The markets are in a funk, mostly because of the ramifications of a slowdown in China. This slowdown has ravaged commodities, energy, and emerging markets, the fate of which depend on exporting these.
Capital first moved massively into these emerging markets, and is now massively moving out.
The Chinese slowdown now also produces large capital outflows from China. The Chinese central bank, the PBoC, is trying to stem these outflows with large-scale interventions in the forex markets.
Markets the world over are holding their breath and gyrating with every minute movement in the daily onshore yuan settlement or the spread between the onshore and offshore (Hong Kong) yuan, every new Chinese data point indicating a further softening of the economy, and those scary declining forex reserve figures.
We saw this game playing out in September last year, and we're now watching a rerun. Those that point to the Chinese stock market are missing the point: While that provides plenty of scary volatility, it's dominated by retail and a side show.
In the meantime, China is not only desperately defending the yuan (rather than manipulating it downwards), but also taking serious actions to revive growth. Here is The Daily Beast:
There have been six reductions in benchmark interest rates since November 2014 and five reductions of the bank reserve-requirement ratio since last February, but this monetary stimulus has had no noticeable effect, largely because there is a lack of demand for money.
The problem is actually not terribly difficult to understand. There is an "old China," consisting of heavy industry, largely state owned, suffering from huge overcapacity and debts.
This situation is simply a result of an exhaustion of the growth model, heavily dependent on investment, huge savings, exports, and construction. But underneath that is a "new China" growing, based on consumer spending, services, innovation and high tech.
China simply has to make the transition from old to new China as easy as possible. The best thing it could do is an organized restructuring of the overcapacity and bad debts in old China.
The Chinese government certainly has the capacity to do that (and they've promised to resolve the problem before 2020), as most of these companies are state owned anyway. The problem is that this will make many people redundant, not something the Chinese authorities are willing to countenance, at least not yet.
Instead, they came with a clever plan to get rid of some of the debt, by pumping the stock market enabling companies to swap debt for equity. A rising stock market would also help to stem the huge capital outflows. But all this isn't quite going to plan, to put it mildly.
They've also started to boost bond markets, in order for debts to be able to float, reduce the dependence on shadow bank instruments, and provide new funds for local governments to embark on spending.
This is working better, but one of the problems is that all the capex interventions by the PBoC is tightening domestic monetary conditions. The flip side of this is that easing monetary policy is only inducing more capital outflows.
This is basically the familiar Trinity problem, a country cannot have control over domestic monetary conditions and a fixed exchange rate at the same time. It can only do this with strict capital controls, but they have been loosened in a bid to boost China's reserve currency status.
Instead of restructuring the dead wood in the heavy industry out of fear of a worker revolt, it's kept limping on credit rollovers. But just like Japan in the 1990s, this approach creates zombies that are a drag on the rest of the economy.
For starters, producer prices have been falling quite sharply for a year or two:
Click to enlargeOne could call this China's internal devaluation. It is slow and painful, like the internal devaluation in the eurozone periphery, and it is having the same disastrous effects on debt dynamics.
And just like the eurozone, but even more so, the question bubbles up whether it isn't easier for China to simply devalue. After all, it's much simpler for China to devalue than, say, Greece or Portugal.
To devalue or not to devalue?
On a fundamental level, it's actually rather odd for a big economy like China (it's the second biggest economy in the world) to have a semi-fixed exchange rate. The US, the eurozone, Japan, the UK, they all let their currencies float.
The reason was basically to keep the yuan from rising in order to keep the exports competitive. In the process, China amassed some $4 trillion in forex reserves, a handy sum.
However, that rationale has manifestly gone, China has already gone through $700B in forex reserves in order to keep the yuan from falling further. You have to realize that actual forex interventions are much larger as China still runs a sizable trade surplus ($595B in 2015) and a positive foreign direct investment (FDI) balance.
The yuan would, in all likelihood, simply have moved down with other Asian currencies like the yen and the won. There are some arguments against devaluation specific to China:
- It would prop old China up longer.
