10-Dec-19
Very interesting interview and sheds light into structural problems China is facing. While Chinese economy may not collapse immediately, as some bears have been calling for a while, the long imbalances go, the harder the fall will be.
Why is there not a credit crisis in China?
China credit market is dominated by the State through State Banks. In China, M2 is >80% of total credit while in the US, it just ~30%. This is because China curtailed shadow bank system couple of years ago to increase state control over credit market. What that means is that as long as the central government dictates that the State Banks roll over the the bad debt, there won't be a credit crisis. This is only possible as long as PBOC is free to print money and lend it to the State Banks.
How do deal with credit bubble in China?
How China can deal with credit bubble is the "impossible trinity framework" developed by Mundell-Fleming in the early 1970s. It has 3-factors, "Open Capital Account", "Domestic Monetary Control", "Fixed Exchange Rate", but policymakers can only control 2 of 3. For China, "Domestic Monetary Control" is a must, so that have to choose between the other two. For China, given its trade position in the world, it cannot control "Open Capital Account". So China needs to grow its credit at double-digit rate otherwise it will create big problem in the credit market, it inevitably puts lot of pressure on its fixed exchange rate. That what happened in 2014-15 when US$ strengthened, and that cause liquidity tightness in China and caused growth to slow in 2015. So they tried managed that by intervening in the FX market and lost $1T of reserves by 2016. But it was an ineffective policy and policymakers started to pursue more pernicious policy.
Explain capital control and US$ shortage?
China does not have capital control because China cannot control every foreign transactions i.e. differentiate trade related FX flows vs. non-trade related flows esp. there are >1M entities in China licensed to engage in international trade. That means trade surplus and FX surplus always does not match. Sometimes more FX comes in like 2011-13 when people play on the Rmb carry-trade, but since fraction of trade surplus came back as FX reserves. This led to heavy handed approaches by the State. First, central planners balance the inflows-outflows by fiat, so the data since 2016 shows a balance. Second, they are forcing exporters to repatriate their FX esp. in HK. Fortunately, China is getting inflows because China has been added to number of global equity and bond indices which forces investors to buy Chinese assets. On the flip-side, the outside investors are piling into already over-valued assets in China; China asset are over-valued because Chinese investors are restricted to domestic market.
What does this mean for China in the "Impossible Trinity" Scenario
It means China has to choose 2 of 3 i.e. (1) open capital account + fixed exchange rate (Japan); (2) open capital account + domestic monetary control (Argentina i.e. could be 12 or 13 on Yuan); (3) domestic monetary control + fixed exchange rate (North Korea). I think it looks more likely N. Korea i.e. closes itself to the world. Michael Pettis advocates Japan scenario i.e. 2025 years of slow growth which started to collapse in asset bubble, down 80%. Given credit bubble in China, and if the government loses control over the process of managing credit market, if there is no devaluation to raise nominal growth dramatically, there is no telling what could wrong. But China will never let real estate price collapse like Japan; they'll halt at say -15%; transaction go to zero; assets become iliquid, don't think China will allow that.
Why won't China do another stimulus?
4 reasons (1) credibility, Xi can see they are on an unsustainable path with credit 260% of GDP. Credit expansion will lead to further rise in real estate price leading to social problems. 2016, Xi told the world they won't do that, and instead came up "Made in China 2025" i.e. upgrading value chain. (2) Global environment is not conducive to stimulus. China is vulnerable to external factors because of fixed exchange rate. When US$ liquidity is easy, i.e. 2017, it transmit easy to China. Now it is the reverse, global liquidity is tight. Going back to 2006, there were 4 stimulus, but only 3 worked; the aggressive stimulus in 2013 failed to increase nominal because global commodity market was weak and US$ was strong. The mechanism is that China PPI has >90% correlation with commodity index, and China PPI is the deflator for China IP. IN 2016-17, PPI swang from -6% to +8%, that helped nominal growth IP sector and that helped improve debt picture. I don't think China will be bailed out by that because US Presidential election and US$ will remain stable to strong. China PPI is now -1.6% is a drag economy and credit stimulus fix that, what they need is weak US$ or easy global liquidity condition. (3) They don't have clean balance sheet to dump next credit stimulus. Bank lending grows 11-13% annually, it will be difficult for China to find external sources to accelerate bank lending to say 18%; previous stimulus programs were done via shadow banking system and they don't want this grow given they can't control it. So everyone thought China is going to leverage government balance sheet i.e. fiscal stimulus. But they did that in 2015, when they layered municipal borrowing (does not include local government financing vehicles which is considered corporate debt) to central government borrowing, and now on the 5th year, total borrowing is 9-11% of GDP per year. (4) The numbers are getting really big. At 12% credit, you're talking $4T of credit, and $4.5T next year; how many bridges and tunnels can you build? The policy structure of fighting this "trinity" and of stimulating every time growth slows is at a dead end.
What's your near-term outlook for China?
We are not going to see a bounce we are used to seeing. If the US$ weakens and global liquidity improve, that'll help China through fixed exchange rate. So the US$ is the key. China will manage NPL ratio. They won't weaken Yuan. So this means slower growth in China, and slow de-coupling from the rest of the world.
