Political and Financial Implications of China's Growth Contraction

In previous posts, I've spoken about the Chinese economic/financial system and China's geopolitical conundrums. In my previous posts, I was rather negative, but this post will contain a lot of good news for China. In 2013, Xi Jinping and the new leadership took over. I'm gonna split this post into several different parts:
1. Anti-corruption Campaign
2. Chinese Financial System and China's Rebalancing
3. Historical Implications of Development Model and Current Circumstances (Falling Growth)
4. Possible and Likely Scenarios
5. Political Shifts Necessary for Rebalancing
6. Conclusion and Fragmentation Risks/Scenarios
I'll start off with the topic I know the least about: the anti-corruption campaign. Once we get that out of the way, I'll talk about the stuff I understand a bit better.

Anti-Corruption Campaign:
There's a lot of focus on the "anti-corruption" campaign, but I pay little focus to this. I view the anti-corruption campaign as a way to get rid of the guys in the old leadership and for Jinping to put his cronies in charge. I basically view it as a swapping of cronies from a leadership that originated in Beijing to a leadership that originates in Shanghai. This is my current understanding of what's going on, which is something I don't understand particularly well and certainly isn't my area of expertise. If someone reading this post knows more about this topic than me, please comment and tell me what I do not understand, know, or what I'm failing to grasp.

Chinese Financial System and China's Rebalancing:
As I discussed in my post on the Chinese development model, this model is nothing new and has its roots in Alexander Hamilton's American System (except Hamilton wanted high wages to sustain strong internal demand). The basic idea of the model is to turbocharge production levels by implicit subsidies to producers (corporations/governments) at the expense of consumers (households). These subsidies are:

1. Financial Repression (as defined by negative lending rates: interest rates minus NGDP growth)--In financial repression, consumers (primarily households) lose out on income from lower interest rates earned on bank deposits while producers get access to capital at very cheap rates. In a flexible financial system, households have savings options other than bank deposits. However, in a tightly controlled financial system like China, households have no other alternatives and are forced to put their entire savings in bank deposits.
2. Wage Suppression--China has held wages below productivity, which is a transfer from labor/workers (households) to capital/business (firms).
3. Undervalued Currency--Currency undervaluation causes the cost of imports to go up and the benefits go to the export sector. The urban middle class (households) are the primary consumers of imports, so they pay the price.

China is bringing down the growth rate of state directed investment, particularly in real estate. Investment in real estate is growing at <10% yoy right now (in February 2014, investment in real estate was growing >20% yoy) while investment in properties with over 144 sq. meters is declining by ~8% (which was growing 15% yoy in February 2013). Since investment accounts for most of China's GDP and GDP growth, it's no surprise that GDP growth rates are coming down.
Note: All of this data is from Stratfor, but the chart requires a subscription to see (I have a Stratfor subscription), so I cannot show it on my blog.

If the Third Plenum reforms of the current Chinese leadership are taken up, the Chinese economy will rebalance. The current Chinese model relies on subsidies from the household sector to the firm/corporate/state sector, which has created major economic, social, and political imbalances. A rebalancing means that the subsidies must be stopped and reversed, which is exactly what the Third Plenum reforms will do. How will the Third Plenum reforms rebalance the Chinese economy?

• Land Reform--Under the current system, land sales had to be carried out through local and provincial governments who were able to acquire land from peasants (households) for extremely low prices. Under the reform, the increase in land value will benefit the original owners as revenue will be transferred from local and provincial governments (the state/corporate sector).
• Elimination of Residency Requirements--Due to the process of urbanization that's been occurring in China, many have moved from the countryside to the city, but those that have moved usually don't have the residency requirement (hukou) to live in the urban areas. In other words, they lack many of the same legal rights as other urban residents. An elimination of the hukou would be a transfer from the state sector to the household sector by giving citizens rights instead of letting corporations and firms use these people as they please by detaining legal rights from them.
• Financial Market Liberalization--Slowly, the repression of interest rates and the constraints placed on the Chinese financial system will be removed. Remember that a requirement of the current Chinese model is a tightly controlled financial system because it allows the PBoC to set deposit and lending rates while preventing households from having other savings options. These reforms will transfer resources from the state/corporate sector to households.
• Other Reforms that I won't discuss--These include reforms like a removal of the one-child policy among others. It's not important what these reforms necessarily are, but the important part is that they redistribute resources from producers (corporations/governments) to consumers (households). Keep in mind that I'm not an expert on China's political situation.

