Stock markets dropped sharply at the beginning of this year, driven by the apparently accelerating slowdown in the Chinese economy and the slide in the Chinese renminbi. The latter threatened to add to the woes of emerging markets, already suffering from the deflation of commodity prices, with crude oil dropping to under $30 a barrel.
China’s economic slowdown has led to confusion among its policymakers on what to do. They would like to engineer a controlled devaluation of the currency to improve export performance. But devaluation is inspiring even more capital flight, with the potential of a disorderly currency drop, a currency war with other emerging economies and a deflationary hit to the world economy.
The reason this is happening is that China is suffering from debt deflation in the corporate sector, mainly in the state-owned enterprises (SOEs). There is an unwinding of China’s debt bubble: a mass of bad assets that is the result of a decade where fixed-capital formation amounted to 45% of GDP annually, a high proportion of which was malinvestment.
Corporate debt has risen by 50 percentage points of GDP since 2007, from 100% to 150%. In the same period, the total debts of the Chinese economy rose by around 80%, to exceed 250% of GDP. That means that every unit of debt added is producing less and less output to pay its cost. At least 40% of Chinese companies (and I reckon more than 60% of SOEs) have interest cover less than 1.0. Corporate profitability continues to fall. This means deleveraging in China has not even begun. And it must.
The stock of bad assets and credits will weigh heavily on growth, keeping it between 4% and 5% for a long time (although official figures will be massaged higher). At that level, the corporate debt mountain just grows in relation to the output to service it. Corporate debts cost 3% to 5% – higher than the nominal GDP growth generated by the corporate sector.
The only remedy is higher inflation. And the only way to get some inflation into the system is via a weaker currency that imports it and lifts domestic inflation expectations. With greater flexibility in the exchange rate at the same time as the capital account is made more convertible, the Chinese authorities would be free to focus on achieving domestic targets. And China could sidestep any immediate pressures on the currency from Fed tightening while allowing it to piggyback monetary easing in the eurozone and Japan.
Managing the renminbi via a trade-weighted index can be seen as part of the economic reform process. It makes sense to move to such a system as domestic interest rates and the capital account are being progressively liberalised. But this makes the ‘impossible trinity’ of controlling interest rates, the exchange rate and capital flows truly impossible.
Moving to a TWI-based exchange rate system steepens the path of depreciation against the dollar, which for a central bank already battling capital flight is a dangerous step. Gradual devaluations are a tough act. There must be at least a 50% chance that renminbi devaluation is not orderly but chaotic.
Whichever method you use to measure capital flight from China the outcome is similar; around $100 billion of cash is heading for the door every month. Chinese foreign exchange reserves fell by more than this in December alone. Efforts to liberalise the exchange rate, including publishing a detailed breakdown of China’s reference trade-weighted currency basket, are aimed at containing this tide. But the reality is that gradual depreciation is a difficult strategy to execute once communicated to participants – they will all want to exit.
I expect a 12% to 15% depreciation in the renminbi/dollar exchange rate in 2016, but the risks are clearly skewed to a more rapid and disorderly adjustment. While China’s shift towards a trade-weighted basket might appear a pragmatic attempt to manage the currency down with more transparency, there is a substantial risk that it actually has a destabilizing effect, making renminbi weakness versus the US dollar even more of a one-way bet.
Contagion from a devaluing renminbi would be felt across Asia, given the entwined supply chains and increasing dependence on Chinese import demand as the region’s growth driver. Falling Asian currencies are deflationary for Japan. It’s going to be a bumpy ride for Asia and other commodity-producing economies this year.