- It would complicate debt dynamics of those Chinese companies holding US$ debt (in the order of $1 trillion).
- It would risk provoking a reaction from trade partners.
The latter is understandable because a substantial Chinese devaluation sends a deflationary shockwave through the world economy. But if one looks at the chart above, the yuan is about the last major currency not to devalue against the dollar.
On the other hand, China still has a large (nearly $600B) trade surplus, on the basis of that there seems little reason to devalue.
Arguments in favor of a devaluation are:
- It gives the export sector some (fairly limited as they also import a lot of materials) breathing room.
- It could end the capital flight and the tendency to generate self-reinforcing devaluation expectations, relieving pressure on the PBOC to intervene and deplete forex reserves.
- It gives the PBOC more room to stimulate the economy.
It's basically a get it over and done with approach. It is the single largest cloud hanging over the markets, according to John Brady at R.J. O'Brien, a major Chicago futures broker, and we agree with that.
Also, China is at present burning $100B in forex reserves in support of the yuan. At this pace, they can't keep this up forever, especially as:
Street economists, along with the IMF, have written that $2.8 trillion is the lowest acceptable level for China's forex reserves [Barrons]
We're now at $3.25 trillion, so at this pace of forex bleeding that's just 4.5 months. Would the pace of capital outflows decline significantly to increase confidence in the yuan?
It's a difficult question, but there are some reasons to believe that's not impossible.
While estimates of the sources of the hard-currency outflows differ, much of the total is thought to be pay-downs of foreign debt. A much bigger threat -- "the dam that the PBOC must make sure doesn't break," according to Frederic Neumann at HSBC Holdings Plc -- would be an exodus of funds from domestic investors. "The worst fears of cascading capital flight have not come to pass," Tom Orlik, a Bloomberg Intelligence economist, wrote after the reserves report on Sunday, noting that the drop was less than some had anticipated. "Households are not maxing out their $50,000 annual quota for FX purchases." That puts a premium on maintaining confidence in the outlook [Bloomberg]
This can be read several ways. On the one hand, if a significant part of the capital outflows is caused by Chinese companies paying down foreign (dollar) debt, then these will decline once that debt diminishes.
On the other hand, it removes one objection to a devaluation, as this would increase the domestic currency value of that debt automatically.
It's reassuring households are not maxing out their $50K quota, but on the other hand, if they do, then the exchange rate will surely fall.
We simply think that it is all a matter of expectations:
"In a nutshell, we believe capital outflows will continue as long as markets expect the Chinese yuan to depreciate," said analyst David Fernandez at Barclays, in a note. [MarketWatch]
And these expectations are rather ingrained, it seems:
According to a Wall Street Journal report published Sunday, Kyle Bass, Stanley Druckenmiller, David Tepper, and David Einhorn have all positioned themselves for sharp devaluations in the yuan. [Business Insider]
The alternative to a devaluation would be to shore up capital controls, which they have already been doing a little. This gives the PBOC some room to escape the Trinity where one cannot have free capital flows, independent monetary policy and an exchange rate target at the same time.
But these are not impermeable, they can slow outflows but not stop them altogether. The only thing that can do that is an improvement in the Chinese economic data, which would change the expectations.
Not impossible, but we wouldn't want to bet on that.
On balance, a devaluation isn't immediately necessary, given still seemingly ample forex reserves, a large trade surplus, and substantial capital controls. But the capital outflows are real and large, and really complicate things for the PBOC.
A devaluation, or better, a move to a flexible exchange rate would relieve those pressures and give the PBOC scope to produce more monetary easing and stimulate exports.
As this prolongs the life of 'old' China, we think this step should only be embarked upon if accompanied by a decisive cleanup of bad debts and overcapacity in the old, largely state-owned, heavy industry sector that is dragging China down.
Decisive rationalization here will reduce the fear the world will be flooded by cheap Chinese products, so this will benefit China as well as the rest of the world.
In that way, the event can even be seen as a positive for China and calm down hyper nervous markets everywhere at least to some degree.
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.