Foreword to Chi Lo’s ‘China’s Impossible Trinity’


China’s ascent to world power has been as eagerly or fearfully anticipated as the coming of the robots. In this sober , well-documented, and persuasive book, HK-based  economist Chi Lo explains why China’s moment will be delayed. The road to global  power and prosperity is open, but it faces severe internal obstacles which will require exceptional leadership to overcome Chi Lo hopes that President Xi Jinping might be that leader.

His analysis is based on Dani Rodrik’s notion of the impossible trinity, the trilemma being that you can’t have monetary autonomy,  an open capital account, and fixed exchange rates at the same time, only two of these.

So far Beijing  has pursued all three policy goals simultaneously,  with costly sterilisation of foreign exchange inflows allowing it to keep control over the exchange rate.

But the author argues that China is fast approaching a choice: which two policy goals   should it retain?  His answer is clear: it should opt for monetary autonomy and an open capital account,  and  let the exchange rate go. Essentially this is what has started to happen.   with a managed (largely upward) RMB float starting in 2005. But he sees central bank autonomy and capital account liberalisation not as ends in themselves, but as drivers of the ‘deep structural reform’ necessary to realise ‘China’s Dream’.

Mr. Lo’s argument in a nutshell is that China has reached the end of the line of the Deng Xiaoping development model based on export-led growth through an undervalued exchange rate; continued political monopoly of the Communist Party, and a repressed financial system which funnels Chinese savings into loss-making state-owned enterprises.

A vibrant private sector has grown up on the fringes, and in the interstices, of the creaking command and control system.  Now the private sector has to crack open the central system to allow the Chinese economy to grow in an uncorrupted,  non-distorted way. This is the only means to rebalance it towards serving domestic consumer needs. But each step of reform challenges the powerful vested interests attached to the old system -elements of the central leadership itself, local governments, state-owned industries and banks -and sharpens the contradictions between the old and the new.

Put like this China seems inevitably headed for a very hard landing. But Chi Lo is hopeful that a sufficiently courageous leadership, with a coherent strategic vision, and skilful sequencing of reforms, can avert the worst dangers.

Mr. Lo shows how financial repression, by forcing interest rates to remain ultra low for three decades, has caused a massive misallocation of capital, favouring state-owned enterprises over the private sector, shielding  the banking sector from building risk-managing capacity,  and diverting resources from dynamic market-driven activity to inefficient state-directed investment.

A shadow (including internet) banking sector has grown up to bypass the interest rate cap, based on trust companies. These companies  attract savings from the banks by paying depositors higher interest rates. They have been especially active in real estate, and fuel the rampant growth of real estate prices in many cities. Local governments, whose revenues come from land sales, cooperate with (and often own) the trust companies.

This is a good example of how a market response to a distorted control system creates more distortions which make the system more difficult to reform.  The rise of shadow banking complicates the task of reform, since it robs the monetary authority of control of credit, while creating a systemic risk for official banks by denuding them of deposits.

Mr. Lo interestingly shows that China reacted to the crisis of 2008-9 with a mixture of demand-side and supply-side measures.  It went the Keynesian way by expanding fiscal spending. But is also went the Austrian way by closing down tens of thousands of SOEs and laid off 30 million state workers. Here China scores in pragmatism, since in Europe and the United States the two approaches are usually seen as diametrically opposite. But the west benefits from the absence of a Marxist mindset of ‘power, public ownership, government subsidies and  the like’.

The author’s account of the dilemmas of the Chinese reform program offers  a fascinating insight into the realities of Chinese politics and economic life, largely hidden from western observers.  More than the fate of China, the  future of global economics and politics depends on its fate.