Daniel Suchenski
March 28, 2016.
Introduction
Will 2016 be remembered for China China
Cause for concern about China in financial terms
A combination of huge trade surpluses, managed
exchange rate and highly regulated capital inflows and outflows has prompted
assertions that China China
Indeed the most fractious issue in China ’s international economic relations in
recent years has been its bilateral trade imbalances, especially with the United States and increasingly with Europe . China’s trade surpluses reached over $200 billion
in 2010 matched by counterpart trade deficits in many of its trading partners (IMF
2010). The U.S imbalance with China is of such concern that U.S law makers have
proposed levying punitive new tariffs against imports from China as a means of
reducing the U.S deficit. Meanwhile the bank of international settlements also
declared that the U.S trade deficit could pose a serious longer term problems
for the global economy.
The major cause for concern about China China ’s policy of pegging the exchange rate is
not only causing its large trade surplus, but also the trade deficits of its
trading partners, including the United
States China
Numerous economic policy reforms have directly
contributed to the high rates of output and export growth. At the international
level, the most important spur has been liberalization of trade barriers and
integration with the global markets. Although China
acceded to the World Trade Organization in 2001, it had previously benefited
from the export growth at higher rates than experienced by Japan and South Korea China
Other factors supporting China’s economic
growth have been its high saving rate, influenced by the contraction of social
welfare previously extended by the State sector, high public infrastructure
spending, enhanced labor mobility and an improved investment climate for the
private sector, and assisted by corruption restraint. An expanding capital stock
attributable to high domestic savings and investment rates has also been
combined with an urban workforce that has flourished as restrictions limiting
migration from rural to urban areas have been eased over the past decade.
There is indeed a causal relationship between China
The macroeconomic variables for china’s trading
partners when compared to those of China specifically the effective exchange
rate show that the Renmnbi (Yuan) is the inverse of the trading partners’
effective rate against the Yuan. That is to say that an appreciation of the
Yuan is a depreciation of the trading partner currencies, in practice with a
heavy weight given to the U.S dollar.
Why should we be concerned about China’s
currency devaluation comparable to that of its trading partners? China’s higher
export oriented growth has been critical to the trade imbalance between China
and its trading partners. First, in view of its stronger growth in China
relative to expenditure, exports increase relatively faster than imports. The
growth in production in China due to utilization of high savings and the
mobilization of relatively cheap labor at a rate in excess of the expansion of
the domestic demand also implies that the prices of China’s tradable goods fall
relative to tradable good prices abroad. Hence, excess production in China is
absorbed through excess demand in its trading partners via a change in relative
prices. Other things the same, the higher export volume from China that is
equal to the higher import volume for its trading partners would appreciate the
nominal value of the Yuan and depreciate the currencies of the trading
partners.
However, as Schwartz notes, under a pegged
arrangement, China’s trade surplus expands and is matched by growth in the
consolidated deficit of its trading partners. Consequently, the trade deficits
of individual trading partners are effectively determined exogenously because
of the pegged exchange rate system administered by the PBC. This way Schwartz
points out, “the trade imbalance is indeed made in China. The collorary is that
the larger is china’s external surplus, the more undervalued is the Yuan.”
(Schwartz, A 2005)
With China’s output growing faster than
spending, the increased import demand from trading partners is satisfied by
higher exports from China. Again however, if the Yuan was free to move against
the exchange rates of its trading partners, including against the dollar, it
would appreciate and they would depreciate in nominal terms. Such exchange rate
adjustment would automatically ensure the trade accounts of China on one hand
and the American and European’s on the other could remain in balance. However,
China’s tightly managed exchange rate policy prevents this.
Pegging the Yuan maximizes China’s exports as
it prevents any loss of competitiveness stemming from nominal appreciation. To
achieve this, the central bank of China purchases foreign currency and invests
in foreign currency denominated securities, mainly G7 treasury bonds held as
international reserves, observes Herd and Dougherty 2007. While the purchase of
foreign currency reduces foreign money supplies, the acquisition of foreign
currency denominated bonds leaves foreign money supplies unchanged.
Consequently, capital inflow from China to purchase foreign securities
satisfies the excess foreign demand for the Yuan arising from imports exceeding
exports.
According to the International Monetary Fund
world Economic outlook (2007), “by pegging the Yuan to prevent losses in competitiveness,
China’s exports and short run output are higher than if the PBC had allowed the
nominal effective exchange rate to strengthen.” Hence, exchange rate management
becomes a crucial instrument for achieving higher short run growth. At the same
time, with less imports of foreign consumer goods and services, China’s living
standards, as measured by absolute consumption levels, are lower than they
could be. Meanwhile the reverse is true in trading partners. Short run output
and presumably employment in the tradable sector is lower while household
consumption is higher.
