China: Let the Deleveraging Begin

Despite widespread concern for years over imbalances in China’s economy and financial system, it has been impossible to find a specific trigger that might lead to conclusion that an unwinding was imminent. But the picture is clearing, and not for the better.

In September 2012, macro conditions were similar to what is going on now, including a string of weak purchasers’ manufacturing index and quarterly gross domestic product releases, a depreciating trend in the currency and signs of capital flight.

At that point, there was speculation that continued weakness in the economy and in the currency could lead to a negative and self-reinforcing cycle eventually leading to accelerating capital flight, further currency weakness, tightening domestic liquidity and slowing growth.

In fairly short order, however, policy makers successfully reversed these trends, and once again the China-is-turning-down-for-good fears went back in the closet. Chinese decision makers stabilized the currency and the economy by deploying a number of effective policy measures including reducing onshore US dollar deposit rates that together eased and reversed downward pressure on the yuan, thus re-establishing the yuan carry trade and triggering a continued surge in foreign borrowing.

With domestic credit hard to come by, Chinese borrowers increasingly looked for offshore funding, which provided the marginal liquidity required to reverse both the depreciating yuan and the growth slowdown, evident in the PMI finally breaking above the 50 expansion/contraction threshold by the fourth quarter of2010

Our concern that this time is different comes after three days of meetings in Beijing and Shanghai with a wide range of foreign and Chinese political and economic experts in academia and in the private sector as well as a diverse range of executives working in the financial sector, real estate, commodity trading and shadow banking.

These meetings helped us see a number of new — and we believe defining — political, economic and financial sector dynamics. They add up to our conclusion that the super-normal China growth story has already begun to reverse and will continue to do so over the coming several years, with near-term negative implications for the yuan as well as for the macro economy, and by implication global commodity demand and economic growth.

The key difference between now and 2012 in the political arena is the emergence of Xi Jinping and the unique consolidation in power he has been able to achieve as head of the party. This is something not seen in China since Deng Xiaoping launched China’s modern reforms in the late 1970s. We believe Xi has been allowed to consolidate such power because fellow elites believe he will need it to navigate a volatile transition for the economy from its export and investment- led pattern to a more service- and consumption-driven framework.

It is hard to say how rocky this transition will be, but what we can say is that China is unlikely to be the first country in modern history to escape the middle income trap without undergoing a major economic retrenchment.

The “smoking gun” that this time is different is the currency. In 2012, policy makers quickly saw the dangers of a weakening currency and reversed course. This time around it appears policy makers at the People’s Bank of China, the country’s central bank, actively encouraged the depreciation of the yuan. They specifically aimed at slowing the accumulation of foreign debt encouraged by a one-way bet on the currency.

Policy makers are well aware of the dangers of an effort to inject volatility into the currency regime with a massive stock of yuan deposits at risk of capital flight.

Here is an opportunity, too: if Chinese policy makers stick to their guns they could put in place the foundation for another secular high-growth story. In the wake of a re-rating of the Chinese economy thanks to a large depreciation of the currency and a significant slowing of activity, they can take advantage of these new realities to implement structural changes, including liberalizing the currency and interest rates. While growth may slow—to a 5 percent average vs. 11 percent over the past 25 years – it would still be high enough for China to eventually take its seat at the table of leading developed economies.

Sam Baker is head of Global Frontiers, Inc. and a contributor to Asia Sentinel. He leads regular research trips to China.