The Great Es­cape from China

Financial Mirror (Cyprus) - - FRONT PAGE -

Since 2016 be­gan, the prospect of a ma­jor de­val­u­a­tion of China’s ren­minbi has been hang­ing over global mar­kets like the Sword of Damo­cles. No other source of pol­icy un­cer­tainty has been as desta­bil­is­ing. Few ob­servers doubt that China will have to let the ren­minbi ex­change rate float freely some­time over the next decade. The ques­tion is how much drama will take place in the in­terim, as political and eco­nomic im­per­a­tives col­lide.

It might seem odd that a coun­try run­ning a $600 bln trade sur­plus in 2015 should be wor­ried about cur­rency weak­ness. But a com­bi­na­tion of fac­tors, in­clud­ing slow­ing eco­nomic growth and a grad­ual re­lax­ation of re­stric­tions on in­vest­ing abroad, has un­leashed a tor­rent of cap­i­tal out­flows.

Pri­vate cit­i­zens are now al­lowed to take up to $50,000 per year out of the coun­try. If just one of ev­ery 20 Chi­nese cit­i­zens ex­er­cised this op­tion, China’s for­eign-ex­change re­serves would be wiped out. At the same time, China’s cashrich com­pa­nies have been em­ploy­ing all sorts of devices to get money out. A per­fectly le­gal ap­proach is to lend in ren­minbi and be re­paid in for­eign cur­rency.

A not-so-le­gal ap­proach is to is­sue false or in­flated trade in­voices – es­sen­tially a form of money laun­der­ing. For ex­am­ple, a Chi­nese ex­porter might re­port a lower sale price to an Amer­i­can im­porter than it ac­tu­ally re­ceives, with the dif­fer­ence se­cretly de­posited in dol­lars into a US bank ac­count (which might in turn be used to pur­chase a Pi­casso).

Now that Chi­nese firms have bought up so many US and Euro­pean com­pa­nies, money laun­der­ing can even be done in-house. The Chi­nese hardly in­vented this idea. Af­ter World War II, when a ru­ined Europe was smoth­ered in for­eignex­change con­trols, il­le­gal cap­i­tal flows out of the con­ti­nent of­ten av­er­aged 10% of the value of trade or more. As one of the world’s largest trad­ing coun­tries, it is vir­tu­ally im­pos­si­ble for China to keep a tight lid on cap­i­tal out­flows when the in­cen­tives to leave be­come large enough.

In­deed, de­spite the gi­ant trade sur­plus, the Peo­ple’s Bank of China has been forced to in­ter­vene heav­ily to prop up the ex­change rate – so much so that for­eign-cur­rency re­serves ac­tu­ally fell by $500 bln in 2015. With such leaky cap­i­tal con­trols, China’s war chest of $3 trln won’t be enough to hold down the fort in­def­i­nitely. In fact, the more peo­ple worry that the ex­change rate is go­ing down, the more they want to get their money out of the coun­try im­me­di­ately. That fear, in turn, has been an im­por­tant fac­tor driv­ing down the Chi­nese stock mar­ket.

There is a lot of mar­ket spec­u­la­tion that the Chi­nese will un­der­take a siz­able one-time de­val­u­a­tion, say 10%, to weaken the ren­minbi enough to ease down­ward pres­sure on the ex­change rate. But, aside from pro­vid­ing fod­der for the likes of Don­ald Trump, who be­lieves that China is an un­fair trader, this would be a very dan­ger­ous choice of strat­egy for a govern­ment that fi­nan­cial mar­kets do not re­ally trust. The main risk is that a big de­val­u­a­tion would be in­ter­preted as in­di­cat­ing that China’s eco­nomic slow­down is far more se­vere than peo­ple think, in which case money would con­tinue to flee.

There is no easy way to im­prove com­mu­ni­ca­tion with mar­kets un­til China learns how to pro­duce cred­i­ble eco­nomic data. It was a huge news story when China’s 2015 GDP growth was re­ported at 6.9%, just short of the of­fi­cial tar­get of 7%. This dif­fer­ence ought to be ir­rel­e­vant, but mar­kets have treated it with the ut­most im­por­tance, be­cause in­vestors be­lieve that things must be re­ally bad if the govern­ment can’t rig the num­bers enough to hit its tar­get.

A good place for the au­thor­i­ties to start would be to es­tab­lish a com­mis­sion of econ­o­mists to pro­duce a more re­al­is­tic and be­liev­able set of his­tor­i­cal GNP fig­ures, paving the way for more be­liev­able GNP fig­ures go­ing for­ward. In­stead, the govern­ment’s im­me­di­ate idea for re­liev­ing ex­change-rate pres­sure is to peg the ren­minbi to a bas­ket of 13 cur­ren­cies, in­stead of just to the US dol­lar. This is a good idea in the­ory; in prac­tice, how­ever, bas­ket pegs tend to have chronic trans­parency prob­lems.

More­over, a bas­ket peg shares most of the prob­lems of a sim­ple dol­lar peg. True, the euro and yen have fallen against the dol­lar over the past cou­ple of years. If the dol­lar re­treats in 2016, how­ever, the bas­ket peg i mplies a stronger ren­minbi-dol­lar rate, which might be un­help­ful. The govern­ment has also in­di­cated that it in­tends to clamp down more heav­ily on il­le­gal cap­i­tal flows; but it will not be easy to put that ge­nie back in the bot­tle.

Life would be a lot eas­ier to­day if China had moved to a much greater de­gree of ex­change-rate flex­i­bil­ity back when the go­ing was good, as some of us had ad­vised for more than a decade.

Maybe the au­thor­i­ties will be able to hold on in 2016; but it is more likely that the ren­minbi will con­tinue its rocky ride – tak­ing global mar­kets along with it.

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