China’s economic slowdown, and resulting bear market, have weighed heavily on international markets and the local currency. In response, Chinese policymakers are promoting measures that exacerbate the problem and kick the proverbial can down the road.
During the February 26th G20 meeting in Shanghai, Zhou Xiaochuan, the governor of China’s central bank (PBOC), made a rare public appearance to address the economic challenges facing China. He attempted to reassure attendees, and markets, that officials stand ready to deploy monetary stimulus and deficit spending to support the Chinese economy.
Without going into the gory details, monetary stimulus generally means increasing the money supply in the economy through lower interest rates and government bond purchases. Fiscal stimulus is connected to monetary policy by allowing governments to raise debt for infrastructure spending and other projects meant to spur aggregate demand.
Not all G20 attendees bought into the purported benefits of deficit spending. Wolfgang Schäuble, Germany’s Finance Minister, had other ideas:
“The debt-financed growth model has reached its limits,” he said. “If we continue on this path we no longer need to watch television, the walking dead will overwhelm us, particularly in finance and construction.
Source: Breitbart
As gross domestic product (GDP) growth and industrial production continue to fall, the Chinese government is under mounting pressure to soften the transition from a production-based economy to one of services and consumption. Predictably, this transition, worsened by state-directed and credit-driven malinvestment, comes with a healthy dose of economic adjustment and unemployment.
Peeling-back a layer of GDP reveals a less-than-flattering economic trajectory. Once a bastion of growth, China’s exports are contracting to levels not seen in the past 5 years. Exports to all major trading partners fell sharply and is contributing to global trade slowdown.
While China was enjoying double-digit GDP growth, corporations and individuals levered-up. Debt as a percentage of GDP is well above 200 percent and interest payments account for over 30 percent of GDP. A protracted economic slowdown will only diminish the ability to service outstanding debts.
Much of the leverage was funneled to redundant capital investments and massive infrastructure projects. Now, excess capacity and under-utilization permeate the economic landscape. This was a result of economic activity completely disconnected from profit-making incentives and fostered by an environment rife with moral hazard. Essentially, investment persisted regardless of profitability or incongruence with market forces.
For example, despite a virtual monopoly in rare-earth metal supply (which go into essential smartphone components), 90% of Chinese miners are unprofitable. Export controls were implemented to favor domestic producers, but unintended consequences soon took hold in the form of overcapacity and illegal mining. How do you like them centrally-planned apples?
In the coming years, the government anticipates laying off millions of workers. $23 billion has been earmarked to assuage the future unemployed.
It is China’s most significant nationwide retrenchment since the restructuring of state-owned enterprises from 1998 to 2003 led to around 28 million redundancies and cost the central government about 73.1 billion yuan ($11.2 billion) in resettlement funds.
Source: Reuters
Credit them with recognizing the necessity of shuttering zombie industries they’ve sustained for years. This comes at a cost, however, and entails structural unemployment for millions of people. By sustaining zombie industries, it increases the number of people who, once attracted to the expanding capital investment pie, now lack the skills for the new economy.
Against the aforementioned economic backdrop, in addition to last August’s unexpected currency devaluation, people and businesses are rightfully concerned about the Yuan’s purchasing power and the economic outlook. Faced with a gloomy economy and weakening purchasing power, a normal response for citizens and businesses would be take their money abroad. Essentially, sell the currency you hold (Yuan) in exchange for international assets or currencies. That is exactly what’s happening.
The chart below illustrates net capital inflows and outflows since 2007 and we observe that the last two years coincide with massive outflows. Money is pouring out of the country. (Where that money went and how it is fleeing the country deserves a separate deep-dive. Suffice to say that it exerts strong downward pressure on the Yuan.)
The PBOC is trying to keep the Yuan afloat (previously relative to the U.S. Dollar, but now relative to several baskets of currencies) by drawing heavily on a stockpile of foreign-exchange (FX) reserves to purchase Yuan on the open market. In this case, think of a central bank’s FX reserves as a rainy-day pile of cash and assets, typically U.S. Dollars and Treasuries. This has the effect of increasing demand for the Yuan.
As of the end of January 2016, reserves fell by approximately $800 billion since mid-2014, greater than the annual GDP of the Netherlands ($782 billion), Turkey ($721 billion), or Switzerland ($687 billion). According to the PBOC’s February data, FX reserves declined by $28 billion. This, however, does not account for valuation adjustments (strengthening of other currencies relative to the Yuan) and a one-week Chinese New Year holiday. Again, the PBOC’s FX reserves represent cash and assets denominated in other currencies.
