(Source: The Daily Shot - link)
My recent article observed the positive impacts at China's latest fiscal stimulus rippling through the economy from the housing sector. Enthusiasm must however be tempered, in the knowledge that fiscal policy has been experiencing the ravages of the law of diminishing returns. China is getting almost exponentially less economic impact for its incremental increase in fiscal stimulus. In my article, it was also noted that recent credit data shows that the law of diminishing returns is ravaging incremental credit expansion also. This signals that the law of diminishing returns is also taking its toll on the PBoC's QE program.
It should be noted that China has scaled back the size of both its monetary and fiscal stimulus. Presumably this is in response to their diminishing impacts on the economy, versus their increasingly negative impact on China's reserve position. Expectations for stimulus driven growth should therefore be scaled back this year.
China also hit the demographic equivalent of the Great Wall last year. The working age population saw its biggest decline ever in 2015. China is beginning to resemble Japan more and more. China now has ballooning debts and a shrinking working population tax base to pay them off. With fewer workers paying taxes, there is also a diminishing window of opportunity to get any bang for the incremental monetary and fiscal stimulus. No wonder the central bank is looking at ways to inflate and devalue away the burden on the national government. No wonder the government has overturned the one-child policy.
Price discovery in Chinese equities, of the fact that China is getting less bang for its monetary and fiscal stimulus buck, has created a bear market. Having embraced the market disciplines of IMF SDR currency basket entry and an opening of the capital account, Chinese policy makers are no longer in control of the situation. The global forces and disciplines of capitalism are now having a stronger invisible hand in the economy. Premier Li Keqiang has audibly embraced the application of "market forces".
China and its equity market are therefore getting the rational application of the "market forces" that they have embraced. This is increasingly becoming a painful experience for the President; and challenging his own political authority. The President now finds himself in conflict with the agent of these economic forces; namely his Premier Li Keqiang.
Unfortunately Chinese policy makers seem to have miscalculated; and assumed that their equity market and currency would be positively rewarded by said "market forces". The obverse of such a reward has come as a great unpleasant surprise. More unfortunately, there remains the kind of policy maker groupthink which assumes that the situation can be controlled. There are some policy makers who still think that they are in control. This classification would seem to indentify the President. This is a classic case of shoot the messenger because the message is not what is desired. Premier Li and his "market forces" are no longer in the ascendancy.
Given China's finite economic resources and their decreasing marginal impact on the economy, it is clear that the situation has reached a critical point. President Xi Jinping evidently feels that this is the case, because he has become more pro-active and interventionist in economic policy making.
Another article observed that President Xi Jinping was moving to get more involved in economic policy action, allegedly at the expense of Premier Li. His first move was telegraphed by his Vice President Li Yuanchao. The Vice President promised that China will intervene in the equity markets, in order to "look after" stock market investors. Loosely translated this means that the President seems to think that he can counteract the price discovery of market discipline that his country has embraced. The Vice President tried to cover up this move, by saying that China was still a developing economy. In truth China has matured and the only thing that is developing is the price action that reflects this aging lack of true economic growth.
Premier Li Keqiang fired back at his challengers, by announcing China's latest moves to "boost range-based, targeted and discretionary macro regulation this year". Without specific policy headline announcements, this amorphous statement of intentions and capabilities to stimulate the economy and engage in structural reform sounded a little hollow. It will be interesting to see how much "discretion" President Xi has to make and execute economic policy which has been traditionally in the mandate of his premier.
The specter of currency wars, attributed to China's abortive attempt to weaken the Yuan which then became a pegging of the Yuan to the weakening US Dollar, was briefly touched upon in my article. Further support to the re-pegging thesis recently came from unnamed Chinese sources; who reported that the PBoC had "guided" Hong Kong banks to stop enabling the shorting of yuan by making loans. The high level of invective from the state media, against the Yuan short speculators, also evinced some support for the peg thesis. The report concluded that China is now exporting deflation again, through falling export prices rather than the falling Yuan.
Oxford Economics has touched upon the currency war subject more heavily, by gaming the scenarios associated with a 10% Yuan depreciation. In a scenario where Chinese growth is absent, yet other nations respond by devaluing, the impact on global GDP is much worse. The inference is that China is exporting deflation; and that this becomes more exacerbated if other nations respond by trying to devalue also. The inference is also that the BOJ and ECB will then be forced to respond with expansions of QE.
(Source: Seeking Alpha - The Negative Halo Effect: China's Capitulation To Creative Destruction Is Bad News Globally)
The currency war thesis was given greater support by ECB Governing Council Member Ewald Nowotny. He sees a collapse in the yuan as a result of China's monetary expansion. China will then be exporting deflation through its weaker currency. Combined with a falling oil price, Nowotny sees the falling yuan creating negative inflation in the Eurozone.
Nowotny's fear is shared by BOJ Governor Kuroda. Kuroda advocates that China should apply exchange controls to prevent the slide in the Yuan. This would be absurd, after the nation has just joined the IMF SDR currency basket and intends to open up its capital account in order to gain developed nations status. It is becoming clear that both the ECB and the BOJ are extremely worried about deflation being exported by China.
The view in this series of reports remains that China has pegged the Yuan to the US dollar. The yuan will therefore weaken in line with the US dollar against the Yen and the euro, despite the fact that the Fed is normalizing interest rates. China therefore exports deflation through the agency of the weakening US dollar and yuan together. The ECB and the BOJ will then be forced to respond with expansions of QE. Expanding QE could be problematic for the ECB, since Germany is currently obstructing this course of action.
