How bad is the Chi­nese econ­omy?

Financial Mirror (Cyprus) - - FRONT PAGE -

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.

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