I had a response to my last blog post in which I indicated that the contagion effects from a China slowdown had been contained (see Bottomed, but wait for a re-test of the lows). A reader pointed to comments by Worth Wray worried aloud about the possible catastrophic of a RMB devaluation. While I had initially dismissed Wray as a permabear, the combination of these concerns and a report of further weakness from China’s Manufacturing PMI meant that these concerns deserve a more complete and detailed answer.
Let me be clear. I don’t deny that China faces many problems because of its stalling economic growth rate. Despite all of the hand wringing by western observers, however, Beijing has many tools at its disposal to mitigate the immediate downside risks facing China and the global economy. The China growth story will probably not end well, but it will not end today.
What western analysts get wrong
Let’s consider what western analysts are getting all wrong when they look at China. Here is Worth Wray outlining the problem:
It’s no secret that China is slowing under a massive debt burden. After the financial crisis of 2008, China went on one of the biggest debt binges in modern history. There are very few parallels and any close examples have ended in hard landings. These kinds of rapid debt growth periods never end well and lead to broad based misallocation; it leads to a lot of bad assets and non-performing loans in the banking sector (even if they’re hidden in China right now). It’s a problem that’s draining liquidity from the banks; it’s sapping growth potential. And so China’s economy is naturally slowing. Now a slowdown is something that you’d expect anyway in China because you’re seeing that economy get much bigger and you’re seeing real GDP per capita grow—you always see economies slowing like that as they develop. But this is a different matter. This is largely debt-induced and China has exhausted the growth model that’s driven it for so long which is largely reliant upon credit, upon investment, and that can’t go on any longer.
Here is the critical error that he makes by assuming that the system has to come crashing down:
The trouble here is that making the transition to a new economic model driven by consumption and services and technology, it sounds fantastic but it’s going to require a cleaning out of the banking system, a cleaning out of bad debt—t’s going to require a tremendous amount of upheaval in these old-economy sectors like infrastructure, construction, real-estate, mining and I’m afraid China is past the point of no return. I don’t think it can pursue that rebalancing plan without Beijing losing an extraordinary amount of control, probably without a hard landing.
China = Argentina, Thailand, Russia?
Here is what many analysts are really thinking when they look at China, “OMG! A gargantuan episode of debt-fueled growth! Asian Crisis! Russia Crisis! Mexico! Argentina!”
The analysis is superficially correct, but the critical piece that is missing is that the template of past EM crisis has been a pattern of excess borrowing in foreign currencies, usually USD. The global economy hits a speed bump, the overly indebted EM economy is forced to devalue its currency, which exposes the country and its corporate borrowers to a negative currency shock. Those EM countries were left vulnerable because of a combination of excessive external debt and a current account deficit.
By contrast, the Chinese economy was fueled mainly by RMB-denominated debt (minimal foreign exchange exposure) and China is running an enormous current account surplus. Consider the level of aggregate Chinese foreign debt exposure and tell me why we should be worried. This story from Barron’s indicated that China has external debt of USD 1.7 trillion, which sounds high. But upon closer examination, about half of that is denominated in RMB:
As of the end of June 2015, China had USD1.68 trillion of external debt, of which USD823.7 billion was denominated in RMB. About half of China’s total external debt, therefore, does not carry the currency risk of foreign currency-denominated external debt (FX debt). Not only do exchange-rate swings not affect the burden of servicing RMB-denominated debt, but also, in the most adverse scenario, the central bank can act as lender of last resort and print money to help borrowers.
How worried should we be about a country with about USD 800 billion in foreign currency (FX) external debt when it has over USD 3 trillion in reserves? Clearly, the analytical framework of overly indebted EM crisis countries misses the mark.
Moreover, the trend in external FX debt is improving. Figures from BNP Paribas shows that Chinese external FX debt has been falling in the past few quarters (annotations in red are mine):
So why are you so worried?
