Published in the Nikkei Asian Review 30/4/2014
You have to feel sorry for China’s economic policy-makers. They are only human, yet the world assumes they have almost magical powers. They are expected to achieve GDP growth of 7.5% while soft-landing one of the largest credit bubbles in history, clamping down on corruption and extravagance, gradually liberalizing the financial system and keeping the currency stable.
In a country as vast and turbulent as China, achieving any one of these targets would be challenging. Pursuing all at the same time is well-nigh impossible. Faced by a conflux of difficult problems, the Chinese authorities may be tempted to copy the attitude of US Treasury Secretary John Connally when the dollar was devalued in 1971. ”It may be our currency,” he informed his European counterparts. “But it’s your problem.”
In 2010 the Chinese authorities abandoned the de facto peg of the yuan to the US dollar and introduced a managed float within a narrow band. The reaction of global markets, like the political reaction overseas, was strongly positive. Surely, went the thinking, this was the first step in the liberalization of China’s capital account.
On most reckonings the currency was greatly undervalued – by 46%, according to The Economist’s Big Mac Index – so long-term appreciation was a done deal, akin to betting on water flowing downhill. Hence the warm welcome for the dim sum yuan bonds that Chinese companies were busily issuing in Hong Kong.
What could possibly go wrong? Even during the Asian crisis, when the currencies of neighbouring countries were sinking beneath the waves, the yuan had been a rock of stability. Since then China had built an enormous treasure chest of foreign reserves. The US and other trading partners were pressing the Chinese to revalue their currency upwards.
While the leaders of the debt-raddled developed economies flailed around for a policy response to the crisis of 2008, Beijing launched a massive program of fiscal stimulus, further burnishing its reputation for omnipotence and omniscience. Direct investment by foreign companies flooded into the country and portfolio investors were eager for a slice of the action too.
That was then. This is now. Even senior officials have admitted that the Keynesian splurge went too far and has left a damaging legacy of uneconomic projects and bad debts. Since 2010 the Shanghai stock market has been one of the poorest performers in the world. Respected money managers, such as John Paulson and Fidelity’s Anthony Bolton exited licking their wounds. Some multi-nationals – albeit a tiny minority of less successful players – are downscaling their presence too. There’s a common theme here – making money is not so easy after all
Now the conventional wisdom about the currency is coming into question. Since the start of the year, the yuan has fallen 3% against the US dollar, which has been far from strong itself. The standard explanation is that the authorities are trying to wrong-foot speculators and the yuan will soon resume its long march upwards. That’s what everybody wants to happen – the holders of dim sum bonds, companies that have invested in China, the US government, perhaps even the Chinese authorities themselves.
There are three reasons why they may be disappointed.
First the yuan is no longer obviously cheap. Even the IMF has changed its tune, claiming the currency is “mildly” rather than “substantially” overvalued. Westpac’s index of the real trade-weighted yuan shows an appreciation of 33% since 2008. In the currency wars that have been a feature of the post-crisis world, China has been one of the losers. No surprise, then, that the ratio of China’s current account surplus to GDP has fallen from 10% to 2%.
Second, it is no longer in China’s interest to maintain a strong currency. The inflationary pressures of the boom years have evaporated and the producer price index has been in deflation for the past two years. Deflation is always bad news for highly leveraged economies and China has unprecedentedly high leverage for a country at its stage of development.
Third, financial liberalization may lead to more capital outflows than inflows. That is the view of Lombard Street Research amongst others. Rich Chinese have gone to extraordinary lengths to squirrel away wealth off-shore – via Macao, phoney export billings, unoccupied luxury apartments, even Bitcoin transactions. While the ignorant money was coming in, the smart money was getting out. Imagine what would happen if the middle-classes followed suit.
How the game plays out depends on developments in the Chinese economy. If the much-discussed financial crisis arrives, the probability of a devaluation will soar. Severe financial crises release severe deflationary forces and the policy response almost always leads to a lower currency.
Devaluation would be a game-changer for the world economy, especially for the commodity producers and peddlers of luxury brands who have benefited so handsomely from the rise in Chinese purchasing power. There would be collateral damage to the economies of Thailand, Vietnam and other competing manufacturing bases. The global tourist industry would notice the difference too.
China’s economic rebalancing would go into reverse and US-China relations would become even more fractious. The rhetoric from Congress would be blood-curdling. There might be a repeat of the quotas and sanctions imposed on Japan in the 1980s, or even worse. But to little avail. With export profitability surging and a new bull market underway in Chinese stocks, Beijing would likely respond with Connally-esqe insouciance and the public would be too busy making money to care.