Another factor for yuan devaluation: capital losses

In Red Capitalism, authors Walter and Howie show that the Chinese financial system is an extension of the Communist Party, used for the benefit of the ruling members. Investment losses are put onto the bank balance sheets, which are then transferred to the central government. China bailed out the banks at the end of the 1990s, and it continues to implement policies in the banks favor. Another bailout is also likely, should NPLs surge.

If the yuan is close to fair value, however, the implication for the currency is devaluation because China's source of funds is the foreign exchange reserves. China socializes investment losses through the banking system and via currency devaluation, but as foreign exchange reserve growth slows, tapping this capital will result in devaluation of the yuan (since deflation is counter-productive).

Here's a post from FT Alphaville China as a post-capital economy discussing the bull and bear case for China.

Here follow extracts from an absolutely fascinating note from Australian analyst James White at Colonial First State, which argues extremely convincingly that none of the usual economic arguments apply to a country that has transcended the conventional role of capital. In short, nobody does financial repression like the Chinese.

What does Mr. White have to say?

In China, capital is just one piece on the board where the aim is to raise living standards of all households. As a result, capital is used and treated remarkably differently, often to the consternation of external observers and investors. It is not a matter of aggregating up the investment decisions of individual firms and households to predict macro-economic outcomes, as was done by some economists prior to the sub-prime crisis in the US. The government’s role is paramount. Despite claims of dramatic imbalances (investment spending has made up to 45% of GDP in recent years, compared to below 15% in some developed economies), investment is driving sustainably higher economic growth. This high investment economy has led to some important outcomes that support the economy’s growth model.

Unlike in developed markets, where the aim is to generate a return on capital, the politically managed Chinese economy views capital as one piece of the puzzle. And it can afford losses in part because it is the state:

First, and most obviously, the government has the ability to fund losses on individual capital projects through the accumulated financial reserves, totalling at least $3.2 trillion. Second, and most importantly, the Chinese government, as ultimate capital allocator, can recoup returns from projects by capturing the positive externalities from projects in the form of higher tax revenues created by higher levels of activity.

Without getting into the long-term results of such a policy, the implication is that China can continue this policy for some time, but capital losses will accumulate and be socialized, as discussed above.

Foreign reserves will not accumulate at their historic pace—unless there's another round of global coordinated money printing led by the Federal Reserve launching QE3. Since those reserves back the currency, depleting them in order to bailout the banks would be deflationary if the central bank took yuan out of circulation. In a bailout situation, deflation would lead to more losses and larger bailouts. Instead, they will take dollars from the reserves, but leave the renminbi in the economy.

Inflation of the money supply by itself doesn't lead to currency devaluation—there are more factors at work—but China's approach to capital may eventually express itself in the exchange rate.