Beijing is not out of options
Nevertheless, Chinese economic growth continues to decelerate. Worth Wray thinks that Beijing is out of options and therefore it needs to devalue its currency, which has the potential to spark a currency war of Apocalyptic proportions:
What really matters right now is the renminbi…but I’m concerned that Beijing is running out of options, they won’t be able to defend the renminbi for very much longer and they may have to let it float. That may end up leading to a better outcome for China long-term…but it’s a very nasty development for global growth, for global economic stability and threatens unleashing huge deflation in the developed world, a very strong dollar, and I think maybe the next global financial crisis.
What I’m concerned about when it comes to the global financial system is it’s really about the interaction of the dollar and the renminbi. You have about 10 trillion dollars in dollar-based debt or credit extended to the world…the stronger the dollar gets, the weaker the commodity prices get, the more pressure gets put on a whole range of emerging market economies. If you get a stronger dollar, which I think you are already in a position to get if we get more European Central Bank competitive easing, more Bank of Japan competitive easing, then the dollar can go up easily another 10%, maybe a little more. But if the renminbi goes, if that happens, then I think you’re setting up for a very big dollar rally so the pressure on commodities, the pressure on dollar-debts, that gets amplified at the same time that there’s a big shock to global manufacturing competitiveness and there’s a wave of deflation that comes over the world.
George Magnus, who has expressed also serious concerns about China, put a RMB devaluation into context this way:
The real threat of a Yuan devaluation is more about what it would signify. The Chinese authorities could be forced into such a policy, for example, because of a looming or actual banking crisis, and or because economic growth had collapsed to, say, 2 per cent or into a recession. Under these circumstances, economic growth around the would probably stall or fall, spurring new urgent discussions about what on earth central banks might do—so-called helicopter money policies have already been aired—and whether governments might have to abandon current budget strategies.
A yuan devaluation would be a policy of last resort:
A Yuan devaluation would almost certainly be reflected in further across-the-board US dollar appreciation bringing new financial stress to both commodity producers, and to non-financial companies that have borrowed in US dollars. Both topics have figured prominently on the IMF’s financial instability watch-list for some time.
At the moment, it is most likely that the Chinese authorities, conscious of all these risks, and eager to convey a positive impression in its financial diplomacy will try to keep the Yuan relatively stable. The internationalisation of the Yuan, membership of the Special Drawing Right, and the success of the Asian Infrastructure Investment Bank, for example, hinge on a stable and credible currency. The even more important economic rebalancing agenda at home also requires the Yuan to remain relatively firm, provided the authorities are willing and able to address debt and overcapacity problems and use fiscal and social security policies appropriately, and by way of compensation.
If Beijing were to choose the devaluation path, it would be an admission of failure of their economic policies and mean a tremendous loss of face after all the efforts it made to get the yuan into the IMF SDR basket. Moreover, China can kiss its dream of a New Silk Road goodbye and the prestige of leading the AIIB turn into dust (see China’s cunning plan to revive growth).
If growth were to really tank, China has many other policy tools at its disposal. The Required Reserved Ratio (RRR) is currently 17.5%. If push came to shove, there would be lots of room for the RRR to fall.
In addition, the PBoC could resort to unconventional monetary policy, or quantitative easing. Here is what quantitative easing might look like: The PBoC decrees that it will buy $1 trillion in local government debt from the banking system and banks are free to submit any local government debt to the PBoC for sale. Such an move would free up $1 trillion in room for the banking system to lend.
Would these actions spur more of the same credit induced growth of building white elephant airports and port facilities? Certainly. Would such a policy mean that things would end badly for China? Undoubtedly. Is this just an exercise of kicking the can down the road? Yes, but kicking the can down the road works as long as you have a long road – and the Chinese still have a long road.
Put it another way. Imagine that you knew ahead of time that the PBoC will lower the RRR by an astounding 4% and enacted QE to throw a trillion or two USD at the economy. Would you want to buy Australia, Taiwan, South Korea, or would you short everything in sight? Now ask yourself if Beijing out of bullets?
