Chinese Engineer Devaluation

"After recent data showing falling exports and a stalling manufacturing sector, the central bank said on Tuesday that it was allowing the yuan to weaken by nearly 2% in the hope of making China’s exports cheaper and pushing down borrowing costs."

From the Guardian. Chris Balding adds that "The trading rate was already near the new official rate almost 2% away from the old official rate prior to the devaluation." He goes on:

"The biggest currency risk here is that by resetting expectations on the RMB/$, it is creating future expectations of devaluations. The [People's Bank of China] PBOC can talk all day about market conditions and their models, but markets don’t like to be surprised and the PBOC has just created future expectations.  It will be very hard for the PBOC to put this genie back in the bottle.  The real risk is that China is going to be forced to release the RMB."

Two things to add:

1) Sweeping policies (even with forward guidance) inject uncertainty and volatility into markets which respond in complex ways.

2) China now has less than $4tn of reserves, which isn't a whole lot for a nation its size. If we consider the RMB 'backed' by foreign reserves (such as the US Dollar), then their position is precarious indeed. The devaluation helps reduce the value of China's liabilities (i.e. the RMB currency), and could perhaps stave off a liquidity crisis if a crunch comes.

"To supplement the liquidity outflows, economists expect the central bank to further reduce the amount of cash that is required to be held as reserves by financial institutions."

Further, there's this:

"Since March 2014, around the time China’s holdings of US Treasuries peaked at $1.65 trillion, through May 2015, China reduced its holdings by $180 billion, according to the US Treasury Department’s most recent data, reported Bloomberg."

This devaluation is likely part of a response to a broader crisis than a slump in exports.

Quote of the Day from China

FT: "On Monday, Zhu Baoliang, director of economic forecast department of the State Information Centre, a government research agency, told Reuters the stock market crash was having a deep impact on the real economy and that it was essential for the authorities to cut interest rates and loosen monetary policy further.”

Christopher Balding: First, apparently Mr. Zhu has not talked to his PR and own statistics bureau. China is achieving 7% GDP growth and anyone who says otherwise is mocked and ridiculed by the Global Times and the China Daily. Second, apparently Mr. Zhu needs a basic introduction in macro-economics. Lowering interest rates is going to place enormous stress on the RMB/$ peg and further pushing capital to leave the country. Third, in breaking news, apparently Mr. Zhu has been re-assigned to a county statistics bureau in Inner Mongolia.

China's government is playing wack-a-mole with economic instability.

The previous round of pessimism came in the bond markets where total debt rose from 100% of GDP in 2008 to 250% by the end of 2014, where nonfinancial corporate debt alone stood at $14.2tn. The People’s Bank of China was reported to have injected as much as $294B into the economy late last year and has cut the one-year lending rate four times since then (now at 4.85%).

Money was already leaving the system before the downturn in the stock market. "According to one report, nearly $250b left China in the second quarter when the stock market was booming for most of that time.  Imagine how fast capital will flee if the stock market is not booming."

Just like in the US, investors sought higher returns by shifting from bonds to equities. This inflates asset prices and creates financial instability, as Claudio Borio has trumpeted here, here and here. No wonder the Chinese equities have been on a tear since the debt uncertainty.

 

Chinese Debt

Here is a compilation of point on Chinese debt and some discussion to follow.

The Western media have made much of Chinese economic pessimism as of late. The Economist laments that that total Chinese household, government, and corporate debt “has soared by 100% of GDP since 2008, and is now 250% of GDP.”

The level, though high relative to other emerging market economies, is not so much a concern as the rapid increase. Alair Turner writes that Chinese investments which rose to 47% of GDP, is “dangerously unbalanced and heavily dependent on infrastructure construction and real-estate development.” Kenneth Rogoff estimated that 60% of Chinese GDP relies on construction.

People's Bank of China

A study by the Chinese Academy of Social Sciences, found that China’s nonfinancial corporations alone had debt 113% of GDP by the end of 2012, which, a year later, would stand at $14.2tn making China the largest issuer of corporate debt. Much of that has gone to largely state owned enterprises (SOEs), which enjoy implicit government backing. Even private companies, such as Chaori, had creditors bailed-out after a bond default.

The situation in China today reflects many of the characteristic traits that Austrian business cycle theory attributes to a credit induced boom. In short, the story goes that there is an exogenous shock to the availability of credit which artificially lowers interest rates and signals to entrepreneurs that marginal investments are now profitable. This leads to an endogenous misallocation of production resources to higher-order goods (i.e. more “roundaboutness”) which is inconsistent with consumer time preferences. While production processes must return to be in line with “consumer sovereignty,” evident by a depression, ever more credit creation can forestall that inevitability.

Although China has a relatively high national savings rate of 50% (compared to less than 20% in the U.S.), there are a number of reasons for concern that the ease of credit access is artificial. For one, central bank policy in the West, including the Federal Reserve’s rounds of quantitative easing, may have had a knock-on effect on emerging market economies. Paul Davies writes that “Between 2008 and 2012, the [growth in East Asian country balance sheets] almost exactly matches the growth in the US Federal Reserve’s balance sheet due to quantitative easing.”

Easy U.S. credit sought the high expected returns from East Asian capital markets and bid down the interest rates, which signaled to firms to lengthen the structure of production. The People’s Bank of China is reported to have injected as much as $294B into the economy, which has covertly gone to select banks and forced borrowing to certain sectors like public housing.

The ultimate test will be whether China can avoid a balance sheet recession from debt overhang. A bad omen is the startlingly low growth in Chinese productivity, only 1% per annum between 1978 and 2012, which further points to growth being investment-driven. Chinese banks report that bad loans are only 1% of their assets, though investors price them as though it is closer to 10%.

The Financial Times writes that Chinese officials were “pleasantly surprised” when it was revealed that 20% of local government debt would be in default. Standard Chartered bank estimates “some 32 per cent of new credit these days is used simply to pay off the interest on existing debt,” and China will pay $1.7tn in 2014 on interest payments alone. China does have the advantage of its financial system being largely under government control, meaning panic induced fire-sales and deflationary spirals are less likely. But this also means that financiers are relatively protected from market disciplining losses and can continue injecting larger amounts of credit stimulus to keep the boom going with potentially larger negative future consequences.

The reality is that Chinese economic opacity may hide the true size of debt burdens until some critical point. It was not so long ago that officials systematically misreported their output during Mao’s Great Leap Forward with horrifying results for the Chinese people.