January 5, 2017 4:45 pm JST
Minxin Pei

China's credit tide recedes to reveal 'naked swimmers'

Policymakers in a bind about renminbi's value, Trump's ascension adds to woes

Those wondering how China's financially overleveraged economy might fare in 2017 will have no difficulty sympathizing with naked swimmers caught in receding tides. In the post-2008 era, the Chinese government has relied mainly on massive credit creation to prop up the country's growth. Between 2008 and 2016, total debt as a share of gross domestic product rose from 150% to around 260%, a staggering increase of $11 trillion in absolute terms.

This tidal wave of credit has kept economic growth buoyant, but also allowed a vast army of naked corporate swimmers -- unprofitable and debt-laden state-owned enterprises, insolvent local government financing vehicles and bankrupt real estate developers -- to continue frolicking in a sea of seemingly endless renminbi. However, several critical recent developments suggest that good times are about to end. In late December 2016, a ferocious sell-off spooked China's $9 trillion bond market, sending yields to their highest level since September 2015 and forcing the People's Bank of China to inject $86 billion into the banking sector to avert a potential meltdown. Although the exact cause of the rout in China's bond market remains unclear, the most likely culprit is the weakening of the renminbi, which has fallen to its lowest level against the dollar since 2008.

The prospect of a depreciating renminbi, in turn, is fueling a torrent of capital outflows. In the last two years, Chinese foreign exchange reserves have dropped more than 20% and now stand at $3.05 trillion. This hoard of hard currency, while impressive, could be depleted to a dangerously low level if capital outflows continue at the same pace as in the last two years.

Although the government has not hit the panic button yet, recent measures taken by Beijing suggest that Chinese leaders are becoming increasingly alarmed by the prospects of a financial crisis. In the annual Central Economic Work Conference, which was convened in mid-December, Beijing listed the prevention and control of financial risks as one of its top policy priorities for 2017.

One of the policy tools deployed to stave off a potential financial panic is tightening capital outflows. At the end of November 2016, the Chinese government announced it would scrutinize outbound investments worth $5 million or more. Foreign companies in China have also begun to notice the extra delay in transferring money out of the country.

In all likelihood, Beijing's attempts to reduce capital outflows and shore up the value of the renminbi will only further reinforce the expectations of one-way depreciation. As long as the Chinese government refuses to address the fundamental causes of devaluation, such as the excessive build-up of debts, massive non-performing loans in the banking sector, and persistent growth slowdown, sensible investors would be foolish not to get their money out of China before the renminbi plunges in value.

Conundrum

The renewed pressure on the currency has created a nearly impossible policy dilemma for Chinese policymakers. They can, of course, maintain the current course -- a combination of restrictions on outbound investment, gradual depreciation, and a loose monetary policy. However, this policy not only may fail to stem the outflow of precious foreign reserves, but also can produce even worse medium-term consequences.

For instance, clamping down on outbound investment has only a modest effect on capital outflows. Total outbound investment from China in 2016 was about $150 billion. Cutting this amount in half would stop $75 billion from exiting China -- about the same amount of foreign reserves China lost in November 2016 of $69 billion.

In desperation, Beijing may resort to reducing the amount of foreign currency each Chinese citizen is currently allowed to convert per year ($50,000). The PBOC has just announced that Chinese citizens cannot use their allotted foreign currency to purchase real estate or securities overseas. In addition, foreign currency purchases in excess of $7,000 must be reported. Besides inconveniencing middle-class Chinese families who want to visit other countries or send their children to study in Western universities, this measure will not deter the truly affluent and well-connected who are determined to get their money out of China. In any case, since the bulk of capital flight occurs through trade in the form of under- or over-invoicing, whatever Beijing does will not stop unauthorized outflows.

"Business as usual" also means that the PBOC will continue to flood the Chinese economy with even more liquidity (such action is required because capital outflows will shrink the monetary base as investors convert their renminbi into foreign currencies). Without adequate liquidity, China's financial sector will likely experience more episodes like the bond sell-off in mid-December.

