Let money leave China to ease Fed ‘taper’ pressure

September 18, 2013 8:54 am

Let money leave China to ease Fed ‘taper’ pressure

By Charles Dumas

Impact could be transformative for global financial markets

China is teetering on the brink of a radical policy change that could transform not just China, but also world financial markets. Current global pressure on emerging markets is felt most acutely in China. In the comparable late 1990s, the Asian crisis largely passed China by. Its hefty devaluation in 1994 had left it highly competitive. The latest upswing of US interest rates will again hit the overvalued emerging markets hardest. This time China is the most exposed.We calculate that China’s exchange rate is about a third overvalued, measured by relative labour costs. China plunged into producer price deflation two years ago, despite rapid wage inflation. Chinese businesses had to cut prices to hold up sales in world markets. They were already about 10 per cent overvalued. Labour costs have since risen a further 20 per cent versus trading partners. Price deflation means overvaluation is less evident in price terms, but the cost is serious profit-margin shrinkage.

With all the focus on rising US bond yields, little attention is paid to the huge upswing in real Chinese interest rates. Two years ago, the rate on one-year loans from the state-owned banks was 6.6 per cent – lower than the 7 per cent rate of producer-price inflation. Now, industrial borrowers pay 6 per cent, but the plunge into producer-price deflation of about 2 per cent means the real rate is 8 per cent – a huge hurdle for borrowers to surmount.

The combination of profit squeeze and high real interest rates is forcing firms to cut back wage gains. At the same time, the long-discussed swing away from excessive capital spending (48 per cent of 2012 GDP) is now beginning. And the cuts in “market-sector” capital spending, though partly offset by the current modest government stimulus programme, are reinforced by the downward pressure on wages, which takes away the hoped-for offset of a consumption upswing.

China’s leaders have two possible escape routes from this extremely tight corner. The first is “business as usual” (BAU) – a rerun of the giant stimulus adopted in 2008-09. But it was the stimulus that landed China in its current fix, by rapidly raising the real exchange rate and gorging the economy on debts that few regard as repayable. BAU would thus cause China to become even more overvalued and over-indebted. A major crisis would be likely in two or three years. This is hardly attractive to the new leadership, which has a 10-year lease on power.

The alternative policy would be to take advantage of the Chinese private sector’s appetite for overseas assets. Despite controls on external capital movements and their recent relaxation for inflows only, which have been strong as a result, the capital account has been in balance this year. Previously, before inflow controls were relaxed, net outflows totalled $500bn in the 18 months to end-2012. But only well-connected Chinese people can slip through the controls. It is “insiders” that want out.

This gives China a “win-win” policy opportunity. Removing controls on capital movements would improve the supply-side operation of its economy, and is essential to the goal of an internationalised, convertible yuan. It would also achieve badly needed devaluation to soften the impact of the capital spending downswing. Private capital would flood out of the country, bringing down the exchange rate and the mountain of foreign exchange reserves. Premier Li Keqiang has several times repeated that a programme for the removal of capital controls will be established by the end of this year.

This policy involves major risks as well as huge potential benefits, so the removal of controls is likely to be phased, not a “big bang”. The biggest problem is that much of the capital outflow would reduce bank deposits, exposing the dubious quality of much of the banks’ loan books. Improving the allocation of capital, by banks among others, is one of the chief supply-side benefits expected from financial liberalisation. But the scale of the recapitalisations needed could be massive, and the leadership is already floating ideas for shoring up the banks.

For world markets, the impact of this reform could be transformative. China’s annual national savings are about $4.5tn, twice the $2.25tn equivalent US number. A large chunk of this sum seeking real assets in the US and elsewhere, at the expense of China’s official reserve holdings of (typically) US Treasuries, would cause property and stocks to soar in price and Treasury yields to adjust sharply upward.

This Chinese reform would be a radical structural adjustment in the world economy. It is an order of magnitude more important to financial markets than the US Fed’s much discussed “tapering” of its quantitative easing.

Charles Dumas is chairman and chief economist at Lombard Street Research