Headlines this month have suggested that the rocky relationship between the US and China is on a path to improvement, following the acceptance of the ‘one China’ policy.
While this does seem to have reversed some of the political tension, it does appear to be a case of giving with one hand and taking with the other.
In this article we will discuss the elephant in the room that is China’s severe foreign currency reserves problem and the potential solution involving yuan devaluation, which has the potential to wreak havoc on global economies.
Chinese growth non-productive and artificial
China has certainly experienced astounding levels of growth, which appear impressive on face value. From 2006 to 2008 the economy saw a double digit percentage growth rate per year, before declining in 2009 as a result of the financial crisis.
Despite this downturn, they still maintained a growth rate of 6% that year, which compares favourably against the negative figures experienced by the US and the EU. Growth returned to over 12% again in 2010 and has maintained a level around 7-8% since then (2011-2016).
However, data and statistics can often be misleading, as we know all too well when it comes to China. A deeper analysis reveals that growth has been stimulated by large levels of public investment, at a level of 45%, significantly higher than the typical level of around 30% observed in western economies.
In order for these investment programmes to be effective and productive, they must have a favourable impact on the economy, which means generating positive returns and only utilising debt sustainably. Unfortunately, when one assesses the Chinese growth against these broad criteria, they fail on both accounts; it is clear that a substantial part of the growth is artificial, since it has no tangible economic return and the overall picture is financially unsustainable due to the large amount of leverage undertaken.
Breaking down the worrying level of leverage, we see that in the past 10 years China’s bank assets have grown from around $2.5 trillion to a staggering $40 trillion. Additionally, a considerable amount of Chinese debt is currently held off the books in illiquid and non-transparent ‘wealth management’ products and derivatives, which many compare to nothing less than a Ponzi scheme.
Managing the issue
China’s approach to managing the intrinsic instability and excessive leverage has been to manipulate its currency, as has been widely reported and denounced by the media and key global influencers. This is by no means a recent solution by China, as it has now been their course of action for a number of decades.
In 1994 action was taken to boost Chinese exports by devaluing the yuan by an incredible 35%. Central bank intervention was then utilised following this severe devaluation to maintain the depressed level in the currency. This continued until intense political pressure from the US in 2007 forced China to allow the yuan to appreciate to a more realistic level. However, since 2014, China has once again allowed the yuan to devalue from levels of around 6.0 yuan per 1 USD, to 6.9 yuan per 1 USD.
Notwithstanding the political tension between the US and China (which appears to have somewhat abated in the past week, at least publicly, with the US re-acceptance of the “one China” policy) any action from China regarding a devaluation of the currency will surely encourage another currency war.
Currency reserves breaking the psychological threshold
Fearing the troubling outcome of a potential currency war, the Chinese public have already begun to take proactive steps to protect their wealth. This has led to a considerable capital flight as the Chinese export their funds abroad, leading to a negative direct impact on the level of foreign currency reserves being held.
It was recently announced that China’s foreign currency reserves had dropped below the psychological threshold of $3 trillion. This is a significant decline in a short space of time, as their currency reserve holdings at the start of 2015 were about $4 trillion, therefore representing a 25% drop. As a result of this concerning decline, Chinese policymakers will be under increased pressure to avoid any further draining of reserves.
Yuan
Examining China’s currency reserves structure
The aforementioned yuan devaluation fears have led to about $1 trillion leaving the country in the past few years. This is something the Chinese authorities are attempting to halt by enforcing regulations limiting capital transfer. The effectiveness of these capital regulations is highly questionable, as there will always be methods of bypassing them through new means of exporting wealth and loopholes in the existing laws.
A further $1 trillion is illiquid, as it includes direct investments such as natural resources, mines and FDI through sovereign wealth funds. In addition to this, another $1 trillion is unavailable as it must be held as contingency for potentially bailing out the insolvent Chinese financial system.
China’s leadership retains its power via implicit consensus rather than by democratic means and is largely maintained by wealth creation, thus making this portion of the reserves structure particularly important. Failure to protect the population’s investments in Chinese banks and financial products will lead to social unrest against the political leadership.
Therefore, with the capital flight that has taken place and the unavailability of other reserves, there is only $1 trillion of liquidity left. However, at the current depletion rate of approximately $70-80 billion per month, it appears likely that China’s reserves will be completely drained by the end of the year.
What options does China have?
The impossible trinity (The Mundell-Fleming Trilemma) suggests that China has three options to counter the negative trend: raise interest rates to defend the currency, continue strengthening capital controls or devalue the yuan.
Raising interest rates would potentially accelerate the crisis and, at the very least, have unfavourable effects on the economy.
Strengthening capital controls has already proven to be an ineffective solution, as discussed in the previous section. This could lead to further decreases in FDI, as well as inadvertently encouraging capital flight to be directed towards illegal organisations.
Therefore, the remaining option is to devalue the yuan and it seems likely that China will soon be flirting with this option once again. If they wish to stop the drain of their reserves, they may be looking at a strong devaluation. This would obviously have severe implications for the global economy.
Assessing historic reactions to devaluations of the yuan, it is clear that the outcome is certainly not positive. When China devalued its currency in 2015, western stock markets lost 11% of their capitalisation in the space of a few weeks; an impact that had the potential of collapsing the markets and causing intense panic.
When we look at the overall situation that China finds itself in, one cannot help but feel concerned about what the next steps will entail.
When we factor in the political uncertainties, including President Trump’s public declarations of his commitment to forcing China to reverse its currency manipulation activity. It appears likely that a new currency war may be on the horizon in the near future.
If that is the case, it goes without saying that there will indeed be many casualties.
By Nicholas Puri & Lorenzo Beriozza