Through all of these reforms, China is preparing to rebalance its domestic economy towards a consumption-based model by transferring resources from the state sector (or its proxy corporates) to the household sector. China will do this by a combination of legal reforms and a reversal of policies that led to the massive growth rates over the past few decades. Keep in mind that the rigidity of China's political system means that these changes have to occur slowly. If they don't occur slowly, the system will crash.

Historical Implications of Development Model and Current Circumstances (Falling Growth):
As I've discussed earlier and in previous posts, the Chinese development model is nothing new. In the 1900's this model was taken up by the US in the 20's, Nazi Germany in the 30's and early 40's, Brazil in the 50's and 60's, the Soviet Union in the 60's and 70's, Japan in the late 70's and 80's, Korea in the 80's and 90's, China in the late 90's until today, and probably other countries I can't think of. In this model, the results end up in a similar manner:

• A debt crisis that causes massive social disruption
• The excess capacity from the model, funded by middle-class savings is used to build armaments, weaponry, and ends in war and ruin
• 10-20 years of slower growth
• Or some various combination of the three

Notice that there has been a drop in China's growth rates since the leadership transition in 2013. Growth rates are currently around 7% and will probably fall below 7% by either March or June. I think we'll probably see growth rates near 6% (possibly even 5%) towards the end of this year with maximum growth entering near 3-4% in the next 3-4 years. A few years ago, the idea of China even growing at 7% seemed preposterous to many, but China will be growing at <7% from now until the end of our lifetimes (I think this is a very safe thing to say). To me, this makes the intention of the leadership very, very clear.

Possible and Likely Scenarios:

I'm happy to say that I do not see war resulting from the current model (at least the kind of war we saw in Europe during WWII). I'm not saying war cannot result, but it won't end like Nazi Germany since the middle-class savings haven't been used to fund weaponry and armaments. The Chinese leadership seems to have already started slowly transitioning the country for a different development model, which means war is off the table. If we do get wars and political instability, it'll be from within and inside of China, not some nutcase trying to conquer the world under a bullshit ideology because his economic system effectively forces him to do so to maintain power. I don't think Xi Jinping is a nutcase to say the least.

Although war is, for all effective purposes, off the table, I do think there is a possibility of a debt crisis. Remember that this model creates a massive run-up in private debt held by the corporate sector by providing capital at extremely cheap rates. A debt crisis occurs when debt/debt servicing capacity ratios hit debt capacity constraints. In China, debt is still continuing to grow, although the growth rate is starting to come down because of the falling growth rates. If China is unable to bring its growth rates low enough in time for debt to stop increasing to the point where the financial system hits debt capacity constraints, then China will have the kind of rebalancing the US had in the Great Depression where growth rates go extremely negative for a few years, unemployment spikes, and social unrest becomes a real issue. If this scenario happens, we'll probably see the Chinese government fall, massive chunks of China fly off into chaos, other parts of China (ex. Southern China) try to draw in foreign investment, and the rest being completely uncertain. The quicker and sooner China can reduce its growth rates in a sensible manner, the less likely this scenario becomes. As of right now, this scenario is highly unlikely.

I think the most likely scenario is the scenario where China experiences a decade or two of much lower growth. The reason I think this is the most likely scenario is because this is what seems to be happening. Investment growth rates in China are coming crashing down with investment growth possibly being negative the next year or two. Using very conservative estimates, Michael Pettis arrives at the conclusion that the maximum growth rates China can achieve are 3-4% over the next 10-15 years after China begins to actually rebalance. I believe there's a realistic possibly that over the next 15-20 years, China's growth rates once it fully starts to rebalance towards domestic driven consumption could easily be less than that of the US.

