the major alternative asset classes that are doing well because of the reflation. Doing these things starts to rekindle "bottom fishing" and “animal spirits.” We are clearly seeing that happen now.
Also, pro-market and pro-entrepreneurial policies are stimulative and, in this case, especially good because there is such enormous power in President policy-indicating statements. In this case, supportive comments came from the highest levels (from President, the Politburo, the CSRC, and the PBoC) encouraging officials and people to adopt innovative and bold approaches to support the economy, and included President reassuring officials that they would not be punished for well-intentioned mistakes made in the process of implementing new policies. These statements matter a lot.
While there’s no doubt that all of this is bullish for the markets, as part of the beautiful deleveraging there will have to be difficult and painful changes in the following areas:
-The debt restructurings will be especially difficult both because they are complex and because they are politically charged because they will have huge effects on people’s wealth. Debts at the local government levels—especially between local governments which paid for their spending through land sales and by borrowings from companies and people in their provinces—are especially difficult situations to handle. Imagine the situation of a perfectly good company that lent to the local government and/or is dependent on local government spending facing the current situation. Who should do what in what amounts to deal with this situation? Who will determine such things and how? These things are not clear. Because similar problems have been faced and dealt with throughout history (including the 1990s in China with Z and many people helping him who are still alive and lucid) in ways that are both effective and painful, this can be done if the courage and capabilities are mustered, but it will be very difficult.
-The tax system for collecting money to spend on shared expenditures and needed remediations and social programs is deeply in need of reform. As things stand, getting and distributing money is highly ineffective at the national, provincial, and local government levels. More specifically there are not effective income taxes, real estate taxes, inheritance taxes, or most other taxes (other than VATs, especially at the production level). This set of conditions makes the last problem I mentioned - the local government debt and financial problem - more challenging.
-Though there was a recent minor change in policy, the demographic problem—especially the early retirement age (on average 53) and relatively late death age (the average 53-year-old dies at 83)—leaves many people with a long time with little income and one child to take care of them. At the same time, the working population is declining rapidly.
So, while last week we saw great actions and words that I am sure will be followed by highly stimulative policies that will help a lot and will support asset prices, I think that there are several important other things to keep an eye on to see how well China’s domestic debt-money-economy challenges will be handled.
Of course, these observations are about just one of the five big forces (the debt-money-economy force) in one of the big countries (China), and it’s important to remember that the other big forces (the internal political conflict force, the external geopolitics conflict force, the acts of nature force, and the technology force) are also affecting China, other nations, and the entire world. Last week was filled with comparably important developments pertaining to all of these things, and these developments seem, to me, to be broadly tracking the big cycle that will have big impacts on what the changing world order will look like. I will keep you posted with my thinking about them.
These views are my own and not necessarily Bridgewater's.
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