2012-08-01

Capital fleeing China; China must float the yuan and slash taxes

China is bleeding capital along with other emerging markets and a crisis is on the way for countries with fixed exchange rate regimes. As I've argued before, one of the features of a currency peg is that it must be defended and any sign of weakness can invite losses as people lose faith in the currency.

Here is Andy Xie in Keeping the Economy Afloat
There are similarities between China today and Southeast Asia fifteen years ago. China could learn from the latter's experience and control the financial risk in today's uncertain environment.

Between 1992 and 1996 the low U.S. interest rate prompted a massive amount of hot money to flow into Southeast Asia. The money was mainly lent to the region's banks, which lent the money out for investment in commodity industries and property speculation. The tide reversed in 1997. It triggered massive devaluation and economic contraction.

When faced with capital outflow pressure, Southeast Asian countries used their forex reserves to defend the exchange rates. Like China today, they had controlled exchange rates. They had plenty of forex reserves when the outflow pressure began. But, after defending the exchange rates for an extended period of time, they couldn't back down from the policy until depletion of the forex reserves forced them to devalue. Some countries even borrowed considerable amounts from the International Monetary Fund to continue the wrong policy. All they achieved was subsidizing capital flight.
That is what the PBOC has been doing for much of the past 9 months: entering the market to halt the slide in the renminbi. The offshore renminbi rate is higher than the mainland rate, opening a small profit window for arbitrage, but also signaling that there's heavy selling of renminbi.

Why might they be doing it?
Without forex reserves, these countries couldn't support their financial systems. The financial collapse brought massive economic contraction and widespread suffering. If these countries had floated their currencies at the first sign of outflow pressure, they wouldn't have suffered as much.

The irrational, costly and sustained defense of fixed exchange rates had much to do with who was taking money out. It was the ruling elite taking their gray income out. This political force may partly explain why these countries were so resolute in defending their exchange rates.
I don't think this is as good an explanation for China, where there are strong political reasons to defend the exchange. Domestically, China wants to be seen as a strong economy with a rising currency. Internationally, it is worried about upsetting trade partners, specifically the EU and the United States.
Float the Yuan Now
China's forex reserves are massive in absolute amount. But they cannot really be all deployed. If the forex reserves fall by one-fifth, it may trigger panic. China's monetary assets are many times the forex reserves. A panic could exhaust the reserves quickly. Even if the government institutes tougher capital control to slow the outflow, as what occurred in 1998, the resulting confidence collapse could do considerable damage to the banking system.
Bingo. China cannot go back on the internationalization and reform of the renminbi. It halted the appreciation during the 2008 crisis, but if they reverse course now, it will be seen as a China-specific problem that causes international, but most importantly, domestic speculators to flee the currency and banking system.

How bad is the economic bubble? Andy lays out how it will come apart:
China experiences overcapacity in most industries. Rising costs have further weakened businesses' ability to earn profits. The economy has been disproportionately dependent on land appreciation as the source of profit. From banks to loan sharks, the financial sector is highly dependent on land appreciation for sustaining lending margins. Commodity industries have been subsidized by commodity traders who earn profits from loan-sharking to property developers. Equipment suppliers depend on local governments' ability to pay. That depends on land sales. Of course, this model of sustaining profitability is a bubble. As the bubble bursts, profitability will be squeezed all around. Sustaining investment through increasing other sources of financing won't change this story.

When businesses see shrinking profitability, they are likely to shrink businesses. If there is no hope for any profitability, they may liquidate and, in many cases, emigrate. In addition to declining profitability, businesses also feel the squeeze from local governments that try to increase revenues elsewhere after losing most land sales. That squeeze is frightening. It has the potential to squeeze out all the past profits of the existing businesses. So for many closing down and leaving is the best option.
Get ready for more stories of fleeing businessmen who shut down their companies overnight.

Andy Xie closes with this advice:
If China wants to incentivize businesses and households to keep money at home, the government should cut taxes substantially and shrink the state sector with numerical targets and timetable. Otherwise, capital outflow is likely to continue.
Luckily for China, that is exactly the plan of Xi Jinping, Li Keqiang, and Wang Yang (see: Liberals aim to unleash new wave of reform). Now we will see who is really in charge: can the rising leadership push through reform or will China go through another costly 2008-style stimulus that benefits the state industries controlled by CCP insiders?

Also see: Chinese hoard dollars; China's dollar short position; China's foreign currency loan-to-deposit ratio sinks again; China's 3000 wealthiest households lost nearly $100 billion

1 comment:

  1. Thank you for this. Good to get this info.

    ReplyDelete