The eurozone was identified in the last report as the first region to feel the consequences of China's unleashing of its consolidated industrial overcapacity by exporting deflation to global markets. It was said that "Europe maybe the first region to experience the new Chinese deflationary economic threat" and also that "companies in Europe and North America will not be able to hide behind protectionist tariffs". Premier Li Keqiang put the European Union (EU) on notice that he is expecting it to accept China's developed market status by removing protectionist tariffs. He applied pressure to Angela Merkel to lead the EU in abiding by its WTO promise to grant China market economy status.
Just to force Merkel's hand Premier Li then announced further cuts in production capacity in the coal and iron and steel sectors. Such an announcement is supposed to elicit the positive response in the world economy (and equity markets!!) that China is capitulating to "market forces". A reduction in overcapacity should therefore provide pricing power for all global producers. Share prices should then rise to reflect this improved pricing power.
As was explained in the previous report entitled "China Scales Up The Risk", this analysis is too simplistic at best and incorrect at worse. The report explained that China had scaled up its "national champions" in these industries by consolidating them. The remaining "scaled up" players have the balance sheet and productive capacity to take over the alleged spare capacity in the plants being shut down. All that is happening is that the Chinese government has focused its economic resources on protecting the "scaled up national champions" rather than a myriad of smaller players. As Premier Li confirmed he is "boosting range-based, targeted and discretionary macro regulation".
These "national champions" now have costs of production that are significantly lower than when they stood alone; so that they can sustain an intense phase of global competition in the event that the Yuan is not weakened further. Premier Li can thus demonstrate that he has shown good faith to Angela Merkel by mothballing plants. In return she and Europe must expose their own producers to these "scaled up national champions". It is no contest. China is exporting deflation through a smaller number of larger companies; rather than through numerous smaller ones. These larger companies can also stay in the game and sell output at lower prices, if it is impossible for the Yuan to weaken further. The net result is the same and will be more sustained, since the "scaled up national champions" are already incumbent.
After Premier Li announced his capacity cuts in the steel sector, the story of how this will be tactically achieved was then presented. The impact in terms of job losses was estimated at 400,000 workers. The Premier then announced that tax breaks will be given to companies where capacity cuts are being made, providing an incentive to cut capacity whilst mitigating the costs of severance payments. Since consumers have been the principal beneficiaries of the falls in commodity and manufactured goods prices, VAT will be levied. The Chinese consumer will thus finance the restructuring of and the enabling of fiscal transfers to the industrial sector. The levying of VAT may also give the impression that consumer inflation is rising, so that the specter of deflation is hidden. It is a neat solution that should mitigate the drain on the resources of the central government in engineering the industrial restructuring.
The size of the cushion, created by the big drop in commodities that gives Chinese industry and labor its competitive advantage, has been estimated as a $460 billion per annum saving on imports. Chinese industry can therefore sustain margins and profitability through lower input costs. Workers can sustain low compensation because their costs of consumption have fallen. This deflationary force will now spread globally as Chinese industry competes on price with its rivals.
The last report argued that an intense phase of competition between China's "scaled up national champions" and their global rivals is in process. This competition was seen as being bad for the competitors' bottom lines but good for consumers. Evidence to support this thesis was provided recently from the auto sector within China itself. Hyundai Motor Company's (HMYPY) CFO has reported that domestic Chinese auto producers are ramping up production capacity. Hyundai's profits have fallen to the lowest in five years on sales that slumped for the first time since 2007. The response from Hyundai is to cut prices.
The incentive and challenge for China, to start competing intensively again, no doubt comes from the recent statistic which showed that China failed to narrow the economic gap with America in 2015. For Chinese policy makers, this gap is both a source of inspiration and a national security threat. It is perhaps also why President Xi decided to get more heavily involved in economic policy recently.
One Chinese policy maker who should be able to provide some key signals about the country's intentions and capabilities, in relation to currency and economic policy, is the PBoC governor Zhou Xiaochuan. His recent absence has been so remarkable that rumors have begun to circulate. The coincidence of Governor Zhou's silence and President Xi's recent "pro-activity" may go some way to explaining the Governor's lower profile.
A pattern is emerging for China-watchers. President Xi recently published his own little red book, in which he related his long march to defeat a coup attempt within the government. Allegedly the plotters have now all been defeated. Further credibility to the story was evinced in the President's announcement of the successful reorganization of the armed forces into five theaters of command; and the parading of these legions in the public domain. The Communist Party now has greater control of the military and President Xi has greater control over the Party. President Xi therefore has greater control over the military by default. Apparently he is now concentrating economic power within his hands also. He is therefore on his way to become a czar.
Whether there has actually been an attempted coup or whether this is all just a political distraction from the less edifying drama in the economy is a known unknown. Whether it has all been an elaborate performance, in order to concentrate power in the hands of one man is also a known unknown. One known known is that capital is running scared from China. Presumably some of this capital is not just running towards higher interest rates in America, but actually running away from the coup plot clampdown.
It would appear that the Great Yuan Crisis, reminiscent of the Great Ruble Crisis, has been headed off for now. Unfortunately, Premier Li's attempt to open the capital account still leaves the door open for the crisis to return. Another known known, is that the President is flexing his muscles for some as yet unknown purpose. If it feels like 1997 again, perhaps it should.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.