Political Shifts Necessary for Rebalancing:

I've discussed the reforms that are being slowly introduced by the Chinese leadership and the shifts in the growth model, but I'm gonna discuss the political shifts necessary for this transition to take place. Due to the nature of China's growth model, I've discussed how this model creates a very unbalanced nature to growth whereby elites and those well connected to the leadership end up getting very, very wealthy while households see their portion of the pie contract. This is basically how the growth model works. Rebalancing, as I've stated above, necessarily means a reversal of this trend. What are the political implications?

• The first political implication is that the power of the elite weakens. If the elites got rich by screwing over households and you no longer transfer those resources from households to the elite, the elite will no longer be able to get rich in the same way. Not surprisingly, we've seen a massive spike in EB-5 Visas from China into the US. The former elites seem to be trying to get out, which isn't only surprising, but has lots of implications.
• The second political implication is that we need some sort of political power shift from the elite to someone else. In a society with democratic institutions (this doesn't have to be a democracy), usually this power gets transferred to the populace at large. However, I think it's safe to say the chances of China turning into a democracy over the next 5-10 years are nil, which means that power will have to be transferred to someone else. This person is Xi Jinping, who is the head of the new leadership.
• In other words, we're likely to see China shift to a more centralized political system as China's economic system decentralizes. China will likely become more autocratic over the next decade or so as the role of the state decreases gradually. I think this is the only way China has a non-chaotic rebalancing.

Conclusion and Fragmentation Risk/Scenarios:

With that being said, all of the political implications in the section above implicitly assume that China will not have a chaotic rebalancing. If China decides to turbocharge growth again and says screw the rebalancing, all of these bets and most of what I've said no longer really matters. With that being said, I think (and certainly hope) the Chinese rebalancing isn't disastrous and doesn't lead to a lot of political fallout.

If we do see China hit debt-capacity ratio limits, China will enter chaos. The risk of China mismanaging its current rebalancing is probably the largest security threat to the world. Chunks of China may go flying off even with a good rebalancing, but at least the mainland should be relatively secure. With a bad rebalancing, shit will hit the fan and everything will go haywire.

Keep in mind that with a political system like China, there are always serious political risks due to the repressive nature of the regimen. If something is politically mismanaged, the risks of a political explosion and the consequences of such an explosion are massive. However, political centralization is, I think, absolutely necessary in order for China to have a non-catastrophic rebalancing, even though other risks can potentially be created.

What Do I Do on this Blog?

In most of my posts, I usually ramble on about whatever ideas or thoughts are floating around in my mind in that particular period of time, but this time, I'll talk about something different. I'll talk about what my perspective is and what I do on this blog, it's purpose, and so forth. I'll split this up into six parts:
1. Rigor and Building Frameworks of Thought
2. Probabilistically Thinking
3. Interfacing Across Different Fields
4. Systemic Thinking
5. Toolbox Approach
6. Conclusion

Rigor and Building Frameworks of Thought:
My primary training is in mathematics, statistics (more so probability), and engineering, but I venture out into other fields ranging from politics to economics to finance to geopolitics. So what does this allow me to bring to the table? Due to my training in mathematics, statistics, and engineering, I bring a very rigorous way of thinking. What do I mean by rigor? By rigor, I mean mathematical rigor. All mathematical rigor is really just a sound way to think about things. It allows us to build conceptual frameworks and models on the fly while understanding all of the assumptions (both implicit and explicit) we're making. It allows us to craft different ways of looking at the same thing as necessary while understanding exactly what the framework's limitations are.

With this rigor, I combine my understanding of concepts from economics, finance, politics, and a whole host of other fields. This allows me to literally construct models to find different ways of looking at all sorts of different things within a very short period of time. It allows me to understand a system's qualitative behaviors and possibly see various scenarios coming; however, there is something more important I have.

Probabilistic Thinking:
I have the ability to think probabilistically. What do I mean by this? I mean that when I look at the world, I don't see something that can be determined. I see something that's constantly shifting. When I look out into the world, I see something that has its own way of operating or working. I see that each individual is a small, useless cog in some self-organizing mechanism--an organism. I view economies and countries as living organisms that need to constantly be adapting and changing as times change.

