Friday, September 23, 2011

China's Next Prize: Global Financial Crown

By Andy Xie 09.07.2011

But the first step toward coronation, and boosting the world economy, should be an international equities board

Labor surplus globalization helped China's economy expand more than 20-fold in nominal dollar terms over a period of just two decades, building what's now the world's second-largest economy and largest international trading nation.

Globalizing China's current capital surplus would make it even bigger. Not only could China take the crown as the largest economy on the planet, but it may become the world's biggest financial center as well.

Each of these developments would be in the best interests of China and the rest of the world. So how can we globalize surplus capital? The first step should be to internationalize China's savings through equities by following through with plans to launch an international board on the Shanghai stock market.

An international equities board would have a significant, positive impact on the global economy. Through board mechanisms, China's surplus savings would be invested in multinational companies, thus contributing to the global economy by inspiring multinationals to expand.

China currently has a highly developed manufacturing sector but a backward financial sector dominated by state ownership and caged by a closed capital account and fixed currency exchange rates. Moreover, China lacks certain conditions necessary to qualify as a global financial center, including the rule of law, strong private property protection and transparency.

Opening an international board, though, would offer a jump-start for the changes needed to improve China's financial environment and lay a foundation for building a global financial center.

For starters, China should lay down rules so that the global top 500 companies can list on the international board. It should be a transparent process that does not include tight controls or force companies to individually lobby the government.

To date, China has missed opportunities to accept significant responsibility for the healthy functioning of the global economy. Its foreign assets of some US$ 4 trillion are overwhelmingly parked in government bonds. These lopsided allocations have created huge distortions in relative prices for bonds and stocks – a distortion that's had a destabilizing effect on the global economy.

An international board could encourage rebalancing. And now that the world economy is double-dipping, the time is ripe. A remedy to this lopsided predicament is needed – as soon as possible.

Surplus to Surplus

Globalizing China's surplus labor was the single most important factor in China's modern-day economic development. Two decades ago, the surplus depressed domestic labor costs to less than 5 percent of developed economy labor prices, even though China's labor quality was several times higher than relative wages suggested.

Since then, opening China to foreign-direct investment and building a supportive infrastructure led to rapid industrialization and export growth.

But in recent years, the labor surplus has clearly disappeared. Indeed, a shortage of blue-collar workers is plaguing many industries in China. Wages for basic labor are rising at double-digit rates. In some industries, such as mining, wages have doubled over the past three years.

Wage levels, however, are still just one-tenth of those found in developed economies. Costs have yet to become a barrier to China's ongoing industrialization, and manufacturing is making the right moves by upgrading in response to the labor shortage. China is now preparing to compete against Germany and Japan.

As China's labor surplus gradually integrated into the global economy, the country migrated from a capital shortage to a surplus situation. The trade surplus grew to today's level of between US$ 200 and US$ 400 per capita – a range that's relatively low by East Asian standards.

The trade surplus per capita could rise by five times or more. But because China has a vast population, a big jump in per capita would create an aggregate surplus that's huge relative to the global economy.

For example, China's trade surplus would be US$ 1.4 trillion to reach US$ 1,000 per capita, which is a modest amount by East Asian standards. If China upgrades its industries successfully in response to rising labor costs, as Japan did in the 1970s and South Korea and Taiwan did in the 1990s, its trade surplus could rise to US$ 1 trillion, and the per capita jump to US$ 715.

China's enormous surplus could eventually exceed all the funds raised on all stock markets worldwide. How that money is spent, logically, would have a huge impact on the global economy.

From Trade to Finance

A country becomes a world financial center after succeeding as a trade center. London won status as a global financial center because Britain overtook other countries to become the largest trader of goods and services. New York rose as a financial center after the United States replaced Britain as the top international trade player.

China is solidifying its position as the world's largest trading nation. By 2020, it could dwarf all others, becoming twice as big as the second-largest country. So could China become the world's financial center? Yes. Should it? I think the answer is, again, yes.

In terms of industrial energy consumption, China is already the biggest industrial economy in the world. The dollar value isn't there yet because Chinese goods are still inexpensive. China could raise prices to absorb rising labor costs in this decade and still grow exports at more than 10 percent per annum. By 2020, China could become twice as big as Germany in international trade.

Nevertheless, China must do something to build its status as an international financial hub. Inaction would hurt its own economy as well as the rest of the world's.

In the past, financial services set up shop after traders were in place because most financing was related to trade. Most financial firm profits were derived from trade, too.

One can see the connection in Pingyao, the little town in Shanxi Province that's small and poor but once dominated China's financing in the 19th century. At that time, Pingyao served as a link between makers of Chinese goods and buyers in the rising Russian Empire. Pingyao bordered both worlds and could arbitrage price differences, creating a national financial center until seaborne trade eclipsed land routes, and Shanghai became China's financial hub.

