Headlines this month have suggested that the
rocky relationship between the US and China is on a path to improvement, following the
acceptance of the “One China” policy. While this does seem to have reversed some
of the political tension, it does appear to be a case of giving with one hand and taking
with the other. In this video, which is based on an article
we recently published on Seeking Alpha, we will discuss the elephant in the room that
is China’s severe foreign currency reserve problem and the potential solution involving
the yuan devaluation, which has the potential to wreak havoc on global economies. This is China, the yuan and the elephant in
the room. China has certainly experienced astounding
levels of growth, which appears impressive on face value. From 2006 to 2008, the economy
saw a double-digit percentage growth rate per year, before declining in 2009 as a result
of the financial crisis. Despite this downturn, it still maintained
a growth rate of 6% that year, which compares favourably against the negative figures experienced
by the US and the EU. Growth returned to over 12% again in 2010 and has maintained a level
around 7-8% since then, between 2011 and 2016. However, data and statistics can often be
misleading, as we know all too well when it comes to China. A deeper analysis reveals
that growth has been stimulated by large levels of public investment, at a level of 45%, significantly
higher than the typical level of around 30% observed in western economies.
In order for these investment programmes to be effective and productive, they must have
a favourable impact on the economy, which means generating positive returns and only
utilising debt sustainably. Unfortunately, when one assesses the Chinese growth against
these broad criteria, they fail on both accounts; it is clear that a substantial part of the
growth is artificial since it has no tangible economic return, and the overall picture is
financially unsustainable due to the large amount of leverage undertaken.
Breaking down the worrying level of leverage, we see that in the past 10 years, China’s
bank assets have grown from around $2.5 trillion to a staggering $40 trillion. Additionally,
a considerable amount of Chinese debt is currently held off the books in illiquid and non-transparent
“wealth management” products and derivatives, which many compare to nothing more than a
Ponzi scheme. China’s approach to managing the intrinsic
instability and excessive leverage has been to manipulate its currency, as has been widely
reported and denounced by the media and key global influencers. This is by no means a
recent solution by China, as it has now been its course of action for a number of decades.
In 1994, action was taken to boost Chinese exports by devaluing the yuan by an incredible
35%. Central bank intervention was then utilised following this severe devaluation to maintain
the depressed level in the currency. This continued until intense political pressure
from the US in 2007 forced China to allow the yuan to appreciate to a more realistic
level. However, since 2014, China has once again allowed the yuan to devalue from levels
of around 6.0 yuan per 1 USD, to 6.9 yuan per 1 USD.
Notwithstanding the political tension between the US and China (which appears to have somewhat
abated in the past week, at least publicly, with the US reacceptance of the “One China”
policy), any action from China regarding a devaluation of the currency will surely encourage
another currency war. Fearing the troubling outcome of a potential
currency war, the Chinese public have already begun to take proactive steps to protect their
wealth. This has led to a considerable capital flight as the Chinese export their funds abroad,
leading to a negative direct impact on the level of foreign currency reserves being held.
It was recently announced that China’s foreign currency reserves had dropped below the psychological
threshold of $3 trillion. This is a significant decline in a short space of time, as its currency
reserve holdings at the start of 2015 were about $4 trillion, therefore representing
a 25% drop. As a result of this concerning decline, Chinese policymakers will be under
increased pressure to avoid any further draining of reserves.
The aforementioned yuan devaluation fears have led to about $1 trillion leaving the
country in the past few years. This is something the Chinese authorities are attempting to
halt by enforcing regulations limiting capital transfer. The effectiveness of these capital
regulations is highly questionable, as there will always be methods of bypassing them through
new means of exporting wealth and loopholes in the existing laws.
A further $1 trillion is illiquid, as it includes direct investments such as natural resources,
mines and foreign direct investment, otherwise known as FDI, through sovereign wealth funds.
In addition to this, another $1 trillion is unavailable as it must be held as contingency
for potentially bailing out the insolvent Chinese financial system.
China’s leadership retains its power via implicit consensus rather than by democratic means
and is largely maintained by wealth creation, thus making this portion of the reserves structure
particularly important. Failure to protect the population’s investments in Chinese banks
and financial products will lead to social unrest against the political leadership.
Therefore, with the capital flight that has taken place and the unavailability of other
reserves, there is only $1 trillion of liquidity left. However, at the current depletion rate
of approximately $70-80 billion per month, it appears likely that China’s reserves will
be completely drained by the end of the year. The impossible trinity (The Mundell-Fleming
Trilemma) suggests that China has three options to counter the negative trend: raise interest
rates to defend the currency, continue strengthening capital controls, or devalue the yuan.
Raising interest rates would potentially accelerate the crisis, and, at the very least, have unfavourable
effects on the economy. Strengthening capital controls has already
proven to be an ineffective solution, as discussed in the previous section. This could lead to
further decreases in FDI, as well as inadvertently encouraging capital flight to be directed
towards illegal organisations. Therefore, the remaining option is to devalue
the yuan, and it seems likely that China will soon be flirting with this option once again.
If it wishes to stop the drain of its reserves, it may be looking at a strong devaluation.
This would obviously have severe implications for the global economy.
Assessing historic reactions to devaluations of the yuan, it is clear that the outcome
is certainly not positive. When China devalued its currency in 2015, western stock markets
lost 11% of their capitalisation in the space of a few weeks; an impact that had the potential
of collapsing the markets and causing intense panic.
When we look at the overall situation that China finds itself in, one cannot help but
feel concerned about what the next steps will entail. When we factor in the political uncertainties,
including President Trump’s public declarations of his commitment to forcing China to reverse
its currency manipulation activity. It appears likely that a new currency war may be on the
horizon in the near future. If that is the case, it goes without saying
that there will indeed be many casualties. Let’s continue the discussion about this topic
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