In brief, China’s trade surplus is a global
concern as it has deeper implications for the global financial markets.
However, the status quo for China’s actions in the global financial market seems
unbounded for now. For example offsetting the benefits to China’s pegged
currency has numerous macroeconomic risks. Although most foreign exchange
market intervention undertaken to peg the Yuan is sterilized, there are limits
to the use of this method. As Tony Makin (2006) points out, “neutralizing the
monetary impact of intervention by issuing debt instruments will continue to
put upward pressure on domestic interest rates which could exacerbate the
non-performing loan problems overhanging the domestic banking system.”
In addition higher money growth resulting from
foreign exchange market intervention that isn’t sterilized and not matched by
sufficient money demand growth eventually fuels inflation. Higher domestic
inflation raises the relative price of domestic goods to foreign goods
increasing imports and pushes up domestic cost of production curbing exports.
Increased imports and reduced exports then reduce trade imbalances. However,
automatically restoring external balance via higher inflation would take some
time and be disorderly because it would create investment uncertainty and put
further strain on China’s fragile banking system.
Cause for optimism about China
in financial terms
Barry J. Eichengreen, a professor from the University of California ,
Berkeley , when asked to make
a prediction about the prospects of the financial health of China in 2016 used his time in a recent article
by the Atlantic, to talk not the concerns he has for China
moving forward but rather the optimism. “It will be another rough year for emerging markets in 2016. But unlike
2015, when investors were fixated on instability in Chinese markets and the bungled devaluation of the Renminbi, in 2016 they
will realize that the situation in China is under control and the real problems
are elsewhere.” (McBride, 2016)[2]
He goes on to explain that while there is less than optimal financial health in
China when it comes to its ability to handle a crisis like a housing bubble,
the stock market crash, or a run as a result of another devaluation of the
Renminbi, there is no soft spot on the resolve of the leaders of the country to
inject capital to offset any sudden change in such markets. “There is little
reason to question the government’s capacity to intervene if something goes
seriously wrong, particularly given the country’s nearly $3.5 trillion in
foreign-exchange reserves. These can be used to support the exchange rate if
the Renminbi shows undue weakness.” (McBride, 2016)[3]
James McBride is not the only one that is upbeat about financial prospects in
China for 2016. Gordon Orr writing for McKinsey and Company in January argues
that Chinese “financial
reforms aimed at moving more of the economy toward a market-based allocation of
capital will continue.” Furthermore, “there will be more progress on
interest-rate deregulation, on the IPO process (registration rather than
approval), on permitting new entrants (especially from the tech sector and from
abroad) into financial services, and on re implementing laws suspended in the
summer of 2015.” (Orr, 2016)[4] Mr. Orr also sees promise in FDI. “Opportunities
for foreign fund managers and brokers are growing as a result of regulatory
changes, with international companies recently receiving approval to open 100
percent–owned investment-management operations and a foreign-controlled
brokerage operation. The historic distribution problem that has held back many
funds is being solved as a result of both the emergence of better wealth
managers and the rapid acceptance of online distribution, initially thanks to
Alibaba’s and Tencent’s push into money-market funds.” (Orr, 2016)[5]
Another improvement for
2016 could well be greater centralization and greater efficiency and perhaps
even transparency that they might bring. One such example is pension funds. As
the control of pension funds move to a more centralized system and potential
shortfalls are better managed this would give local governments in China a
greater incentive to improve their investment performance. “The coming
centralization will try to remove perverse incentives and to professionalize
the overall approach to investments. Already, Guangdong and Shandong have
entrusted part of their assets to the National Council for Social Security
Fund. More regions will follow in 2016.” (Orr, 2016)[6]
What about outbound
financial investments? Orr has a positive uptake on that as well. Based on commitments
made between the UK and China over the last years and the desire on the part of
China to grow the Renmibi especially in light of the recent November IMF ruling
including the Yuan as part of a basket of currencies that help make up the Special
Drawing Rights (the IMF’s tradable reserve asset), he sees, “large
financial-sector investments as London moves to become a leading Renminbi
offshore market and possibly also Chinese acquisitions of UK asset managers.” (Orr, 2016)[7]
Even in
the wake of the recent stock market crashes at the beginning of 2016, many
prominent financial Chief Executive Officers talked up the growing opportunity
in China despite the dire reports of collapse that were flying in the
headlines. In an article for Bloomberg Business, Tidjane Thiam, the chief
executive for Credit Suisse, only 12 days into the year and in light of the Shanghai
Composite Index having dropped more than 15% in that time, Thiam is quoted as
saying, “there will
be growing pains, yes they’re changing their model from export-led capital
intensive growth to consumerism, but I think they’ll manage,” Thiam said about
China. “Overall, we remain positive on emerging markets.” (Voegeli, 2016)[8]
Thiam’s comments came two days after the CEO of UBS made similar commitments to
China and its financial growth for the year saying times like these are “the
good times to plan for the future, and that’s the reason why we are starting to
implement our strategic plan.”(Bloomburg Business, 2016)[9]
What is the ‘strategic plan’ exactly? UBS is so confident in the future of
China’s financial sector that they announced that inspite of the market turmoil
that they would be doubling the staff in the country to keep pace with expected
demand.