However, given massive overcapacity in China's real economy, additional credit creation these days does not result in investment in productive assets. Instead, it allows deadbeat borrowers to stay afloat and fuels asset bubbles (mostly the real estate bubble in first- and second-tier cities). Over time, the current policy of supporting growth will only further distort the economy by keeping zombie companies alive, inflating asset bubbles even more, and driving the amount of debt to an even higher level.

The other option -- a dramatic change of course -- may reduce the pressure on the renminbi but would risk pushing the economy into a recession and forcing many corporate borrowers into outright default. To defend the renminbi, the PBOC could raise interest rates. However, tightening money supply will most likely lead to a decline in growth, which has been artificially supported with loose monetary policy in the last few years.

An even worse danger is a cascade of defaults that could follow such a development. It is common knowledge that China has averted large-scale debt default so far only with its extra-loose monetary policy. Higher interest rates will make it harder for debtors to service their loans. Worse still, a liquidity crisis could cause a financial meltdown as less funds flow into the shadow banking system that supports many zombie companies.

Even under the best circumstances, few competent economic policymakers would have found an effective solution to this policy dilemma. In the Chinese case, domestic politics and the uncertainty in its external relations have further constrained the options of Chinese leaders.

In terms of domestic politics, the ruling Chinese Communist Party will convene its 19th congress in the fall of 2017. At the event the party is expected to appoint General Secretary Xi Jinping to another five-year term and give him the opportunity to remake the top echelon of the Chinese leadership. If growth slumps or the renminbi plunges, the party will have little to celebrate. In all likelihood, Beijing will be motivated to maintain the current course until it can no longer sustain it.

The Trump factor

But Chinese leaders are not the only actors with influence on the direction of the Chinese economy in the coming year. U.S. President-elect Donald Trump now looms large as the greatest external risk factor. The real-estate tycoon-turned politician ran on a platform of trade protectionism. Since his surprise win in November, Trump has consistently shown that he will turn his "get-tough-with-China" rhetoric into action.

He shocked China -- and the rest of the world -- by taking a phone call from Taiwanese President Tsai Ing-wen, breaking a long-held protocol that restricts official contacts between the U.S. and Taiwan, which China claims as a province. Trump further compounded his action, which many observers saw as an inadvertent mistake, by declaring that he would use Washington's "One-China policy" as leverage to force Beijing to make commercial concessions.

When the Chinese navy captured an American underwater drone in December, Trump accused Beijing of "theft." In a move sure to alarm China, he has appointed Peter Navarro, an unabashed trade hawk and producer of a documentary, "Death by China," to head a newly created White House office on trade policy. Trump's nominee for the U.S. Trade Representative, Robert Lighthizer, also has a track record as an advocate of protectionism.China's apparent economic weakness will only embolden Trump, who is convinced that since China cannot afford a trade war with the U.S., it will have no effective response to his protectionist measures.

Nobody knows what Trump will do exactly. But two outcomes are almost certain. First, the near-term uncertainty about U.S.-China relations will heighten investors' risk perception of China, thus pressuring the Chinese currency.

Second, the high probability that the new U.S. president will fulfill his campaign pledges of trade protectionism (those still harboring illusions about a pragmatic Trump should take a look at his appointments of radicals to senior positions) means that, when he actually carries out his threatened actions, investors' confidence in the Chinese economy will take another hit.

The market could react by sending the Chinese currency to a new low, a development that Trump would likely, albeit incorrectly, cite as evidence of China's "currency manipulation."

For those naked swimmers in China's ebbing tide of loose money, Trump must be the nightmare they have never dreamed of. They can be totally forgiven for thinking that way.

Minxin Pei is a professor of government at Claremont McKenna College and author of "China's Crony Capitalism" (2016).

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