The United States didn't plot to supplant Britain as the international financial center. It happened because the United States replaced Britain first as the biggest industrial power and trading nation. Wall Street's importance is a consequence of American industrial success.

The most important economic development in the 21st century will be China's rise as the largest industrial nation. I have anticipated this for a long time. This is a consequence of globalization and China's cultural characteristics. The government has adopted supportive policies, i.e., not standing in the way. And no other country is on the horizon to challenge China's industrialization.

Some may argue that things have changed since Pingyao's glory days. The IT revolution has made the physical place for asset trading irrelevant. But Germany's plight is a reminder that when profit sources and financial centers are disconnected, bad things happen.

Germany amassed the world's biggest trade surplus over the past decade, but its financial system has been woefully underdeveloped. So it has had to rely on London bankers to recycle money into other countries. Naturally, London bankers can screw Germany; they're even paid to do so.

A decade or two from now, as a result of this mismatch, Germany may become a poor country. People may look back and pin Germany's downfall to the country's hyper-competitive manufacturing combined with an inadequate financial sector.

No Substitute

China has avoided Germany's fate so far by pouring its surplus capital into government bonds, especially U.S. Treasuries. This strategy has worked: Major economy government bonds have held up in value, even though their economies are in shambles.

But government bonds cannot sustain value if underlying economies are in constant crisis. At some point in these situations, either government debt levels become too high or tax revenues are too low. Central banks are then forced to bail out governments by printing money. China would get its money back in this scenario, but only after currency depreciation.

Unless China changes its strategy, it cannot avoid Germany's fate. China's net foreign assets have risen twice as fast as its trade surplus, mainly due to capital inflow, especially from overseas Chinese, to avoid the dollar's depreciation.

The Chinese government is essentially taking on currency risks for the entire, overseas Chinese community. If China loses its foreign exchange reserves, the central government may go bankrupt and the country's financial foundation will vanish.

In addition to risking assets, China's foreign reserves strategy is distorting the global economy. The sharp price divergence for stocks and bonds is mostly due to the fact that money is concentrating in institutions that only buy government bonds, including those in China. Oil exporting countries have even more money than China in the bond market.

Putting all that money into bonds keeps stock prices low and discourages company investment and hiring, thus destabilizing the global economy. A country that saves a lot of money must instead allocate that money effectively and efficiently to help the global economy, not just governments.

Over the past decade, though, China has been one of several countries that amassed savings but did a bad job allocating surplus capital. And over the next decade, China's money pile may grow until it dwarfs all others. If China fails to allocate this wealth effectively, the world will blame China for its ills.

Stop Sauntering

To successfully allocate this surplus capital, then, China must become the world's biggest financial center. The money must be deployed efficiently, i.e. put toward things that improve rather than impede global growth. Otherwise a backlash would impede China's development, and everyone would suffer.

An alternative to a trade surplus would be to create a massive asset bubble that exaggerates domestic demand. Japan did that in the 1980s. China is doing quite a bit now. Without a domestic asset bubble, I think, China's trade surplus would be twice its current size.

Running a bubble, though, merely delays the inevitable and leads to financial crisis. China's total property value, including work-in-progress and land reserves, is already five times GDP. The bubble is about 100 percent above the sustainable level but could double if the government allows.

When the bubble is big enough, the country will start running trade deficits rather than surpluses. But if the bubble bursts and China's currency is devalued, property values would fall to 2.5 times GDP or less and create a huge trade surplus equal to more than 10 percent GDP.

The world won't tolerate such an outcome. Countries would react with protectionist policies that shut down the global economy for everyone.

Neither will the global economy wait for China to saunter along at its own financial services development pace. Surplus capital must be injected into the global economy, and soon.

The only way out is to develop a global financial center that allocates China's surplus capital effectively and efficiently to boost global economic growth, thus safeguarding its ability to earn surpluses.

Another argument for a new board is that multinationals must expand in emerging economies such as China because their home countries don't have surplus capital. It makes sense for them to raise money in places where that money will be invested.

Many argue that an international board would hurt the A-share market. This is petty reasoning. A-share market values are low because it's concerned about growth at home and abroad. The international board would help the global economy, which would be good for China's economy. Besides, the A-share market could rally as multinational business confidence improves.

Liquidity is not a problem in China. And appropriate policy adjustments can help maintain liquidity levels that support stock investing on domestic markets.

To boost stock demand, the Chinese government could introduce new sources of funds for equities. A 401K-like retirement plan, for example, could boost A-share demand greatly, possibly by more than 100 billion yuan per annum, sufficiently offsetting fund-raisings on the international board. Raising stock investment ratios for insurance companies would provide another source of domestic equity demand.

In the end, China must internationalize its surplus capital for the global economy and its own to function normally. The alternatives are asset bubbles and financial crises. Continuing to lock up surplus money could encourage protectionism and destroy the global economy.