I’ve been loath to say much about the Chinese market turmoil, due to the difficulty in getting a decent handle on what is going on via the English language media. And given the huge incentives for Chinese officialdom to engage in heavy applications of porcine maquillage, it’s not clear that one would know all that much more by reading the presumably pretty-well-controlled Chinese press.
It’s thus a bit of a relief to see a Western media outlet actually admit that analysts at a loss in reading the Chinese terrain. From Why It’s Getting Harder to Understand China, in the Wall Street Journal:
The quickening pace of depreciation in the Chinese yuan spilled over into global markets this week, raising concerns about global growth. It’s exposing the increasing difficulty of getting a firm reading on the world’s second-largest economy.
“The sheer size of China’s economy and financial markets make it one of the key countries to watch,” Peter Marber, head of emerging markets investments at Boston-based Loomis Sayles, said in an e-mail. “But the economy’s opacity and China’s distorted financial system makes it incredibly difficult for investors to know exactly what to watch.”
What may have investors most rattled is the impression that Chinese leaders have hit the panic button. They spend lots of foreign exchange reserves propping up the renminbi late last year so as to not derail its inclusion in the IMF’s Special Drawing Rights basket, even though the decision to include the renminbi was clearly political (as in there were key respects in which the currency did not qualify for inclusion). The Chinese central bank has let the renminbi depreciate sharply in the new year, while bizarrely trying to deny responsibility. From an earlier Wall Street Journal article, on the closure of China’s stock markets for a second day as they hit circuit-breaker limits twice, first a 5% fall, which led to a 15 minute halt, then a second fall when trading reopened, which quickly reached the 7% “no more for the day” threshhold:
“The plunge in stocks was mostly caused by expectations that the yuan will depreciate further, which will raise worries over the country’s economic conditions,” said Qian Qimin, a senior analyst at Shenyin Wanguo Securities….
As Chinese stocks tumbled, China’s yuan fell as much as 0.6% onshore. In the offshore market, where the yuan is traded freely, the yuan fell as much as 0.9%.
The onshore-traded yuan is now down 1.5% for the year, after posting its largest annual loss last year. The daily fix was set at 6.5646 against the U.S. dollar, its weakest level since 2011. While traders had expected the yuan to weaken this year, the pace of depreciation has taken many by surprise.
“They’ve confused enough people this week,” said Ashley Perrott, head of pan-Asia fixed income at UBS Global Asset Management in Singapore. “Sentiment is incredibly fragile.”
The offshore yuan is now down 2.7% for the year, at a record low against the U.S. dollar.
China’s central bank attempted to soothe investor nerves and clarify its position, stressing the need to keep the yuan stable and at an equilibrium level, while attributing the yuan’s moves to speculators.
Its statement, released Thursday morning, said “some speculative forces are trying to reap gains from playing [the] renminbi,” using another name for the yuan.
Those trading activities “have nothing to do with [China’s] real economy” and have only caused “abnormal fluctuations” in the currency, the PBOC said.
By letting the yuan depreciate, Beijing is acknowledging that the economy faces greater challenges this year and any boost that a weaker currency gives to exports would help, economists said.
While Chinese leaders have been trying to keep the economy on a measured path downward, investors are betting that the government will have to let the yuan fall further to maintain growth momentum.
Some analysts late last year fingered a fall in the renminbi as the greatest risk to international markets, both because it would export deflation (Chinese buyers of commodities, who are the biggest drivers of demand, would have less in real terms to spend with a weaker currency) and due to the damage it would do to companies and investors who had borrowed in foreign currencies, seeking a dangerous bargain by betting they’d save enough on lower interest rates to offset the FX risk. There is a third possible vector, that of capital flight as Chinese investors try to get out of the renminbi and get into investments in currencies that have better prospects. But anecdotal reports indicate that Chinese buying of foreign real estate, one of the most prized foreign assets, had already fallen off as Chinese investors were feeling less flush by virtue of volatility in the Chinese stock market and a deteriorating market for investment real estate in China.
So rather that try to come up with answers, which is perilous in the absence of sufficient information, I’ll instead throw out what amounts to informational chum and see if readers have additional data or facts that seem germane. Keep in mind that some of the factors are not analytically discrete; they overlap a tad, but one frame for defining a vector might be more analytically useful than another
There are some things that are known about China, even if only at a pretty high level:
No significant economy has gone through a smooth transition from being export and investment led to being consumption led. Unfortunately, orthodox economic thinking has strongly encouraged developing economies to focus on export-led growth, rather than a more balanced growth model. The problem with trying to make the shift is that more consumption requires consumption infrastructure, like bigger houses and lots more retail stores. One big impediment to Japan increasing its domestic consumption was its small houses and apartments (you have no idea how small until someone has invited you to have a look, a perspective foreigners seldom get). China winds up in a similar spot by virtue of the need to build retail infrastructure. Rather than go down that path in a serious way in the last decade, China instead doubled down on its existing national strategy. While exports as as share of GDP have fallen somewhat, investment as a percent of GDP has risen relative to its pre-crisis level. So China is either by accident or design fighting the economic evolution it needs to make.
