China's lonely fight against de­fla­tion risk

The Pak Banker - - OPINION - An­drew Sheng

IN early Fe­bru­ary, as China cel­e­brated the start of the Year of the Mon­key, a widely cir­cu­lated hedge fund news­let­ter roiled fi­nan­cial mar­kets by pre­dict­ing a hard land­ing for the econ­omy, the col­lapse of the "shadow-bank­ing" sys­tem and the de­val­u­a­tion of the yuan. Sta­bil­ity re­turned only af­ter Peo­ple's Bank of China Gov­er­nor Zhou Xiaochuan, in an in­ter­view with Caixin mag­a­zine, ex­plained the logic of China's ex­change-rate pol­icy.

But China's abil­ity to main­tain that sta­bil­ity de­pends on a mul­ti­tude of in­ter­re­lated fac­tors, such as low pro­duc­tiv­ity growth, de­clin­ing real in­ter­est rates, dis­rup­tive tech­nolo­gies, ex­cess ca­pac­ity and debt over­hangs, and ex­cess sav­ings. In fact, the cur­rent bat­tle over the yuan's ex­change rate re­flects a ten­sion be­tween the in­ter­ests of the "fi­nan­cial en­gi­neers" (such as the man­agers of dol­lar-based hedge funds) and the "real en­gi­neers" (Chi­nese pol­i­cy­mak­ers). For­eign ex­change mar­kets are, in the­ory, zero-sum games: the buyer's loss is the seller's gain, and vice-versa. Fi­nan­cial en­gi­neers love spec­u­lat­ing on th­ese mar­kets, be­cause trans­ac­tion costs are very low and lever­aged naked shorts are al­lowed, with­out the need to hedge an un­der­ly­ing as­set. The ex­change rate, how­ever, is an as­set price that has huge eco­nomic spillovers, be­cause it af­fects real trade and flow of di­rect in­vest­ment.

Fi­nan­cial en­gi­neers are in­creas­ingly shap­ing the ex­change rate through fi­nan­cial transac- tions that may not be linked to eco­nomic fun­da­men­tals. Be­cause fi­nan­cial mar­kets no­to­ri­ously over­shoot, if the short sellers win by push­ing ex­change rates and the real econ­omy into a low-level equilibrium, the losses take the form of in­vest­ment, jobs and in­come. In other words, fi­nan­cial en­gi­neers' gain is real peo­ple's pain.

In or­der to achieve th­ese gains, fi­nan­cial en­gi­neers use the me­dia to in­flu­ence mar­ket be­hav­ior. For ex­am­ple, short sellers por­tray sharp de­clines in com­mod­ity and oil prices as neg­a­tive fac­tors, even though lower en­ergy prices ac­tu­ally ben­e­fit most con­sumers?and even some pro­duc­ers, by al­low­ing them to com­pete with their oligopolis­tic coun­ter­parts. It is es­ti­mated that lower oil and com­mod­ity prices could add some $460 bil­lion to China's trade bal­ance, largely off­set­ting the loss in for­eign ex­change re­serves in 2015.

Sim­i­larly, China's growth slow­down and the rise of non-per­form­ing loans are be­ing dis­cussed as ex­clu­sively neg­a­tive de­vel­op­ments. But they are also nec­es­sary pains on the path to sup­ply-side re­form aimed at elim­i­nat­ing ex­cess ca­pac­ity, im­prov­ing re­source ef­fi­ciency and jet­ti­son­ing pol­lut­ing in­dus­tries.

The real en­gi­neers, ex­clud­ing those whose judg­ment is clouded by per­sonal fi­nan­cial in­ter­ests, should counter this in­flu­ence, while re­fus­ing to suc­cumb to the temp­ta­tion of quick fixes. For­tu­nately, China's au­thor­i­ties have long un­der­stood that a sta­ble yuan ex­change rate is crit­i­cal to na­tional, re­gional and global sta­bil­ity. In­deed, that is why they did not de­value the yuan dur­ing the Asian fi­nan­cial cri­sis. They saw what most an­a­lysts missed: leav­ing the US dol­lar as the main safe-haven cur­rency for global sav­ings, with near-zero in­ter­est rates, would have the same de­fla­tion­ary im­pact that the gold stan­dard had in the 1930s.

In the face of to­day's de­fla­tion­ary forces, how­ever, real en­gi­neers in the world's ma­jor economies have been un­will­ing or un­able to re­flate. The United States, the world's largest econ­omy, will not use fis­cal tools to that end, ow­ing to do­mes­tic political con­straints. Europe's un­will­ing­ness to re­flate re­flects Ger­many's deep-seated fear of in­fla­tion (which un­der­pins its en­dur­ing com­mit­ment to aus­ter­ity). Ja­pan can­not re­flate be­cause of its ag­ing pop­u­la­tion and ir­res­o­lute im­ple­men­ta­tion of Prime Min­is­ter Shinzo Abe's eco­nomic plan, so-called Abe­nomics. And China is still pay­ing for the ex­ces­sive re­fla­tion caused by its 4 tril­lion-yuan ($586-bil­lion) stim­u­lus pack­age in 2009, which added more than 80 tril­lion yuan to its own debt. The con­se­quences of fi­nan­cial en­gi­neer­ing are in­ten­si­fy­ing. Zero and neg­a­tive in­ter­est rates have not only en­cour­aged short­term spec­u­la­tion in as­set mar­kets and harmed long-term in­vest­ments; they have also de­stroyed the busi­ness model of banks, in­sur­ance com­pa­nies, and fund man­agers. Why should savers pay banks or fund man­agers 1-2 per­cent in­ter­me­di­a­tion costs when prospec­tive re­turns on in­vest­ments are zero? A sys­tem in which fi­nan­cial in­ter­me­di­aries can in­crease prof­its only by in­creas­ing lev­er­age?sus­tain­able only by in­creas­ing quan­ti­ta­tive eas­ing?is doomed to fail.

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