China: Imminent Doom or Necessary Adjustments?
China continues to be the catalyst for waves of pessimism in international financial markets as the country follows a tricky path of transition to a more sustainable economy. Current prevailing opinion seems to favor an imminent crash of some sort that poses risks to the international financial system. We, however, disagree.
In our opinion, the tasks China has undertaken are necessary and challenging, and we will continue to see bumps in the road. However, the Chinese government—with power over spending, over banks, and over large, state enterprises—still has a great number of levers with which to manage. Disaster scenarios are overblown. But, it is the instinct to over-manage markets, such as the attempts to limit stock market price moves earlier this year, which contributes to volatility and confusion. Yet, at least in that case policymakers learned fast and reversed course.
The most recent alarm was raised over reports that China is “bleeding foreign exchange reserves” to support the value of the yuan (see Figure 1). That concern is linked to the real issue of the debt burden of Chinese governments, companies, and individuals.
Some Observations on Foreign Exchange Reserves in China
|China is rapidly spending its foreign exchange reserves to keep the yuan from collapsing (U.S. Presidential candidates continue to accuse China of manipulating the value of the yuan as an unfair trade practice).
|China is indeed intervening in foreign exchange markets to prop up the value of its currency. It is true that $100 billion in a month is a lot of money to spend to support a currency. However, China is hardly at risk of “burning through” their foreign exchange reserves unless intervention continues over an extended period. No country has ever been able to prop up a currency against the sentiment in the market for very long. Although, if there were a run on the currency, reserves can be used quickly. These politically-driven criticisms are obviously misguided.
|A run on the currency is a real possibility.
|The chances of a run on the currency are minimal. Owning yuan outside of China has only recently become possible and holdings are small. Also, Chinese citizens are not allowed to buy large amounts of foreign exchange with their yuan.
|The yuan has become overvalued by a very large amount so the fundamentals also point to a danger of collapse.
|The value of the yuan should decline significantly and it should be able to be managed gradually. As we noted late last year, China has seen a 40 percent appreciation over the past several years due to its link to the U.S. dollar. While this has hurt China’s exports and growth, China is still running a very large trade surplus so no collapse in the currency is needed or likely.
Some Observations on Debt in China
|China’s situation mirrors the United States prior to the great recession with debt, especially housing debt, getting dangerously high and setting the stage for a crisis. A housing bubble is in evidence.
|China’s debt is not individual debt. Households and small businesses have had limited borrowing options beyond homes and savings rates are very high. To avoid a housing bubble, the legal minimum down payment is 25 percent. Because real estate is one of the few available investments, many put down significantly more. Housing defaults are far less likely than in countries with higher leverage.
|Banks have recklessly been offering loans to companies with no prospect of repayment.
|Bank debts accumulated by state enterprises and local governments are a concern, especially because the state-owned banking system offers loans for political reasons, without ensuring borrowers can repay. However, it’s important to recognize that both the banks and companies are owned by government. In the United States, we would call this a government bailout or aid to companies. In China, the same goals are accomplished through loans from state banks.
|The imminent debt collapse will cause repercussions all around the world.
|The big concern is not a disruption from a financial collapse because the government would not let that happen. Yet, there is concern that the government banks continue to loan money to the state enterprises (knowing that it will never be repaid) and the state enterprises continue to operate despite the downturn in its markets. It will be painful to shut down nonviable companies, but China set up asset management companies in 1999 to clean up similar bad debts.
|This situation resembles the United States a decade ago, when the government needed to bail out the banks.
|When one thinks about debt and default, it is important to understand the context. In a very real sense, debts are loans from government organizations to other government organizations. When banks need to be recapitalized, it can be done directly by the government owners.
Based on the above observations, we do not foresee anything but a major policy error that would cause China to create a short-term macro shock to the global economy. In the United States, for example, we would worry that a wave of defaults would lead to credit being cut off from the credit-worthy, causing a local problem to become a national problem. In China, the big borrowers don’t default, they just keep borrowing. This borrowing by government companies needs to stop, but the potential for contagion is limited.
We appeal to the data and economic structure to say that there is no China collapse on the horizon. At the same time, we agree that China has a number of very significant issues to deal with, all of which are long-term in nature and challenging. In the meantime, we can look forward to lengthy periods of panic from observers who see only the challenges and not the progress. Stay tuned for next week’s post where we will discuss China’s future challenges and why, in our opinion, there should be no cause for alarm.
For further analysis on China’s changing landscape refer to Blue Canyon’s whitepaper, China: The Bad News and The Good News.
 People’s Bank of China. (2016). [Graph illustration of Foreign Exchange Reserves in China from 1980-2016]. China Foreign Exchange Reserves. Retrieved from http://www.tradingeconomics.com/china/foreign-exchange-reserves