China has used borrowings in a very big way to fuel growth, both before and after the global financial crisis, and that borrowing has become less and less productive in terms of how much in incremental growth it has delivered. There is nothing wrong with borrowing to generate growth, but one has to be mindful of investing in unproductive or insufficiently projective projects. Aside from various analyses that have shown declining productivity of Chinese borrowing, the media has been awash in pictures of ghost cities and other projects that look like white elephants (please don’t tell me that peasants need housing. They do, but this is not peasant housing. It’s speculative investment. And even if there is eventually enough of a Chinese middle class in 20 years to fill all this relatively high end housing, is anyone going to want to buy housing that is 20 years out of date in terms of appliances and other amenities? It would probably need to be upgraded in a serious way then to be competitive).
Similarly, industrial investment looks to have questionable payoffs. China has been investing heavily in higher-value-added manufacturing, often well in advance of demand. An August 2015 article by Jayati Ghosh gives a sense of the scale:
Between 2007 and 2014, total debt in China (in absolute Renminbi terms) went up four times, and the debt- GDP ratio nearly doubled. At around 282 per cent of GDP, this makes debt in China relatively much larger than in, say, the United States. Corporate debt increased to reach 125 per cent 2 of GDP; provincial governments are also highly leveraged for infrastructure investment; and debt held by households has gone up nearly threefold to a hefty 65 per cent of GDP. Fully half of the debt (much of it coming from the unregulated shadow banking institutions that were allowed to flourish) was oriented directly or indirectly towards the real estate market and housing finance, fuelling property bubbles in major Chinese cities that began to burst around a year ago.
A great deal of this borrowing has occurred through what amounts to a shadow banking system. In very simple terms, local real estate authorities have been major borrowers, and the debt has been used as the grist for various “wealth management products.” Some of these are better structured than others. The central government intervened at the end of 2014 when this market looked rocky.
The Chinese stock market is highly geared, which means a crash can produce nasty knock-on economic effects. It’s astonishing that China, which prided itself on the wisdom of its central planning, allowed high levels of margin lending. The 1929 crash was a decisive demonstration of the cost of letting too much money be sucked into stock market speculation via access to borrowed money, and the high cost when the investors not only lost their money in the crash, but lenders took huge, and sometime terminal hits too. And this was an even more reckless policy in China, where the Chinese culturally love gambling. It’s like letting an alcoholic have access to an open bar.
Chinese leaders were trying to pump up the stock market last year to prop up growth. This was a not-well-recognized warning of desperation. As we’ve repeatedly pointed out, the strategy of using asset bubbles to produce more consumption, which was explicit policy in Japan in the later 1980s, has a very poor track record. Again from Ghosh as of last August, emphasis ours:
The subsiding of the froth in the housing market led to investor focus on the stock market, which then began to sizzle. The past year showed how irrational such markets can be, as stock market indices went up by more than one and a half times in around a year, reaching a peak in early June. For some stocks, the price-equity values crossed 200. This was clearly crazy and begged for a correction, which was bound to happen. But that correction was untidy in the extreme. Since 12 June, stocks have plummeted, and on the worst day in early July they were trading on average at nearly 50 per cent lower than the peak. Worse still, at first various emergency measures of the government – from suspending trading in stocks of nearly 800 companies, through forcing brokers not to sell their shares, to indirectly buying shares on a mass scale through the China Securities Finance Corporation and sovereign wealth funds–did not work in stemming the downslide and may even have backfired by adding to the sense of panic.
Thereafter, there has been some stabilisation, although this is clearly artificially created and the market is likely to remain jittery for some time. In any case, the inflated stock prices have still not come down to what could otherwise be called reasonable levels given the crazy increases during the bubble phase, and so there may be more “correction” required. This has created a problem for the Chinese state, whose aura of economic omnipotence has taken a severe battering, because it is no longer clear how exactly they should best deal with this situation. Having talked up the stock market, extolled it as a sign of China’s growing economic strength and encouraged much greater participation in it by relatively small retail investors who are now suffering, they will find it difficult to allow it to decline any further, yet may be powerless to prevent it in the medium term.
