China’s Currency and Debt Problem

The latest question to sweep the ongoing debate about what is happening in China is the focus on capital outflows.

The primary focus so far has been on trying to estimate the size and type of outflows.  While undoubtedly important to estimate the size which multiple parties have already made good faith well reasoned estimates, which I won’t revisit here, what I believe is more important is to focus on why this matters and transmission mechanisms to the larger economy.

My bias when analyzing these situations is that history does not repeat itself, but it does rhyme.  The 1998 financial crisis has been the absolute intellectual framework for Chinese politicians in the design of economic and financial policies.  Capital controls, preventing short term money, restrictions on trading, and international lending constraints are all lessons learned by Chinese policy makers from 1998.  However, if the study of economics teaches us anything it is that there are no free rides and everything has a trade off.  While these policies may prevent a replica 1998, they open up a host of other problems and so far China seems ill prepared or failed to have considered the ramifications of these policies.

Let’s consider some of the key differences and their implications. The capital outflows from China right now are not driven primarily by foreigners but rather domestic firms.  Portfolio outflows from China are limited by the data we see empirically but also the quota nature of “hot money” outflows and investment.  As foreign investment is heavily tilted towards the FDI variety with production focused on serving the Chinese market, there is little evidence that foreign firms are exiting China en masse and their export volumes are not high enough to drive over invoicing variations.  In short, capital outflows and pressure on the RMB is driven primarily by Chinese investors trying to leave China not foreign investors pulling their money.

Though somewhat speculative, there is evidence that current outflows are not short term outflows but are longer term in nature.  Whether it is corporations diversifying their onshore/offshore RMB holdings to internally manage currency risk, central banks buying offshore RMB to build up their reserves, foreign direct investment in other countries, or real estate purchases in other countries, these are funds that likely will not be returning to China anytime soon.

There are a few significant implications here.  First, a major driver of the Chinese miracle is the very simple expansion of the money supply.  In a little more than the past decade, Chinese expansion of the money supply trailed only serial or hyper inflators like Russia among major economies.  Large capital inflows and rapid expansion of the money supply was arguably the greatest driver of the Chinese economy.  Driven by an undervalued currency followed by a credit orgy of historical proportions, the Chinese economic miracle was driven at least as much by an explosion of money as economic fundamentals. This prompted knock on effects in rapid price increases in assets like real estate and credit growth fueling developers and government debt.  Any slowdown in capital inflows and money growth will have an outsized impact on an economy dependent on easy money fueling asset price increases.

Second, given the relative lack of bond and equity financing in the grand scheme, the real risk of capital outflows is the reduced liquidity available to banks.  We are already seeing banks facing liquidity pressures as the PBOC injected nearly $50 billion into banks via reverse repos in July.  Given the lare demands for bond repurchases, loans to prop up the stock market, and stretched duration coupled with the strong suspicions of large rollovers, draining liquidity from the primary financing mechanism for the entire Chinese economy could have an enormously negative impact.  Given wide variety of indicators implying significant credit stress in the Chinese economy including multiple debt restructuring and bank equity injections by the PBOC, draining liquidity via capital outflows could pinch banks ability to continue rolling over loans or making fresh loans in an effort to boost GDP.  Chinese NPL’s in foreign banks, especially in Hong Kong, are simply exploding and likely the only reason that Chinese NPL’s aren’t following is that their unique definition defies all but credit drug addled common sense.

Third, capital flight like immigration is a confidence bellweather.  Chinese firms are telling you they do not have confidence in the Chinese economy and investment opportunities.  Forget the press releases and the stock market and watch how Chinese firms are behaving. If we look at how they are acting to move capital out of China, their revealed preference is telling you everything you need to know.

Fourth, while China has virtually zero foreign debt, that does not negate the fact that it has enormous domestic debt.  While lenders can’t flee the country in large numbers, that doesn’t mean that asset prices and accompanying cash flow will remain buoyant enough to support the debt.  For instance, Chinese real estate prices per square foot are almost 25% than the United States even though the nominal per capita GDP in the United States is 619% higher.  This implies cash flow unable to support the asset value.  There are large number of similar examples implying what very real risk of a “balance sheet” recession to bring asset values back in line with their cash flow values.

Fifth, the PBOC and entire Chinese financial regulatory apparatus is stuck in 1998 blind to the current challenges.  China actually has increasingly competitive and high quality firms that want to expand abroad and global investors, like central banks, that want to hold RMB. If China wants to further its global economic ambitions of raising up globally competitive firms and make the RMB a global reserve currency, it has to move beyond the 1998 framework manage the demands of creating a global currency and the large currency outflows that is going to necessitate.  They also seem oddly unaware of unable to face the current risks and environment that they have created. Intellectually slaying the 1998 dragon has made them oddly unable to fight the 2015 dragon.

I think the risk of a currency crisis attacking China is relatively low.  However, that any significant shift in currency policy would be a major blow to the aspirational confidence and signal profound concern about the state of Chinese economy.  As I have almost always stressed, any of these problems in isolation can be handled by China. I believe the real risk is when these stress points join forces with other markets like credit, equity, and currency, joining forces to cause real financial havoc.

In closing, let me note just how invested China is in maintaining the status quo.  In a rapidly slowing economy with producer price deflation, the most direct method of driving the economy would be lowering interest rates.  However, the PBOC can’t even entertain significant cuts because of the pressure to the RMB, capital outflows, and knock on effect of liquidity reductions in the credit market. In short, Beijing is willing to strangle its own economy to meet its political objectives of maintaining the peg and joining the SDR.

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