China: Something has to give

A trip I took to Hong Kong and Singapore in March proved a useful way to gauge the mood of clients on China’s doorstep. Overall, my meetings with these clients—all entrepreneurs with significant investments in the Middle Kingdom— tended to confirm what other observers have been saying: the Chinese authorities have the resources to ensure the economy attains 6.5%-7% growth this year, and maybe even next year as well, but things may get complicated before the end of this decade.

Exports and imports have slumped, while overinvestment has led to massive job losses in heavy industry and the bursting of some local property markets. But the central government, which has a low debt burden equivalent to 40% of GDP, has ample budgetary resources to sustain the economy through tax cuts and infrastructure spending, while remaining committed to structural reform. Although it has already cut base lending rates and banks’ reserve requirements the People’s Bank of China (PBoC) still has room to manoeuvre in terms of monetary policy. While painful for some, the transition from high, unsustainable growth based on heavy fixed investment and cheap exports to slower but more sustainable and focused on the rising wealth of China’s domestic consumers could still be achievable without a ‘hard landing’.

But there is a fly in the ointment. Total debt in China stands at 240% of GDP by some estimates, overwhelming represented by private debt (200% of GDP). This is well above the level seen in the US on the eve of the financial crisis in 2007-08, and only slightly lower than in Japan at the onset of its lost decade in 1991. Even more ominously, debt has been rising faster than GDP since 2008. At the least, a concerted effort to deleverage on the part of banks, corporates and households of the kind seen in the western world post-2008 would lead to a period of sluggish subpar growth.

But the catalyst in the West for deleveraging was the financial crisis. The worry must be that something similar might be brewing in China.

Given massive currency reserves and the government’s relatively low debt burden, China’s policy makers should be able to intervene to cushion the economy and prop up the banking system if things look like unravelling in the short term. But longer out, there are reasons to doubt that China will avoid its own ‘Minsky moment’, when a debt crisis saps confidence and a period of credit-fuelled economic growth ends with a sudden collapse in asset values.

Maintaining confidence among borrowers and investors is vital if China is to avoid such a scenario. But confidence cannot be decreed, even by the Communist Party of China. Already, the handling of last year’s stock market rout shook belief in the authorities’ ability to manage events. They are now facing a much bigger challenge. Along with continued market instability, the authorities find themselves having to curtail capital flight (itself a symptom of declining confidence), while at the same time pursuing the goal of currency convertibility. How can they ensure that the currency doesn’t plummet in value once it is freed up, while at the same time cutting interest rates and pumping more stimulus into a slowing economy?

In essence, China has come up against our own definition of the financial trilemma. The trilemma in question is China’s aim to control rates across the entire yield curve, to regulate but progressively liberalise the exchange rate and to control the growth in credit—all at the same time. As China has progressively integrated itself into the global economy, these three policy objectives have, in our view, become incompatible. Something will have to give. If the Chinese persist in their march toward capital liberalisation, then devaluation of the renminbi is in the offing. But even a small devaluation could trigger expectations of further depreciation and quickly spiral out of control. The most benign way to avoid this risk would be to give up on the free movement of capital and introduce capital controls on currency transactions instead—indeed, the Chinese have moved in this direction by restricting offshore bank accounts.

Capital controls mean a stop in the liberalisation of the Chinese economy. In the circumstances, that might be the best thing to do for now. But China’a ability to deal with its bloated debt burden at a time of economic upheaval has yet to be proven and the prospect of a Minsky moment in the next two to five years cannot be dispelled—with dire consequences for the global economy.

Christophe Donay
Head of  Asset Allocation & Macro Research, Chief Strategist
Member of the Wealth Management Investment Committee