The latest downdraft in global equity markets was triggered by concerns over China, as was the previous pullback in August-September of last year. In our previous post on the topic we discussed why markets were reacting negatively to China’s actions to devalue its currency. The question is no longer whether China is slowing, but whether Beijing and the People’s Bank of China (PBoC) can engineer a soft landing. Till the past year, the answer seemed to be in the affirmative but markets are now losing confidence that this is possible thanks to the PBoC’s recent actions. The other, perhaps bigger, concern is whether China will unleash a wave of deflation across the world, just as the Federal Reserve embarks on a tightening path in the U.S. (expecting inflation to rise).
China essentially has three tasks:
1. Clean up financial excesses that built up over the last few years
2. Reshape the economy so that it is more dependent on consumption, as opposed to massive levels of investment
3. Achieve both of the above while sustaining economic growth
The actions of Chinese authorities during the last six months indicate that they are still trying to figure out how to pull this off. The second point is a medium to long-term goal for China but the first point is the more immediate issue that Beijing is grappling with.
In this post we will dig into the first bullet item, and the consequences of it.
An explosion in debt
China went on an epic credit binge after 2008, which initially started off as a way to shore up the economy during the financial crisis but metastasized. Overall debt (household, business and government), which was about 160% of GDP in 2007, grew to over 240% of GDP in 2015. This increase in credit growth is the third largest historically, after Ireland and Spain in the 2000s – even more so than credit growth in the U.S. over five years leading up to the subprime bubble, or in Japan prior to the 1990 Nikkei crash.
Note that while a large increase in debt has historically been indicative of future financial collapse or stagnation, there is no level that automatically triggers it. While other countries (like Japan) also have large debt loads relative to their output, the real concern here is the unprecedented growth in credit, and how it can be sustained in the face of a slowing economy.
Most of China’s debts are held within the government controlled parts of its economy, giving authorities the seeming ability to avoid a systemic crisis. The government can simply cease to call in bad loans, or let the “zombies” roll over these loans as they come due. The Economist notes that this spares short-term pain but leaves a chronic ailment that requires ever more credit to sustain growth. In an October 2015 report, they wrote:
“In the six years before the global financial crisis, each yuan of new credit brought about five yuan of national output. In the six years since the crisis, that has fallen to just over three yuan. It is not hard to find examples of companies on life support that in other countries might have perished by now. In September China National Erzhong Group, which makes smelting equipment, received a bail-out from its parent. Investors in Sinosteel, a metals conglomerate, are now hoping for the same after it delayed payment on a bond this week.”
The exact amount of “bad” debt (non-performing loans, or NPLs) in the financial system is bit of a mystery due to famously opaque financial statements of state owned banks, but reports indicate that new bad loans more than doubled in 2015. The proportion of NPLs in the banking system is currently estimated to be around 1.5 percent, which is well below levels of more than 20 percent in the early 2000s. However, at that time the economy was growing substantially faster than it is now, and was expected to continue doing so, unlike the present situation.
Irrespective of the exact numbers, we do know that mounting bad loans are causing bank capital buffers to dwindle, forcing them to issue ever more expensive bonds to shore up their capital base – this is after raising record amounts in 2014. We could well have a credit crisis on our hands if a slowing Chinese economy pushes up the number of bad loans in their banking system.
The long and short of all this is that the central bank has to continuously inject cash into the banking system to keep it liquid, while at the same time using its reserves to shore up a currency that is under pressure to fall.
This brings us to the “impossible trinity” that the PBoC is trying to achieve.
The impossible trinity or the “Trilemma”
Some background is in order here. The impossible trinity is based on an economic model set forth independently by economists Robert Mundell (who subsequently won the Nobel prize in 1999) and Marcus Fleming in the 1960s. It is a trilemma in international economics that speaks to the impossibility of achieving the following three at the same time:
1. A stable foreign exchange rate (example: a peg to the U.S. dollar)
2. Free capital movement (absence of capital controls)
3. An independent monetary policy (ability to set interest rates)
While writing about Mundell’s Nobel prize back in 1999, future nobel prize winning macroeconomist Paul Krugman noted that a country must pick two out of three – it cannot have it all.
