Gold Investor, October 2018

Q: China’s financial markets have undergone rapid change in the past 30 years. What are the highlights, in your view?

A: There are two important facts about the development of China’s financial markets in recent decades. First, China has moved slowly but steadily towards liberalisation. Interest rate and bond markets have gradually opened up and there has been growing interest in further financial reform. Of course, this is an ongoing process but there has been steady and significant progress.

Second, it should be noted that our markets have developed without provoking any significant market crises and without impeding real GDP growth – which has averaged 8-10% per annum for the past 40 years.

I believe that these two points are closely linked. Other transitional economies have pursued rapid financial reform, so-called “overnight privatisation,” but it has often had an adverse effect on growth. Russia, for instance, privatised all its banks overnight but that type of “shock therapy” caused tremendous economic damage.

In China, privately owned banks and businesses are allowed to grow and develop alongside state-owned institutions – and GDP has risen eight-fold in the past 40 years.

Q: Thinking about the future, what is the right path and proper pace for exchange rate reform?

A: This is a very important issue and there are two opposing and extreme views among economists in China. One school of thought advocates an immediate move to a free float, on the grounds that a depreciating currency would boost exports. The other school worries about capital outflows and advocates tighter controls and more government intervention.

I believe that both are wrong. I think we should keep loosening currency and capital account controls but gradually. On the exchange rate, for example, evidence from other transitional economies suggests that an immediate free float is not always the best strategy.

In fact, I would advocate an even slower pace than the government has proposed. It has suggested a one- to three-year programme of reform but that was before the trade war erupted between the US and China. Now I think a three- to five-year timeframe is more appropriate.

The government needs to play a delicate balancing act – on the one hand, it needs to break the implicit government guarantee; on the other one, it needs to ensure there is sufficient liquidity in the market so as not to create unnecessary distress.

Q: Credit conditions have tightened in the past year – what are the implications for China’s financial markets and economy?

A: The decision to tighten credit conditions and gradually raise interest rates is partially a natural response to economic growth. The housing sector, for example, has experienced buoyant conditions in recent years. But the government is also trying to break the implicit guarantee problem by allowing some financial firms – both stateowned and private – to experience default.

Clearly, it is good for firms to understand that if they cannot pay their debts and they cannot make a profit, they will go into default. However, if these policies are introduced at the wrong time, during a trade war, for example, they may have too harsh an effect on the economy. As such, the government needs to play a delicate balancing act – on the one hand, it needs to break the implicit government guarantee; on the other one, it needs to ensure there is sufficient liquidity in the market so as not to create unnecessary distress for small and medium-sized enterprises (SMEs) and others.

Fortunately, policymakers have reversed some earlier tightening in response to the trade war and resultant negative sentiment.

 

Q: So, what are your views on the US-China trade war?

A: The global trade war adds another layer of uncertainty to our economy. It has affected market sentiment and increased concerns about systemic risk.

Any escalation would damage export-oriented firms, particularly SMEs in the private sector. In fact, it seems as if there have already been casualties, as non-performing loans have increased and the People’s Bank of China has loosened monetary policy to allow SMEs to take out more secondary bank loans.

The stock market has been badly hit too, although estimates suggest that even a full-blown trade war would reduce Chinese GDP growth by a maximum of 1%. It is also true that the vast majority of the economy – about 80% of all businesses – remain unaffected by this trade war.

So, in sum, the short-term impact is quite harsh, for some SMEs and for (stock) market sentiment. But the long-term impact may be relatively slight.

Estimates suggest that even a full-blown trade war would reduce Chinese GDP growth by a maximum of 1%. And the vast majority of the economy – about 80% of all businesses – remain unaffected by this trade war.

Q: Analysts around the world pay keen attention to emerging sources of systemic financial risk. As you look at China’s financial system, which risks stand out for you?

A: There are three broad areas of concern. First, China’s debt to GDP ratio: at 250%, it is considered too high for an emerging market. Second, the debt accumulated by local government and state-owned enterprises: local government debt is hard to measure and hard to manage; state-owned enterprises are traditionally less efficient than their private counterparts so less able to cope with high levels of debt. And third, the shadow banking sector, which is considered vulnerable, particularly as interest rates rise.

I believe that people should adopt a balanced view of risk within the Chinese financial system. Yes, the debt to GDP ratio is high but the economy is still growing at around 6% a year, so that ratio may be more sustainable than people think. Also, even though some areas of the economy are heavily indebted, others are not. Chinese households have very few borrowings and could become more leveraged. The central government has very little debt too and it has US$3 trillion of foreign exchange reserves, so there may be more flex in the economy than outside observers think. We should also bear in mind that if debt levels are reduced too abruptly, that may provoke a recession.

In terms of shadow banking, the asset management sector in particular experienced tremendous growth between 2010 and 2016. Since then, however, parts of the real economy, such as manufacturing and housing, have been growing rapidly and attracting capital away from the shadow banking industry. Policies have also been introduced to clean up over-extended parts of the industry, with particular focus on products designed to appeal to small investors. The regulation is well intentioned but I believe that some regulation tightening could have been too aggressive. In fact, certain measures were reined in earlier this year, following market feedback.

Q: Turning your attention to the global landscape, where do you see potential sources of systemic financial risk?

A: My personal view is that Europe – specifically the euro – poses the biggest risk to the global economy and international financial system. I worry about potential systemic risk arising from a Greece-like situation, because Southern European economies are so much weaker than those in Northern Europe, and that creates a serious structural imbalance without a proper remedy.

The euro also creates an internal inconsistency, because there is one central bank for the Eurozone but no fiscal cohesion or unification. In the past, currency union without political unification typically broke down. If that happened with the euro, it could potentially ignite a financial crisis.

I would suggest that Brexit is another related risk, particularly a hard or no-deal Brexit.

Nonetheless, I believe that the world is less risky today than, say, a year ago because economic growth is generally improving.

Q: Do you have a view on gold?

A: I have a conjecture: as economic growth in the US and China improves, demand for gold should improve as well. Overall therefore, I predict rising demand for gold in the US, China and other countries where GDP is growing.