Throw a stock market collapse, economic contraction, unsustainable debt, mass unemployment, and currency flight into a blender and out comes one noxious economic and social cocktail.
The Communist Party has no appetite for social unrest so, naturally, proposed remedies do nothing more than perpetuate past mistakes.
The can-kicking is now manifesting itself in various financial and censorship maneuvers that are just as surprising as they are helpful.
Bank Reserve Ratios Lowered to Spur Lending
Since March 1st, the PBOC lowered the reserve requirements for commercial banks. This means that banks can now store less cash with the central bank which should enable more lending. Even prior to the announcement, Chinese banks issued more loans in January 2016 than any other month in the past 12 years.
China’s troubles do not stem from a lack of debt but from too much of it. Misdirected investment through debt-accumulation has reached it’s near-term limit and the new bright idea is to increase lending. This may spur short-term activity but only worsens the problem. Thus, making the ultimate deleveraging more painful.
Non-performing Loans, Asset-Backed Security Issuance on the Rise
Evaluating loan performance raises even more red-flags. Non-performing loans (NPLs), that are in default or close to defaulting, have ballooned to 1.27 trillion Yuan (~$200 billion in U.S. dollars), more than doubling since 2010 with no signs of abatement. As economic growth slows, it becomes increasingly difficult for already-strained companies and individuals to service their debts.
Compounding the problem further is the PBOC’s mandate for commercial banks and all state banks to repackage the steaming piles of non-performing loans into asset-backed securities (ABS). Essentially, let’s gift-wrap bird crap, put a bow on top, and sell it to investors or state asset management companies.
The mandate’s purpose is to move NPLs off of bank balance sheets and to free-up capital for more lending. Worst of all, the ABS will likely receive high ratings from Chinese rating agencies.
This may sound similar to the U.S. subprime crisis of 2008. But this time around, the world can witness the sausage-making process in broad daylight. Unfortunately, the ingredients have already gone bad and the mandate is incentivizing creditors to lend more. What this amounts to is an enlargement of the credit bubble blast-radius.
Tightening Flow of Economic Data
The government recognizes that economic and financial turbulence undermine public confidence in the Communist Party. GDP isn’t only an economic indicator. It is a symbol of national pride and is laced with political sensitivity.
In its current predicament, the PBOC is doing what any other self-respecting, (nearly) absolute monetary institution would do: obfuscating or outright censoring market-moving data.
China’s reputation for releasing reliable statistics was always in question. When provincial GDP numbers do not corroborate with the national figure, it is appropriate to take the numbers with a fistful of salt.
Last September, Markit Economics, a British company, and Caixin Media, based in Beijing, stopped publishing preliminary results from a monthly survey of purchasing managers at Chinese factories. The preliminary results, which came a few days before the two firms and the government separately released complete numbers, often affected markets.
Source: The New York Times
Reducing visibility and transparency will only serve to undo investor confidence in the Chinese market and dampen foreign investment. Although censorship is nothing new for the Chinese regime, this actually works against efforts to liberalize markets and monetary policy. These measures will not expand the Yuan’s usage in international trade and muddies the path to international reserve status.
China in a Bear Shop
The definition of insanity is to do the same thing over and over again, expecting different results — which is exactly what the Chinese government is doing. A quote from F.A. Hayek is instructive:
To combat depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection — a procedure which can only lead to a much more severe crisis as soon as the credit expansion comes to an end.
-F.A. Hayek
Unprecedented credit expansion has billionaire investors lining-up to profit from, what might be, the biggest short of them all. Government officials even went so far as to publicly rebut George Soros’ prediction about a hard-landing for the Chinese economy. It’s debatable whether challenging the PBOC to a financial duel is a good idea, but the fundamentals show China is painting-itself into a room full of angry bears — and it’s a well known fact bears don’t fight fairly.
In the short-run, the government might actually succeed in calming markets by projecting optionality and a willingness to act. But given the forces at work and the proposed can-kicking masked as solutions, perception will inevitably collapse to economic reality. Worse of all, it’s the Chinese people who will suffer most from central planners who think they know what’s best for individuals.