Consider an example: say country A wants to drop its interest rate lower than a neighboring country B. As a result, investors in country A will want to sell out of their domestic currency and buy the higher yielding currency B. This in turn leads to capital outflow and depreciation pressure on currency A. Now if central bank A wants to maintain free capital flow, it will have to use its foreign currency reserves to shore up its domestic currency in order to maintain a stable exchange rate. Of course, any central bank has only limited reserves and once these dry up, the only option is for the domestic currency to depreciate.
Trying to hold onto all three tends to lead to a financial crisis and eventual devaluations, big ones.
Previous tussles with the trinity
Mexico’s peso crisis in 1994 was a classic example of this. Post-NAFTA, Mexico gained new access to international capital. However, the central bank struggled to maintain the peso’s peg to the dollar after capital flows reversed amid an easing of monetary policy. Supporting the peg led to a depletion of central bank reserves by December 1994 and the Mexican government finally gave in, letting the peso free float – it dropped 50% against the dollar in the months after.
The East Asian crisis in 1997 was another recent example of nations wrestling with the trilemma. The crisis began in Thailand in May, with the government keeping rates steady and instituting some capital controls to curb outflows, all the while maintaining that the Thai baht would not be devalued. In a replay of the Mexico case, Thailand’s central bank ran out of foreign reserves to support the dollar-baht peg and in July, they allowed their currency to free float. The baht swiftly lost 50% of its value and the Thai stock market fell 75%. This was the trigger for the Asian financial crisis, spreading rapidly to other East Asian nations including Indonesia and Malaysia, who also grappled with the trilemma and eventually saw their currencies plunge more than 50%.
So how long can China hang on?
China has a massive amount of foreign reserves, with more than $3.3 trillion at the end of 2015. Nonetheless, this has fallen 19% from its peak in 2014. Reserves fell by a record $107.9 billion in December 2015 and again by $99.5 billion in January 2016. The decline in reserves can be directly attributed to China selling dollars to stabilize its currency and to capital outflows.
A growing number of investors – foreign and domestic – are shifting assets out of China quickly. This results in a negative feedback loop where investors pull assets out and sell yuan owing to fears that the currency will be devalued. This puts the yuan under renewed pressure and the PBoC has to dip even further into their reserves to stabilize the currency.
On the face of it, China appears well capable of defending its currency but it may be limited in practical terms. Its current reserves are less than 16% of domestic money supply, which is lower than the 20%+ that East Asian countries had in the late 1990s.
On top of this, questions are being asked as to what exactly comprises the reserves and how quickly they can be liquidated, if needed. The exact composition of China’s foreign reserves is unknown but investor Kyle Bass, of Hayman Capital Management, argues that China’s liquid foreign reserves are $2.2 trillion at the most, and already below a critical level. China just may not have the resources to keep its banks liquid while also defending its currency.
Needless to say, time could be running out for Chinese authorities. The question is how long they can hang on without devaluing their currency significantly – a week, a month or even a year, if not longer?
The question is a hard one to answer, not least because of the lack of accurate data and the opacity of Chinese authorities. Note that the decision is ultimately a political one. Officials vehemently maintain that they don’t intend further devaluations, but this is only to be expected (and seems to be a theme before countries eventually bite the bullet).
A global peril
Over the past six months we have twice seen the effect of Chinese currency devaluation, as little as it was, on global markets. If China does indeed reach a point where they are unwilling/unable to defend their currency, while also maintaining independent monetary policy and somewhat free capital movement across its borders, we may be looking at significant global financial instability.
A China slowdown may not directly affect economies in Europe and the United States since these nations are more dependent on internal consumption rather than exports to China and other emerging markets. For example, the U.S. exports less than 1% of its GDP to China. Nevertheless, a global financial crisis triggered by China could possibly derail developed world economies just as they appear to be getting on the path of recovery. Especially at a time when central banks do not have too many more arrows in their quiver.
It is uncertain how China will balance its domestic obligations with its role in maintaining international financial and economic stability as the world’s second largest economy. These responsibilities may well be aligned at some point in the future but it is not so right now, and it is not hard to figure out which one they will prioritize if it comes to that.
This is clearly a pronounced risk for global markets and economies at this time, yet one that is hard to quantify and time for reasons discussed above. While the probability of China reaching a point where it cannot hold on for much longer may not be much more than a coin flip, it is certainly not insignificant.