Other reports flagged the influx of newbie small investors in 2015, often a warning that a market top is nigh.
Some Possible Factors
China may be caught between its international leadership aspirations and its growth model. China benefitted by running tightly controlled financial markets, particularly by having de-facto capital controls. But a major driver of its liberalization of its financial markets appears to have been its international ambitions, since playing a bigger role in the various perceived-to-be-important international clubs required China having more open capital markets. Recall that we’ve repeatedly cited the forced* liberalization of Japanese banking regulations and its capital markets as a major, and arguably the major, driver of its joint real estate/stock market bubbles and their eventual implosion (I saw first hand how ill equipped Japanese banks and investors were to analyze and manage the risks they were suddenly allowed to take).
Economist Victor Shih flagged a danger of liberalization: capital flight. From Ed Harrison’s summary of a 2011 presentation by Shih (trust me, it was a radical point of view at the time):
China has three structural causes of capital flight. First, wealth in China is highly concentrated. Using three different
methodologies based on survey data, data on large share holders of listed company, and data on the total financial and real estate assets in China, the wealthiest 1% urban households command between 2 and 5 trillion USD in wealth.
A 20% reallocation of this wealth overseas would cause a substantial but likely controllable drainage of China’s foreign exchange reserve.
A 30-40% reallocation of this wealth overseas would see the depletion of China’s foreign exchange reserve by close to 1 trillion USD or more.
Second, underground banks, false trade invoicing, and now an experimental scheme to allow individual investors to invest overseas provide multiple channels for capital to circumvent China’s exchange control.
Third, real deposit interest rates are negative and will remain so in the foreseeable future, thus prompting wealthy households to speculate overseas on a large scale if relative returns suddenly decrease in China.
If the top 1% of households in China reallocates 1 trillion USD of their wealth overseas, the central bank then will be faced with a choice between large scale quantitative easing and an illiquid banking system.
In the short term, China’s only recourse to reduce the volatile state of its foreign exchange reserve is to bring real interest rates back to positive territory.
And an additional key point via FT Alphaville from the underlying paper (the original is no longer at the link):
If the foreign exchange reserve is depleted by capital flight, the central bank will need to resume large scale money creation, as it did in the 1980s and the 1990s, to maintain the solvency of the banking sector.
The nasty bit here is the “large scale money creation” to save the banks conflicts with the officialdom’s desire and need to lower inflation, both to preserve domestic stability and to get real interest rates into positive territory to stop further capital flight. If you’ve watched Chinese action over the last year or so, it’s been schizophrenic: episodes of being tough on inflation seem to lead all too quickly to “support the banks and/or the markets” exercises which look to be contrary to the effort to tampen down inflation (keep in mind inflation is also a negative for competitiveness: inflation produces increase in nominal wages and finished goods prices, which unless the currency depreciates by a corresponding amount, translates into higher purchase prices for importers, making Chinese goods less attractive). So navigating a soft landing is tantamount to treading through a minefield. It might be possible to pull it off, but it is a more fraught operation than most analysts have seemed willing to concede.
The risk of political instability may be greater than is widely perceived. The government is acutely aware that its legitimacy rests on producing increasing prosperity, which means among other things, rising levels of wages and high levels of employment. The great increase in living standards in the last generation may have raised expectations that cannot be met, even before you get to the high odds that the current Chinese growth model has hit its sell-by date. In China, unhappy workers riot. Moreover, there’s also rising discontent with the health cost of high levels of pollution, yet addressing that in a serious way will (at least in the short term) conflict with the employment mandate.
There are signs of strains on businesses. We’ve heard stories of manufacturers taking no-profit orders to keep from cutting jobs, with the owners (unlike Americans) taking the point of view that they have a duty to maintain employment. Similarly, Lambert has pointed out that the horrific explosions at Taijin were ultimately caused by margin pressures.
Mind you, I’m not proposing that this list of factors is either definitive or complete. I’m offering it instead as what consultants call a “forcing device,” a set of ideas and observations intended to elicit discussion and debate. So I hope readers will have at it!
* Forced by the US. Under Reagan, making the world safe for America’s investment bankers became a big policy priority. Japan, as a US military protectorate, was hardly in a position to say no, particularly since the banks themselves didn’t understand the issues. While they correctly assessed that gaijin would not make much headway with Japanese corporations and investors, they were clueless as to how successful the gaijin would be in seducing them into participating in markets and products where they would be the marks. And that’s before you get to all the self inflicted damage…like by being wiling to lend 100% against the market value of urban land which never traded for tax and other reasons, hence the “market” prices were a complete fiction.