No immediate crisis
Despite all of the anxiety over the growth deceleration in China, signs of stabilization are starting to appear. Andrew Batson explained the Chinese growth slowdown very simply. It’s all about real estate and construction:
It’s not like it’s a secret. From about 2003 to about 2010 China had the biggest construction boom of modern times and probably in all of human history. Then in 2011-12 the construction boom ended. That’s it. Really, that’s all you need to know. Well, you might need one more fact: housing and construction account for as much of a third of China’s GDP, once all their indirect linkages to other sectors are considered. I think a housing downturn explains very well the timing, severity and distribution of the economic slowdown that has actually occurred.
But property prices in China are recovering, which should alleviate much of the pressures on the financial system (via Ambrose Evans-Pritchard):
Tom Orlik at Bloomberg confirmed this observation with this recent tweet:
What about the tanking stock market? The Chinese stock market is dominated by retail punters with minimal financial sophistication and lacks the professionalism of institutional sponsorship, which serves to put a damper on the wild volatility that stock prices have experienced. That’s another way that many western observers have failed when analyzing China – they think that they’re still in the US. Linking Chinese economic performance to the Chinese market is like trying to forecast the American economy by observing the results of the Kentucky Derby.
Explaining capital flight
What about the risk of capital flight? Even if the Chinese economy holds itself together, the PBoC is running an inappropriate monetary policy and faces the Impossible Trinity of stable exchange rates, free capital movement and an independent monetary policy. Every month, we are confronted with the news of billions leaving China.
Louis Gave of Gavekal had some perspective on this supposed capital flight: Anecdotal evidence does not suggest panic behind the CNYUSD weakness:
My problem with this line of thinking is that there is little evidence on the ground that this [the Chinese losing confidence in their own government] is what is actually taking place. Sure, Chinese people have been taking money out of China. But that is nothing new. Ask anyone in Vancouver, Sydney, Auckland, Hong Kong, or Bordeaux. Chinese money has been coming in for years. Macau was built as one huge conduit to get money out of, and sometimes into, China.
The big question today is whether many more Chinese people are taking their money out, and whether they are doing it on a scale large enough to overwhelm China’s US$600bn trade surplus. The recent contraction in China’s reserves suggests that this is what is happening, and of course this is what the media are latching onto. But I am troubled by the fact that at the anecdotal level, there are few signs of these massive capital outflows. For example, one easy way for Chinese people to send money abroad is through the Shanghai-Hong Kong Stock Connect scheme (which channels funds indirectly into the Hong Kong dollar); but this has barely been utilized. Meanwhile, real estate transaction volumes in the markets typically favored by Chinese buyers—Vancouver, Hong Kong, Macau, Sydney, Auckland—have fallen recently (although prices have proved more sticky). So if the Chinese are shipping their money out of China, where is that money going? In what asset markets can we see volumes and prices rising?
Instead, he attributes CNYUSD and CNHUSD weakness to hedging by exporters:
This brings me to my next point. Maybe the drop in the renminbi is not primarily linked to the Chinese public panicking over the value of their currency and deciding, en masse, to buy US dollars. Perhaps it has more to do with large numbers of Chinese exporters adjusting their currency exposures and hedging their positions as they have been caught up by the general global US dollar buying panic. To me this seems a much more plausible explanation. And it is one for which there is anecdotal evidence. A number of Hong Kong-based friends in the import-export business have recently told me that they are now hedging their foreign exchange exposure for the first time. If this is what is happening on a general scale—and admittedly it is a big “if”—we should probably not read too much into recent market moves, as they will have been the result of short term panic-buying by corporates, rather than the start of wholesale capital flight out of China.
I would also add that, as Chinese external FX debt has been falling, some of the “capital flight” can be attributable to the paying down of FX debt.
A ticking time bomb?
None of this post is meant to suggest that China is not sitting on a ticking time bomb. Their economy faces serious imbalances, which cannot be easily corrected. While the authorities are taking positive steps to rebalance the economy toward consumer-led growth, I had highlighted analysis from Michael Pettis that the rebalancing process is not happening fast enough.
In all likelihood, it will all end very badly for China someday, it just won’t be today (see Why the next recession will be very ugly).