The first installment of capital outflows
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, etc.do 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.