China & Confidence


Nice chart above showing the implied capital outflow. The chart title is quite witty too. From the Economist yesterday:

Many economists reckon China will allow the yuan to fall. After all, the currency has appreciated by 20% against a broad range of currencies since 2012, thanks to rising wages and a peg to the strengthening dollar. Yet a sinking yuan poses threats. Roughly $1 trillion of China’s accumulated debts are denominated in dollars. That is small beer next to $28 trillion in total Chinese debt. But because Chinese firms are so highly leveraged, even a small rise in the cost of servicing dollar-denominated debts could force some into asset sales or bankruptcy. That, in turn, would encourage more capital outflows, depressing the yuan’s value still further.

The economy could expect only a modest boost to exports for its trouble. Since much of the material that goes into Chinese exports is itself imported, devaluation does not boost exports that much. It also squeezes the purchasing power of Chinese consumers and thus slows the rebalancing of its economy from investment to consumption, while irking America and encouraging competitive devaluations elsewhere.

China seems not to have absorbed the most important lesson of that crisis: that confidence matters.

Compare this with Gavyn Davies’s article today:

The key question is whether China can restore confidence in its exchange rate policy, not least among its own citizens.

Most other economies, both developed and emerging, are experiencing negative producer price inflation as commodity prices have collapsed, but the size of the industrial sector in China makes it a particular problem there, and it has been exacerbated by the rising renminbi in 2013-15.

In the Central Economic Work Conference in December, President Xi firmly established “supply side reform” as the new buzz word for policy in 2016. That means that excess capacity will be tackled by plant closures and job losses, offset by easier fiscal and monetary policy.

In a western economy, it would be taken for granted that such a programme would be accompanied by a drop in the real exchange rate as overall monetary conditions are loosened. Flexible, market determined exchange rates can go down as well as up. Perhaps that is also becoming a necessary evil in China.

According to Reuters today, the PBOC will raise the yuan reserve requirement ratio (RRR) for offshore participating banks to a yet to be set level from the previous zero. This will help reduce the liquidity of the CNH market, but would probably not be fully effective in stemming speculation of further depreciation.

From Reuters,

The PBOC has been under increasing pressure from policy advisers to let the currency fall quickly and sharply, after spending billions of dollars buying yuan over recent months to defend the exchange rate. Confusion over China’s foreign exchange policy and its commitment to reforms has roiled global financial markets in recent weeks as the central bank allowed the yuan to fall and then moved in aggressively to try to stabilize it.

China’s foreign exchange regulator has ordered banks in some of the country’s major import and export centers to limit purchase of U.S. dollars this month. China also suspended forex business for some foreign banks, including Deutsche, DBS and Standard Chartered at the end of last year.

Cleaning up a financial system is a multi-year process, a luxury that is not afforded to the Chinese currently. Nor is an all-out effort to rig the markets recommended as a sustainable solution. Political credibility also ties the hands of policy makers. In addition, a sharp depreciation must be avoided: the consequences would spread unpredictably across not just China but Asia and the emerging world.

What are the solutions – if there is even one, then? The solutions must address both one; capital outflow and two; currency speculation. Back in 1998 Malaysia employed capital controls, but the political environment of this small country was very different than what it is now in China.

As I see it, because of the political obstacles and ‘losing face’ convertibility ‘IMF-just-included-us-in-the-basket’ issues, there needs to be an intermediate solution and a long-term solution. Furthermore, no matter the plan, it must be laid out and conveyed effectively to the Chinese themselves, in a way that confidence (or shall I say, greed?) will overcome fear.

The only way to prevent this crisis is to restore confidence.


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