China: On the horns of a trilemma Global Economic Outlook, Q2 2016

Chinese authorities are striving to stave off a sharp decline in the renminbi’s value. Yet the government’s uncertain economic goals have put the country in an untenable spot.

China

Growth still slowing

More evidence is accumulating concerning the slowdown in Chinese growth. China’s exports plunged in February, sparking worries about the state of the global economy. In February, exports denominated in US dollars fell 25.4 percent from a year earlier, the sharpest decline since early 2009. This compares with a drop of 11.2 percent in January. It is true that the February decline was likely amplified by a shift in the timing of the Lunar New Year holiday. Still, the combined decline in January and February, which excludes the impact of the holiday timing, was substantial.

When evaluated in China’s currency, the renminbi, exports in February were down 20.9 percent, less than the dollar-based decline. This reflects a modest depreciation in the value of the renminbi over the past year. However, the decline in exports partly reflects the fact that the currency still remains overvalued. The US dollar has soared against other currencies over the past two years; as the renminbi has been relatively steady against the dollar, the renminbi’s value has effectively increased against other currencies such as the euro and the yen, hurting China’s export competitiveness. In addition, the decline in exports reflects weak global demand.

As the renminbi has been relatively steady against the dollar, the renminbi’s value has effectively increased against other currencies such as the euro and the yen, hurting China’s export competitiveness.

China also reported that dollar-denominated imports fell 13.8 percent in February versus a year earlier—a bit lower than the 18.8 percent decline in January. This reflects weak domestic demand as well as the impact of lower prices for oil and other commodities.

 

China’s weak trade performance is consistent with that of other Asian countries. Taiwan and South Korea have recently reported sharp declines in exports. Both countries are highly integrated into China’s manufacturing supply chain.

Interestingly, imports from Hong Kong surged 88.7 percent even as imports from other Asian economies fell. This follows a 108 percent increase in January. Yet in January, Hong Kong reported that exports to China fell 7.9 percent. The discrepancy between the Chinese and Hong Kong figures is attributable to the practice of fake invoicing, which is used to hide capital outflows. Hong Kong has not yet reported February export figures.

China’s weak trade performance is consistent with that of other Asian countries. Taiwan and South Korea have recently reported sharp declines in exports. Both countries are highly integrated into China’s manufacturing supply chain.

The trilemma

While much punditry has focused on China’s equity market, it is the market for China’s currency that is truly of global importance. If the renminbi falls sharply against the US dollar, it would have several effects. First, China would effectively be exporting deflation, creating deflationary pressures in other countries that import Chinese goods. Second, global companies that operate in China would see their translated earnings decline. Third, Chinese companies that have substantial foreign-currency–denominated debts would have greater difficulty in servicing those debts. Finally, Chinese consumers and businesses would experience an effective decline in purchasing power, given the increased price of imported goods and services.

Given all of this, the Chinese authorities have shown a considerable inclination to avoid a sharp decline in the renminbi’s value. As capital outflows from China have accelerated, stabilizing the currency has involved sizable sales of foreign currency reserves in order to meet demand for foreign currency and avoid depreciation. In addition, the authorities have attempted to restrain the outflow of capital by tightening capital controls.

Yet in the midst of this, China faces what economists call a “trilemma.” That is, China has three separate goals:

  • To retain an independent monetary policy so that the government can stimulate the economy, or not do so, at will
  • To target the exchange rate
  • To loosen capital controls in order to shift the renminbi toward being a major trading and reserve currency

Yet, if a country wants an independent monetary policy, it should either let the currency float, or implement severe capital controls. If it wants to target the exchange rate, it should consider either subjugating monetary policy to the needs of the exchange rate target, or implementing severe capital controls. Clearly, something has to give.

Some analysts (and hedge funds) believe that the renminbi will ultimately be allowed to fall much further. One reason to believe this is that the country has finite reserves and, at its recent rate of selling reserves, will eventually run out of liquid reserves. Others, however, believe that China is loath to allow a sharp depreciation. Rather, they believe the country is more likely to go for temporary capital controls. Whatever happens will have a big impact not only on China but on the global economy.

Concerns about debt

One of the big worries for China’s leaders is the high level of debt issued by Chinese companies, especially state-run companies, much of it in the form of bank loans. And many such loans are nonperforming. Now, word has come that the authorities are considering debt-for-equity swaps for the country’s banks, which are sitting on nearly $200 billion in nonperforming loans, according to official figures.1 Some analysts say that the true number is even higher. China’s Premier Li Keqiang said that such swaps would “progressively reduce corporate leverage.”2 The idea would be that banks would obtain equity stakes in corporations that have borrowed and cannot service their loans. For the banks, the nonperforming loan ratio would decline. For the companies, the amount of cash devoted to interest payments would be reduced. The problem, of course, is that banks would wind up having a stake in companies for which they must make credit decisions, creating a conflict of interest.

To deal with the large number of nonperforming bank loans, the Chinese government plans to encourage banks to bundle nonperforming loans into securities that can be sold to investors. The idea is to help remove such loans from banks’ balance sheets, thereby improving the quality of bank assets. The end goal is to boost liquidity. The government estimates that $194 billion in such loans now exists, although some private sector analysts say the true amount is much greater. In the past, China dealt with such loans by moving them to “asset management companies” that sold the loans at a discount. Now, the securitization plan has removed the middleman.