Finally, and perhaps least surprisingly, to
continue the message from those in the know on the financial health of China,
their governor of the People’s
Bank of China (PBoC) has also been making the rounds to remind investors that
“The fundamentals of China’s economy remain strong. There is no basis for
persistent renminbi depreciation” in the Chinese future outlook. (JP Update,
2016)[10]
While there is still much to keep an eye on in the overall health of the
Chinese financial model in the near-term it’s clear that many international
financial managers expect that China will be able to hold onto its position and
even grow through its maturation stages of which there has been much discussion
of late. One thing that is important to keep in mind however is a longer-run
understanding of the health and the risk that such a forward view might afford.
China Future Financial Health
The real question
people should be asking when it comes to the market health of China and its
international financial tools, is that in lieu of significant financial reforms
that many believe are coming but few think will be implemented in short-order,
what is the financial health and
stability outlook for China beyond 2016? A growing body of thought seems to
revolve around China following the path that its pseudo-predecessor did some
years ago and begin the slow march to stagflation.
In a
February 2016 article for Newsweek, the prospects for China were more than
casually likened to China’s neighbor, and sometimes enemy to the East, Japan. “Both growth miracles were driven by domestic investment,
which fed export-led growth; both countries suppressed domestic consumption and
elevated savings rates to fuel that investment-led growth. Both countries piled
on debt to do so. Moreover, for decades now, Japan has been an aging society
with a shrinking workforce, detracting from its gross domestic product growth.
China over the next two decades will be much the same.” (Powell, 2016)[11]
Not too long ago, Japan was
predicted to fuel a century of Asian prosperity with a number of countries in
the region leading the charge. However that journey has taken some turns along
the way. Once a country that seemed to know no end to its growth trajectory,
Japan by the end of January said; “that it would implement a policy of negative
interest rates in order to forestall yet another onset of deflation. For years,
Japan held to a zero interest rate policy (ZIRP) and massive injections of yen
into both the bond and stock markets to try to stimulate growth and, thus, at
least a little inflation.” (Powell, 2016)[12]
While China is nowhere near this situation right now as it is only slowing as
opposed to stagnating, China is mirroring a Japan of the past. One indication
of this is that, “It takes about 2.5 Renminbi of new credit to generate one Renminbi
of additional output in China, according to Anne Stevenson-Yang and Carlo
Reiter of J Capital Research, a China-focused investment research boutique. That
means that at a time when most economists believe debt growth needs to slow
markedly in China, an additional $1.7 trillion in new loans is necessary merely
for the government to hit its 6.5 percent growth target this year.
Complicating matters for
Beijing is the fact that an increasing amount of new debt is being issued
merely to service existing debt—a sure sign, in the minds of many analysts that
a debt crisis looms.” (Powell, 2016)[13]
While it’s too early to tell just how similar or different the two countries
recent histories will turn out, the greatest threat that comes from financial
issues is a lack of transparency backed up by a lack of competent oversight.
China, a country that has bent, battered and destroyed many of the benchmarks
and records that existed in the financial and economic worlds for decades is
notorious for its lack of transparency and oversight and the real question is
how much change the country is willing to endure to break the status quo and
prevent a repeat of history. In the words of George Santayana, “Those who cannot remember the past are condemned to repeat it.”
In conclusion, despite
its persistent surprises within the global financial markets, China continues
to be a critical player within the international monetary system. As China
continues to advance as a strong leading economy, it should as well be
accountable to the other global giants so that a sense of parity prevails. The
acceptance of its currency into the basket of acceptable international
currencies should set ground for fair play within the limits of international
transactions. Its trade surplus and the collorary trading deficits of its
trading partners particularly the United States is indeed of grave concern to
many policy makers. In a financial system that is dependent on the exchange and
interest rates between and among countries, China’s pegged currency system that
is continuously devalued to give it a competitive advantage over its exports is
a cause for great concern. The positive take on all this is that China has
weathered most of the negative predictions and actually surprised many analysts
about her financial outlook. China continues to have strong foreign direct
investments surpassing many of the other developed countries, and with its
currency reserves up to about $3 trillion (2013) the sky is the limit with what
China can potentially do with this strong financial arm. As a member of the
IMF’s Special Drawing Rights- having recently added its currency to the basket
of recognized currencies, China is once again in a more strong position and a
true key player that can’t be ignored within the financial markets.
