When China released “Some steps to expand China’s opening-up and aggressively use foreign investment capital”, a light bulb went on in my head: China is finally “getting” the limits of financial engineering and will return to first principles.
Deng Xiaoping is still the name most closely associated with China’s modernization drive, but it was Zhou Enlai in 1963 who spoke of the Four modernizations (Agriculture, Industry, Defense and Science-Technology). After Mao, Deng made the connection between the opening of the Chinese economy and the acquisition of Western know-how, and he added a fifth sector to the Chinese list: finance. The 40-year dominance of his thought on the Chinese economic landscape is perhaps why many Western observers have linked his openness to financial modernization. But that has always been China’s choice. It is not a logical necessity.
Economist Arthur Krober compared the decoupling of these two agendas to look at a “very slow train crash”. Yet, in exactly the same time frame, China has accelerated its Herculean efforts to modernize the architecture of its national financial system. Digital payment systemsadopting a registration system for securities, listed ABS, central bank led digital payment clearing systems, AND Fall sprouted like mushrooms after President Xi took office in late 2012.
As a frequent speaker to senior Chinese regulators and bankers, I have been asked to provide insight into many cutting-edge finance topics: derivatives, securitization, private management products, financing participatory and the eternal favourite, financial innovation: what is it? ? How can China initiate it? In my mind, the case for financial engineering in building national wealth has yet to be made. Market risk engineering guru Rich Bookstaber blinks. In its definitive study on the technical roots of the crisis, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, his best advice is “be careful”. Even the dean of Chinese economists Cheng Siweispecialist in complexity and the Chinese virtual economy, warned against relationship between financial engineering and crisis end of 2014, a few months before his death.
It is fair to say that financial engineering has brought China to its current economic inflection point. After the Yuan fell from 7.5 to 1 to around 6 to 1 ($0.167) between 2008 and 2014, it lost around two-thirds of its gains, ending in 2016 at 7 to 1 ($0.143). Meanwhile, to contain inflation, China’s central bank sold dollars and bought yuan, reducing its foreign exchange reserves (which function like a cash reserve account in a structured balance sheet) by 25% from 4 US$ trillion at its peak in 2014 to about US$3 trillion now—the average level of reserves after the crisis, but well below average while Xi was in power and poised to fall further.
The yuan has been caught in a seesaw, with one side claiming it has been manipulated to take advantage of China’s export earnings while the other claims it is propped up to please the IMF and appease the West. Such one-dimensional debates contain some truth, but they take us away from “fair value”.
A national economic balance sheet – not the paper, but the real one – is a non-linear or complex system where money links the assets, liabilities and capital stock of public and private enterprises. Fair value is the set of capital costs over the foreseeable future that can align assets, liabilities, and equity to generate low-volatility self-sustaining growth. For any nation, this would be a delicate balancing act. But China must balance the wealth expectations of its citizens with the commercial expectations of its foreign relations and with the material constraints of an economy with very uneven rates of regional development.
China has used all the traditional tools of financial engineering at its disposal to grow at a physically impossible speed. Hence the swing. Now China wants to add the most powerful tool of all: quality. It could be a game changer.