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Opinion

Lucky number 7? Not for China

Xi must stop yuan's slide out of concern for economic stability, capital flight and Trump

The accelerating pace of the yuan's fall is making managers even more uneasy.   © studioEAST/Getty Images

Chinese President Xi Jinping turned heads with a pledge to buy $40 trillion of goods globally to end the U.S.-China trade war. A startling number meant to call U.S. President Donald Trump's bluff. Yet the only figure that really matters may be 7.

That is the level versus the dollar to which China's currency is sliding as Xi speaks. If this milestone is reached, 2019 will be an even more contentious and chaotic year for geopolitics and markets than 2018 has been.

The yuan’s 10% drop since April bring some benefits. Mainland growth is losing momentum as Trump’s tariffs slam the all-important export engine. Even if China can make its 6.5% gross domestic product growth by again boosting credit, it will exacerbate the longer-term challenge of runaway debt.

Some weakening of the exchange rate would seem a rational response to a darkening trajectory. That goes too for interest-rate differentials. The Federal Reserve in tightening in Washington, while the People's Bank in China is easing in Beijing.

But the speed and depth of the yuan's decline is beginning to look worrying. With the U.S. midterm elections now out of the way, the Trump will have less need to talk up the financial markets by sending conciliatory signals to Beijing, as he has done recently, and more incentive to act tough.

Here are three reasons Xi's team needs to put a bottom under the yuan, and fast.

One: It could panic markets. Chinese exporters may like a lower yuan, but its roller coaster ride this year makes it hard for executives to plan ahead. It has investors fearing increased defaults on dollar-denominated debt, especially corporate borrowings. It also heightens a risk that greatly worries Xi's team: a capital flight they cannot control.

Beijing has powerful levers to influence the capital account. A dominant theme in currency circles is the reported tidal wave of tycoon cash trying to flood abroad. Billionaires are taking no chances should Trump's trade assault trigger the great China slowdown investors feared for years.

Xi's government is heading off options for spiriting money abroad: capital controls; the central bank adding 20% reserves on short yuan derivatives contracts; curbing opportunities to disappear to Macau with steamer trunks full of cash. Blockchain enthusiasts look on with alarm as Asia's biggest economy holds cryptocurrencies at bay. But why should the authorities open a financial Pandora's box of channels to reduce mainland exposure?

Good data are as hard to come by as they are unequal to the task of describing the flow of capital trying to escape. Foreign exchange sales by Chinese commercial banks rose by a net $18 billion in September, the highest in 15 months.

The real smoking gun, though, may be the drawdown in currency reserves. In September, foreign-exchange reserves held by PBOC shrank to $3.09 trillion from $3.15 trillion at the start of the year. That is very likely related to market intervention efforts to slow the yuan's decline.

These steps are aimed at filling a growing void on the part of foreign demand for onshore mainland debt, which in September was at a six-month low. Yuan deposits in Hong Kong dropped 2.9% in September, the biggest decline since January 2017.

Two: Trolling Trump. America's protectionist U-turn since January 2017 is rapidly changing the calculus in Beijing. Trump threatens to double the roughly $250 billion of Chinese goods his levies currently target.

A yuan coursing past 7 from 6.9 to the dollar now may set Trump off in unpredictable ways. Trump could always make good on his oft-stated desire for a weaker dollar. He might, for example, dispatch Treasury Secretary Steven Mnuchin to talk down the dollar.

It is time Xi announced a clear financial red line. A good start would be stating unequivocally that Beijing is committed to defend the 7 level. Not only would that disarm speculators, but it would deprive Trump of a key talking point ahead of his meeting with Xi in Argentina later this month.

Xi's $40 trillion pledge this week seemed aimed at front-running Trump's narrative ahead of the Group of 20 meeting in Buenos Aires beginning Nov. 30. On the sidelines, Xi and Trump hope to bridge the epic divide separating the two biggest economies.

Yet Xi showmanship comes with more than a whiff of Trumpian exaggeration. The figure is spread out over 15 years. As per Xi's breakdown, that means $30 trillion of goods and $10 trillion of services. At $2 trillion per year, that implies little growth from 2017 levels, when imports totaled more than $1.8 trillion. Such figures also imply that Chinese GDP will grow around 7% per annum, a rate Xi will not make in 2018.

Moreover, Xi's "Made in China 2025" plan promises "self-sufficiency" in everything from tech to agriculture. How does a leader trying to lower the trade temperature square that circle? Who knows, Xi's own "Art of the Deal" ploy to call Trump's bluff might work. Yet nothing would blunt Washington's criticism faster than Xi promoting a stronger yuan.

Three: Regaining reformist momentum. There are indeed short-term pressures to boost demand. While Xi is China's strongest leader in decades, his legitimacy relies on heady gross domestic product growthrates. Hence the flurry of moves to offset Trumpism with increased government spending, tax cuts, business loans and easier monetary policy. A more accommodative yuan surely helps exporters, too.

Within reason, though. Since 2013, Xi has been winning global clout by promising to give market forces a "decisive role" in Beijing decision-making. At the moment, though, Xi is doubling down on a stimulate-at-all-costs model that will prove counterproductive in the long run.

A weaker yuan is a clear sign of backtracking on reform. It signals a lack of resolve in moving China away from exports to domestic services -- and from championing startups over bloated and inefficient state-run enterprises.

Any wholesale recalibration of the growth engines will necessitate slower growth. That is why, over the next 12 months, good economic news out of China is really a bad omen for the inevitable debt reckoning that lies ahead. Already, China is sitting on a $34 trillion mountain of public and private debt. That will only look worse as the population ages and wages rise driving manufacturers to diversify to Vietnam, Indonesia, India and elsewhere.

Though Xi's growth imperative is understandable, a balance must be struck. A key element of equilibrium could be a stable, if not a firmer, yuan. The more Beijing tolerates the yuan's slide, the more incentive mainland punters have to get their money out.

And the more reason they have to continue selling Shanghai stocks already down 25% since January into 2019. The costs of a weak currency are rising as Xi speaks.

William Pesek is an award-winning Tokyo-based journalist and author of "Japanization: What the World Can Learn from Japan's Lost Decades." He was given the 2018 prize for excellence in opinion writing by the Society of Publishers in Asia, for his work for the Nikkei Asian Review

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