In every part of every way we look at the world, there is uncertainty involved. On top of this uncertainty, the response of the system or the agent to the uncertainty of some dose is usually far more important than the dose itself (in mathematics, it's equivalent having a stochastic dose with a nonlinear response). For options traders, this concept is very easy to understand. Leverage and scale matter, a lot. What matters isn't just which direction the move happened, but the degree to which the move happened and each added degree of the move changes the scale of the impact on us.

Interfacing Across Different Fields:
I have interests ranging across lots of different fields and while I'm nowhere close to a specialized expert on each of these fields, I do have fundamental basics in fields ranging from politics to economics to geopolitics to finance to mathematics to even history. Thus, I try to build models that link across economic, political, geopolitical, financial, ecological, and other kinds of systems. I'm able to take my view of risk and overlay it across differing assumptions to give me possible scenarios.

Since I'm able to think soundly about different fields, I can integrate and across many different fields, that automatically gives me a huge advantage. Then, if you add in my ability to think probabilistically, I have a sound way of thinking about possible scenarios. Due to my understanding of probability, I also have the seemingly rare ability to understand and think about winner-take-all systems (very few people fully understand the implications of winner-take-all effects). This allows me to have a healthy way of thinking about risk, developing ways of thinking that's robust to what we don't know and don't understand, and visualize possible scenarios along with possible pathways for the development of the system that interconnects many different fields.

Systemic Thinking:
Due to my mathematical ability, I have a very easy way of thinking in terms of systems. When you add in all of the other abilities I bring to the table, I have ways of understanding things that few do. On top of this, I combine all of this with key concepts and ideas from politics, economics, finance, geopolitics, international relations, and so on. Through this method, thinking in terms of systems is relatively simple for me.

The ability to think systemically means not just focusing on what happens next, but on what the possible sequence of events are. In mathematics, we call these higher order effects. In the real world, the impacts of what we do aren't straightforward and linear. On the contrary, they're complex and nonlinear. My ability to think systemically allows me to understand complex, nonlinear systems better than most.

Toolbox Approach:
In my daily approach to things, I like to take what I call a toolbox approach. I have various concepts, ideas, and frameworks that stem across differ across fields. I like to be able to create and design whatever I need in order to better understand what's going on at a certain time about a certain system. How can I do this? As I stated, I build models using different concepts and ideas, make simplifying assumptions, and then add in constraints into the system. I'm able to shift the concepts/ideas, the assumptions, and the constraints as I please to understand the limit to each model or conceptual framework I build.

Basically, I create and build tools on the fly to do understand as much as I can. I don't try to regurgitate other models or the same models because that limits our perspective. Instead, I try to gather as much understanding as I came from any way of thought I can. Then, I integrate across each of these areas by making assumptions and adding constraints. This allows me to take a toolbox approach to understanding what's going on and how to engineer systems/my behavior (I bet on the stuff I say here too BTW) to create a response that allows the system/me to benefit the most.

Conclusion:
The central key to my approach is adaptability. My goal is to build a way of understanding, looking at, and dealing with things that's robust in the face of or gains from what we don't understand/don't know/don't know we don't know. This is why I take a toolbox type approach. If one model doesn't apply, I like to play with it and tinker with it in such a way where I can get something about the system from it while making sure I understand the model/framework/whatever's limitations.

My primary concern is not in eliminating error (such a view of the world results from stupidity and sucker thinking). Error cannot and should not be eliminated while volatility cannot be suppressed. Instead, we want lots of error while gaining from the corresponding error; volatility must be dissipated and information must be disseminated. In other words, we want to be adaptable. The key aspect I strive for in my approach is adaptability. I try to look at the world where I can change my mode of operation/understanding/engineering with the times.

I'm not looking for one theory or underlying framework about how the world works--I think that's stupid and pointless. Instead, I focus on a fundamentally sound process that's highly adaptable with little downside risk, primarily tail risk, that allows me to catch the upside from the positive tail.