References:
1.
Wolf, M (2005) “Will Asian Mercantilism
Meet its Waterloo?” Richard Snape Memorial Lecture, Australian Productivity
Commission, Australian Government Publishing Service, Canberra.
2.
International Monetary Fund (2010) Annual
Report Washington DC. Online www.imf.org/annual reports.
3.
Hale, D (2006) In the Balance: China’s
Unprecedented Growth and Implications for the Asia-Pacific, Australian
Strategic Policy Institute, Canberra.
4.
Schwartz, A (2005) “Dealing with Exchange
Rate Protectionism” Cato Journal 25(1), 97-102.
5.
Herd and Dougherty (2007), “China’s
Economy: A remarkable Transformation” OECD Observer, September, 251, 13-16.
6.
International Monetary Fund (2007b) World
Economic Outlook, IMF, Washington DC.
7.
Tony Makin (2006) “Macroeconomic
Determinants of Exchange Rates.” The use Of Monetary Policy to Control
Inflation, Journal of Global Finance.
8.
Eichengreen, B, “Chinese Currency
Controversies” Discussion Paper Series No.4375, Centre for Economic Policy
Research.
9.
James McBride, “Expert Prediction for the
Global Economy for 2016, the Atlantic.” Online www.theatlantic.com/international/archive/2016/global economy.
1.10. George Orr (2016), What Might Happen in China
2016, Mckinsey and Company. Retrieved March 11th, 2016, www.mckinsey.com/business-functions/strategy
and corporate-finance/our-insights/what-might-happen-in-china-2016.
11. Jeffrey
Voegeli. “Credit Suisse CEO says he remains positive on China, Echoing UBS.”
Bloomberg Business. Retrieved on March 11th 2016, from: http://www.bloomberg.com/news/articles/2016-01-12/credit-suisse-ceo-says-he-remains-positive-on-china-echoing-ubs
12. Bloomberg
Business. “UBS plans to double staff in China, CEO Ermotti says.” Retrieved on
March11th, 2016 from: http://www.bloomberg.com/news/articles/2016-01-11/ubs-to-double-china-headcount-over-five-years-ermotti-says
13. JP
Updates. “China projects positive message as reassurance on economic growth.”
Retrieved March 11th, 2016 from: http://jpupdates.com/2016/02/27/china-projects-positive-messages-as-reassurance-on-economic-growth/
14. Tidjane Thiam, “CEO Credit Suisse says he remains positive on China,
echoing UBS.” Bloomberg Business, retrieved March 11th 2016. www.bloomberg.com/news/articles/2016-01-12.
15. Bill Powell 2016, “Will China follow Japan into Economic Stagnation?
Newsweek. Retrieved March 11th 2016. www.newsweek.com/China-Japan-renminbi-economy.
[2] James Mcbride. “5 Expert
Predictions for the Global Economy in 2016.” The Atlantic. Retrieved March 10th,
2016 from: http://www.theatlantic.com/international/archive/2016/01/global-economy-2016/422475/
[4] George Orr. “What might happen in China
[8]
Jeffrey Voegeli. “Credit Suisse CEO says he remains positive on China, Echoing
UBS.” Bloomberg Business. Retrieved on March 11th 2016, from: http://www.bloomberg.com/news/articles/2016-01-12/credit-suisse-ceo-says-he-remains-positive-on-china-echoing-ubs
[9]
Bloomberg Business. “UBS plans to double staff in China, CEO Ermotti says.”
Retrieved on March11th, 2016 from: http://www.bloomberg.com/news/articles/2016-01-11/ubs-to-double-china-headcount-over-five-years-ermotti-says
[10]
JP Updates. “China projects positive message as reassurance on economic
growth.” Retrieved March 11th, 2016 from: http://jpupdates.com/2016/02/27/china-projects-positive-messages-as-reassurance-on-economic-growth/
[11]
Bill Powell. “Will China follow Japan into economic stagnation?” Newsweek.
Retrieved on March 11th, 2016 from: http://www.newsweek.com/china-japan-renminbi-economy-426747
[12]
Ibid.
[13]
Bill Powell. “Will China follow Japan into economic stagnation?” Newsweek.
Retrieved on March 11th, 2016 from: http://www.newsweek.com/china-japan-renminbi-economy-426747
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