The first in­stall­ment of cap­i­tal out­flows

The Pak Banker - - OPINION - V. Anan­tha Nageswaran

Last Tues­day, the Peo­ple's Bank of China (PBoC) or, more pre­cisely, the Cen­tral Com­mit­tee of the Com­mu­nist Party of China, de­cided to fix the yuan against the dol­lar at 1.9% weaker than the pre­vi­ous day's mar­ket close.

As of to­day, the cu­mu­la­tive weak­ness since last Mon­day is of the or­der of 3%. Such is the cred­i­bil­ity of Chi­nese gov­ern­ment in­sti­tu­tions that the mar­ket did not think that it was so in­nocu­ous or be­nign. All hell broke loose. Most East Asian cur­ren­cies plunged (not the In­dian rupee) and stock mar­kets tum­bled.

Some apol­o­gists for China sprung to its de­fence. They wrote that China was ac­tu­ally re­spond­ing to the re­port that the In­ter­na­tional Mon­e­tary Fund (IMF) had re­leased on the up­com­ing re­view of the Spe­cial Draw­ing Rights (SDR) bas­ket. The Fund's board is eval­u­at­ing whether to in­clude the Chi­nese yuan in the SDR bas­ket. The IMF re­view ap­peared to rule out an im­mi­nent in­clu­sion.

One of the con­di­tions is that China must al­low the mar­ket to set the price of the cur­rency against the dol­lar, at least in­cre­men­tally more than it had done so in the past. Hence, the move by the PBoC was ac­tu­ally a step in the right di­rec­tion. How­ever, hav­ing seen the re­spect China ac­corded mar­ket forces in the stock mar­ket in July-Au­gust, its claim that it was re­spect­ing mar­ket forces on the cur­rency must be sub­ject to rig­or­ous ex­am­i­na­tion.

Upon do­ing so, we come up with more ques­tions than an­swers. The ar­gu­ment that has been put forth is that China had enough scope to use do­mes­tic stim­u­lus such as fis­cal pol­icy, in­ter­est rate cuts and cuts in the re­serve re­quire­ment ra­tio be­fore it needed to turn to an ex­ter­nal de­val­u­a­tion. To as­sert that China needed stim­u­lus is to ac­cept the ar­gu­ment that China's gross do­mes­tic prod­uct (GDP) growth rate was far lower than 7% that the gov­ern­ment re­ports. If so, then all other claims put out by the Chi­nese gov­ern­ment need to be put through the truth-wringer.

In the Na­tional Peo­ple's Congress in 2013, China had promised to un­der­take eco­nomic restruc­tur­ing and let mar­kets fix many prices. It has done pre­cious lit­tle. State-owned en­ter­prises are in con­trol of the com­mand­ing heights of the econ­omy and they are be­ing strength­ened through con­sol­i­da­tion. Lo­cal gov­ern­ment fi­nanc­ing ve­hi­cles are al­lowed to bor­row again, that too in for­eign cur­rency, and banks have been asked to en­gage in for­bear­ance of their ex­ist­ing debt. When the stock mar­ket bub­ble stoked by the gov­ern­ment burst, it re­sponded with a fe­roc­ity that blew away fatu­ous ar­gu­ments that the stock mar­ket was an in­signif­i­cant part of the Chi­nese econ­omy.

In any case, it bears rep­e­ti­tion that many other eco­nomic in­di­ca­tors-such as the pur­chas­ing man­agers' in­dex, sale of au­to­mo­biles, em­ploy­ment trends and va­cant floor space, not sup­port gov­ern­ment growth sta­tis­tics of 7%. The ques­tion then is whether China re­ally has any do­mes­tic eco­nomic levers to pull.

It is usu­ally not well-known that China's public fi­nances are not in good shape. Many sim­ply make that as­sump­tion with­out sub­ject­ing to ver­i­fi­ca­tion. JP Mor­gan wrote in July that China's con­sol­i­dated fis­cal deficit was around 9%. The Ar­ti­cle IV con­sul­ta­tion re­port re­leased by IMF on China puts the fig­ure closer to 10%. So, how much more is the scope for fis­cal stim­u­lus? As for mon­e­tary stim­u­lus, with a debt to GDP ra­tio of close to 300% of GDP, how much more of debt-led growth should China en­cour­age? Not that the ques­tion ap­pears to bother China much. But, it would not be long be­fore its credit stand­ing is called into ques­tion.

Hence, the con­clu­sion is that China's econ­omy is in bad shape but its do­mes­tic stim­u­lus levers have al­ready been pulled hard. There­fore, its ex­change rate move last week was in the na­ture of test­ing the wa­ters. It is more likely the first in­stal­ment be­cause China's prodi­gious cap­i­tal out­flows pre­clude dras­tic moves in one stroke. A large de­val­u­a­tion would cause panic and the en­su­ing cap­i­tal out­flow would be im­pos­si­ble to ar­rest, let alone re­verse. If this move threw the US Fed­eral Re­serve off the path of rais­ing the funds rate in Septem­ber, it is a bonus for China. It has more short-term ex­ter­nal debt than many recog­nise-around 9% of GDP. Mor­gan Stan­ley thinks that such a level nor­mally raises the risk of a cri­sis.

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