August 12, 2015
(with apologies to Bertrand Russell, “The Problem of China” published in 1922)
When Bertrand Russell published his fascinating observations of China, its role in the world, relationships with its neighbours and prospects for growth, little did he know that almost a century later China would still represent an enormous challenge for the West.
While the devaluation of the Yuan in recent days has been surprising in its timing, it is a policy shift that we have expected and written about for quite some time and reflects the big problem that is China. Here are 4 reasons to expect a sizable Yuan devaluation over the next year or two:
1. Major Chinese financial institutions are expanding their balance sheet at a rate equivalent to 35% of GDP annually. If we, conservatively, expect half of those assets to be non-performing (perfectly prudent by historical standards) and apply a 50% recovery rate to the losses then the financial system is writing off an amount annually equivalent to 9% of GDP (that is approximately estimated as (0.5 * 35%) * 0.5 = 8.75%). Think about that number carefully, if you believe (and we don’t for a second) Chinese GDP growth numbers, then the economy is actually contracting: 7% GDP growth less 9% write-offs.
Summary of Point 1 = The Chinese economy is, and has been for some time, in outright contraction/recession.
2. The capital stock of the Chinese manufacturing sector is expanding at a 10% year/year rate. That contrasts with a 31% median annual growth rate in the ten years through 2013. Unfortunately, domestic demand in the USA + Euro area+ Japan + UK is growing just 2.5% year/year.
Summary of Point 2 = China is adding capacity to supply goods way faster than demand is growing. That means increasing amounts of idle and costly capacity in China. When supply growth rapidly outpaces demand growth it means only one thing… deflation. China is slowing capacity expansion, which is slowing growth, but the gap remains enormous and suggests a huge deflationary pulse is headed west as the capacity finds sales. The impact of much, much slower investment growth has to be cushioned… by devaluation.
3. The Chinese Yuan has appreciated in real, effective terms by 11-15% in the last year (depending on whether you apply a consumer price or producer price deflator). For an economy in contraction/flat at best, with rapid capacity expansion, a corporate sector that is grotesquely leveraged by international standards and sits atop wafer thin/non-existent profit margins… that’s a big problem.
Yuan appreciation on this scale is almost unprecedented and Chinese industry just does not have the ability to withstand it…
Summary of Point 3 = The Chinese Yuan has appreciated on an almost unprecedented scale and the strength of the USD, with a policy tailwind behind it as the Fed presses to normalize interest rates, makes it unbearable. Lower interest rates in China, changes to Reserve requirements in China or any other monetary policy changes in the Western style are ineffective. Devaluation is the only way out.
4. China is haemorrhaging foreign exchange reserves. Over the years capital flowed into China, chasing the “miracle”, and the Chinese central bank purchased those foreign currency inflows and in return provided Yuan liquidity – the central bank increased its assets and had a corresponding increase in its liabilities in the form of Yuan liquidity. The growth in reserves fuelled the economy.
With a former Trading Manager responsible for the UK Foreign Exchange Reserves at our firm, this is an issue close to our heart.
Now, in the last 4 quarters, China has lost $299 billion in reserves. This represents an effective tightening in domestic monetary conditions on an enormous scale. As if Yuan appreciation were not enough, this makes policy conditions much, much more restrictive just when the economy is floundering.
Summary of Point 4 = A huge loss of international reserves represents a substantial tightening in monetary conditions, on top of the real appreciation in the Yuan.
What are the implications for the West?
Well, just take a look at the UK Consumer Price Index to see what looms.
Over half of the index components have already deflated over the last year, and that is before the Chinese devaluation trend kicks in.
Fully 83% of the index components have inflation in the last 12 months below 2%.
Moreover, 75% of the index components individually have lower inflation rates today than a year ago.
A Chinese devaluation cycle is only going to compound the existing trend.
The Bank of England might want to normalize interest rates to deal with the record current account deficit. Private sector financial deficit and grossly overvalued housing market will face a challenge in coming months/quarters.
Do you deal with monetary sector inflation or do you deal with real economy deflation/disinflation… ?
Either way, a desire on the part of the Chinese to devalue (and they need significant devaluation) probably means less of a desire in the UK and US to tighten policy. Monetary liquidity conditions are likely to remain more accommodative for longer and there is a non-negligible risk that another round of QE might be necessary to counter the Chinese move. Monetary policy competition between the Bank of England, the ECB, the Fed and the Chinese.
This is what the world looks like when you have one tool – QE – and you use it to abandon… “The Problem of China”!
MONOGRAM CAPITAL MANAGEMENT