Is China's Economy Past the Point of No Return?
The most important driver of events in 2017 could very well be the Chinese economy, which is shaking the country’s political system and affecting its external policies.
Beijing, which once thought it would dominate the world, has been playing defense for the last year and a half as almost no economic trend has been going its way.
Next year, China’s economy will more resemble the turbulent 2015 than the relatively calm 2016. The measures employed to stabilize the situation, which looked like they worked in the beginning of this year, have only made it more difficult for Chinese technocrats to rescue the situation in the longer term.
We start on the 14th of this month, when Janet Yellen inadvertently highlighted China’s fragility. The Federal Reserve’s hawkish comments on interest rates—the central bank signaled three rate increases next year instead of the expected two—along with the quarter-point rise in rates forced bond prices down across the world. In China, the damage was historic.
Last Thursday, just a few hours after the Fed’s announcements, futures on China’s benchmark 10-year obligation stopped trading when they hit the daily down limit, the first time that has ever occurred. Trading on the five-year also was halted, another first. The People’s Bank of China, the central bank, injected the equivalent of $22 billion in short-term money, and that allowed trading to resume.
The next day, bond prices recovered in China, but only because the PBOC injected more than $57 billion. Beijing, by brute force, was able to stabilize the bond market, already rocked by defaults and cancelled offerings.
And the Chinese central bank has also muscled the currency markets by orchestrating rescues. The renminbi is ailing, down 6.9% this year against the dollar. Beijing once had ambitions of the “redback” replacing the greenback as the world’s reserve currency, but now it is merely trying to stage an orderly descent.
If the renminbi were allowed to float and if there were no capital controls, Chinese money would become worthless. China’s people and businesses certainly don’t want to hold it, and increasingly the same is true for foreigners. International use of the renminbi, even in the face of Beijing’s strenuous efforts, has declined this year.
Last year, there was $1 trillion of net capital outflow according to Bloomberg. This year, despite the imposition of draconian capital controls, the outflow could approach last year’s astounding total. And those controls, which are now failing to prevent capital fleeing, are working against Beijing’s efforts to attract investment cash from the outside. Few want to invest in China because repatriation risk is high and growing.
Many people, pointing to China’s forex reserves, don’t worry about a tumbling currency. The State Administration of Foreign Exchange, the custodian of the country’s forex hoard, reports that those reserves amounted to $3.05 trillion as of the end of last month.
Yet that number is almost certainly too high. Beijing has been engaging in dubious practices designed to hide the depletion of reserves caused by the support of the renminbi. For instance, there is incomplete reporting of its use of forward contracts to mask its selling of dollars, a trick Chinese technocrats learned from Brazil in 2013.
More important, Beijing has used its reserves, which are supposed to remain liquid, for long-term investments, such as the so-called One Belt, One Road infrastructure projects, and for loans to Venezuela and other risky borrowers. The reserves have also been deployed to capitalize China Investment Corp., the country’s sovereign wealth fund. No one outside a small circle in Beijing knows the amount of these ill-liquid investments, but they amount to at least $400 billion.
Finally, SAFE’s monthly announcements of changes in the reserves are questionable. It has continually been announcing monthly declines smaller than the estimates of analysts, a sign of deliberate misreporting.
In short, China’s liquid reserves are, in all probability, substantially less than Beijing claims, which means the country may soon run out of ammunition to defend the sagging renminbi. The liquid reserves are almost certainly far smaller than the $2.8 trillion IMF guidelines recommend China maintains.
None of this would matter if China’s economy were growing fast. The official National Bureau of Statistics has announced that gross domestic product increased 6.7% in each of the first three quarters of the year. Many observers believe growth is more likely to be half that figure.
Yet even if China is growing at a 6.7% clip, the country is creating debt at least five times faster than incremental GDP. At the moment, the debt-to-GDP ratio could be as high as the 350% that George Soros noted in January at Davos or the 400% that the respected Orient Capital Research in Hong Kong estimated at the beginning of this year. In any event, debt is far too high and its rate of accumulation much too quick.
Beijing can continue its rescue efforts for some time—perhaps years—because it runs an increasingly state-dominated economy, but state economies tend to fail spectacularly when they go.