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Alexander Friedman: Copycat Capitalists

It is all too easy to envy China. At current growth rates, the Chinese economy will double in size in only nine years, raising an estimated 100 million people above the poverty line in the process.

Compare this to the major economies of the Western world. The eurozone’s GDP remains mired below 2008 levels, and the United States last enjoyed Chinese-style growth back in 1984, when gasoline was $1.10 a gallon and the first Apple Macintosh was rolling off the production line in California.

Given the West’s anemic performance in recent years, it is hardly surprising that envy of China’s economic dynamism has manifested itself in official policy. Recent examples range from direct market interventions (such as America’s effort to boost its automotive industry via the “cash for clunkers” program), to the British government’s attempt to reflate the United Kingdom’s housing market by guaranteeing mortgages under its “Help to Buy” scheme.

Even hitherto independent central banks have not escaped the creep toward state-sponsored capitalism. The US Federal Reserve has been gently encouraged to buy 90% of annual net issuance of US Treasury bills, effectively funding the US fiscal deficit and ensuring, via the resulting negative real interest rates, that businesses and individuals wishing to save, rather than spend, will lose purchasing power by doing so.

Ironically, Western countries are shifting to statism at the very moment that China appears to be heading in the opposite direction – witness its recent moves to liberalize its financial system. In just 10 years, the share of state-directed bank lending in China has fallen from 92% of new credit creation to less than half.

But copycat capitalism is not without risk; indeed, it is unlikely to end without someone getting scratched. The West’s efforts to emulate China are hindered by its inability to replicate the conditions of Chinese growth, such as labor mobilization, and its unwillingness to pursue practices such as the one-child policy. Thus, the West’s forays into state capitalism are more likely to result in the misallocation of capital, more in the vein of China’s vastly oversupplied steel industry but without the stellar headline economic performance of the national economy.

Coming from the other direction, China’s crawl toward a more market-oriented brand of capitalism also has potential pitfalls. We need look no further than its recent problems with so-called wealth-management products (WMPs) for evidence that reform intentions without adequate regulatory institutions can cause problems.

WMPs were commonly marketed to individuals as alternatives to deposit accounts. But the funds contributed were then invested in riskier assets that included “trust loans” to companies such as property developers. The number of trust loans rose by 40% in 2012, which triggered serious concern among China’s authorities that WMPs could become the next financial “WMDs,” because banks had strong incentives to make uneconomic lending decisions.

The subsequent state-directed WMP regulation put a brake on credit creation and sent Chinese stock markets plunging. Ultimately, however, the measures should enable China’s shadow banking system to continue to grow at a more manageable pace and in a more sustainable way.

There is a risk that the lack of growth in the West may make economic transformation in the direction of the Chinese model appear more urgent to its governments. But the Western economic model has brought about unprecedented standards of living. This achievement should not be dismissed because of one crisis, no matter how prolonged, and the economic model that produced today’s living standards should not be cast aside without careful consideration.

By contrast, China’s rapid growth should not obscure its need for economic change. According to the International Monetary Fund, at some point between 2020 and 2025, China will pass what economists call the “Lewis Turning Point,” at which a country’s vast supply of low-cost workers is exhausted and factors such as labor mobilization provide a diminishing contribution to growth. With smaller demographic and resource advantages in the coming years, the consequences of capital misallocation, unavoidable under a state-directed economic model, will come to the fore.

As China’s recent experience with WMPs demonstrates, economic change can expose old problems and create new ones. Ironically, China’s transformation from a state-directed to a market-driven economy may require the greatest amount of planning of all.

Alexander Friedman is Global Chief Investment Officer for UBS Wealth Management.

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Posted: June 13, 2013 Thursday 06:15 AM