How bad is the Chinese economy?
Wild speculation has fueled fears about the Chinese economy. There are no two ways about it: 2016 has been an annus horribilis for China. The world’s second-largest economy has endured the most inauspicious start to the year, although the Chinese will argue differently. The Chinese New Year began in February 2016, and things have looked markedly different since then. Nonetheless, capital flight remains a major source of concern for market analysts, fund managers and investors the world over. China currently has a forex stash of approximately $3.23 trln, but that figure is quickly being eroded by capital flight which has heretofore ramped up to as much as $100 bln per month.
Were that rate to continue unabated, the People’s Bank of China could soon find itself in a cash crunch. Fortunately, the tide appears to have turned in China’s favour of late. All the market bears will be shaking their heads in confusion about the performance of the Chinese economy. While fundamental weakness is pervasive across multiple sectors, a turnaround strategy is at play. This is easily seen in the reduction in capital flight during February 2016. Last month, $28.6 bln left China, and the mathematics of this number clearly shows a reduction of $71.4 bln from the average of $100 bln per month.
This begs the question:
Why has capital flight declined? The answer could be a combination of multiple factors, but the fact of the matter is that China’s economy is turning the corner. There are no two ways about it. For starters, February was the Lunar New Year in China, and that meant that all trading activity was suspended for seven days. A shortened month, albeit a leap year ensured that less capital flight was expected for the month. However, China’s economy has strengthened to a degree as evidenced by improving sentiment in the steel industry and elsewhere. What may have started out as a large Sell China attitude has weakened to a degree. The appreciation of the Chinese renminbi against the USD (the offshore CNY) is evident. The onshore renminbi is subject to exceptionally tight control by Beijing.
Many traders have opted to short sell the CNY, and in so doing reveal their sentiment about the Chinese economy. It is also evident that shorting the Chinese currency is having a dire effect on the country’s foreign exchange reserves. As confidence in the Chinese renminbi sours, so the Chinese government sells foreign currency to prop up its own currency. International investors and local investors who have the wherewithal to remove their capital from the country (against the backdrop of a rapidly deteriorating local currency) are doing so. One of the most scathing indictments of official Chinese policy came from the Bank for International Settlements. The renminbi is being sold en masse, of that there is no doubt; so much so that the Chinese government has enacted policies to make it more difficult and expensive for capital flight to take place. By increasing the costs of this type of trading activity, the PBOC is discouraging capital flight.
In terms of foreign currency reserves, there has been a sharp decline from June 2014 to the present day. Back then, China held approximately $3.99 trln in foreign exchange reserves. Today that figure has dropped to $3.23 trln. While still substantial, the rate of decline is unprecedented in China’s history. Chinese companies have been scrambling to repay dollar-denominated debt, and people across the mainland have been seeking ways and means of withdrawing their finds and getting them out of China. This is the research that the Bank for International Standards uncovered.
Every day, traders would be remiss for thinking that it’s the typical Chinese family that is seeking to withdraw money from the country and take it abroad. In fact, a large part of the decline in forex reserves is due to the sharp reductions in external debt and the unravelling of the carry trade. During Q3, 2015, forex reserves in China declined by some $285 bln. During the same quarter, cross-border loans in the mainland declined by $175 bln. A tidy figure of some $80 bln is likely a result of the reversal in carry trade figures.
What happened between 2005 and 2013 was that individuals and companies were borrowing dollars and holding Chinese renminbi at a time when the renminbi was appreciating. Then the reversal took place and traders did an about turn, selling off their positions with USD for substantially less CNY. As the dollar strengthened, speculators wanted to hold less CNY deposits. And this was done to the tune of $80 bln in the third quarter of 2015. Many similar stories to this abound in China, such as the $34 bln worth of outflows from Chinese companies on the mainland interested in repaying cross-border debts.
It has been estimated that Chinese companies held approximately $800 bln in forex that was labelled as debt in mid-2015. The net value of net forex debt owed by Chinese companies to Chinese banks was reduced by $7 bln in Q3 2015, adding to the outflow of some $175 bln. Debt is being driven by widespread expansion of credit in China. Consider for example that the Debt/GDP ratio back in 2008 was 125% and the ratio today is close to 280%. The BIS (Bank of International Settlements) estimates that private sector debt in China was 200% of gross domestic product in mid-2015. If the current rate of capital flight continues in China, and there is nothing to suggest that it will not given the figures that have been released, forex reserves will drop to $2 trln by the year’s end. That will not inspire confidence in the Chinese economy whatsoever.
China erred by spending a large part of its capital on things like coal mining industries, real estate, steel mills, infrastructure growth and development and other capital intensive industries. In and of themselves, these investments are sound, but not in the current economic climate. There is simply too much excess production and not enough global demand to justify the investment that the Chinese government and corporations have made in the country. What has happened in the interim is fierce competition among companies to try and undercut one another’s prices to get their goods to market cheaper. This is particularly devastating in the steel industry where deflationary fears are a threat to the global economy. Local steel manufacturers are now faced with massive dumping of Chinese steel on their shores, causing local industries to go bankrupt. With prices being undercut all the time, deflation is a real phenomenon.