China currency devaluation – matter of when and not if

India is not ready to step in as China’s economic engine stutters and stops.

In October 2014, the Takshashila Institution published a discussion document on the China outlook for 2015. Events have followed that pattern that the document anticipated. China’s economy is slowing and the domestic economy is not rebalanced. Net exports constitute an increasingly larger share of China’s gross domestic product, despite some real appreciation of the Chinese yuan in recent months. China has maintained a stable exchange rate in furtherance of its geo-political and geo-economic goals. Soon, they will clash with the harsh and worsening underlying economic reality in China. A significant devaluation of the Chinese currency in the months ahead is likely. This will badly hurt India’s competitiveness as the country is woefully underprepared to take advantage of the worsening competitiveness of China’s exports. That window will close with the yuan devaluation that is anticipated. In conclusion, the discussion document noted that “in the course of 2015, India should be prepared for a substantial yuan depreciation, which attracts only symbolic condemnation but no significant international condemnation or sanctions.”

Nearly six months later, is China closer to depreciation and if so, is India better prepared for one than it was last year?

Economic growth slows to a crawl in China
China has been in the news lately. Its first quarter GDP growth (7 percent y/y) was reported as the weakest in six years. Other unofficial estimates put the growth rate between 1.6 percent and 3.0 percent. One such indicator is the ‘China Momentum Indicator’ (yellow line in the chart below), developed by Fathom Consulting. It is based on the three indicators that the Chinese Premier Le Keqiang once said that he tracked closely to gauge the strength (or the lack thereof) of the Chinese economy – rail freight volumes, electricity production and credit growth. According to CMI, China’s growth rate has slowed to 2.8 percent in the first quarter. Fathom Consulting expects the true Chinese growth rate to be around 2 percent by the end of the year. The government statisticians reported a growth rate of 7 percent. For now, growth rate of 7 percent remains the official line in the sand in China that statisticians dare not cross.

Image 1

Chart 1: China’s growth momentum slows sharply

China’s exports plunged in March after soaring in February. Export growth in March dropped 15 percent y/y. According to market reports, the strength of the yuan was a big factor. Exports to Europe declined 19.1 percent and exports to Japan declined 24.8 percent y/y in March.  However, for all the brave talk of rebalancing of growth towards domestic consumption, China is more and not less reliant on exports as imports are falling even faster. On a quarterly basis, “export sales were up 4.7 percent in the first quarter compared with a year ago, improving from a 3.4 percent fall seen between January and March last year.” China’s imports declined 12.7 percent y/y in March. On a quarterly basis, imports crumbled 17.6 percent in the first three months from a year ago, reversing the 1.6 percent increase in 2014’s first quarter.

In other words, as domestic spending (investment and consumption) slows more, net exports are still making a sizeable contribution to economic growth. China still needs the world and not the other way around as European nations engage in an ungainly scramble to be part of the founding shareholders of the Asian Infrastructure Investment Bank, promoted by China. Global economic growth scarcely reflects the fact that it has been handed a 60 percent decline in the price of crude oil. Normally, this should be causing upward revisions to global economic forecasts. On the contrary, growth forecasts are being revised down. In its twice-a-year World Economic Outlook, the International Monetary Fund (IMF) has warned of a prolonged period of below-average global growth. It dedicated an entire chapter to the prospect of secular stagnation. It downgraded its estimate of potential GDP growth for the developed and for the developing world.

(Chart 2: IMF lowers estimate of global growth potential)
Source: Chart 3.2, Chapter 3, World Economic Outlook, International Monetary Fund (April 2015)

On 14th April, amidst all the attention on the IMF forecasts, the World Trade Organisation (WTO) released its outlook for world trade and lent its voice to those who argue that the slowdown in trade growth is not only cyclical but has also been due to structural factors. With last year’s 2.8 percent growth in global trade, “global trade has now expanded at, or below, the rate of the broader global economy for three straight years”. IMF and WTO are joined by the International Energy Agency (IEA).  A report in the Financial Times begins as follows: “The rebalancing of the global oil market may still be in its early stage with the outlook “only getting murkier”, according to the International Energy Agency, as uncertainties remain about demand and supply responses to the steep drop in prices”. If the world economy were in normal health, there should not be any uncertainty about the demand response to a 60 percent drop in the price of crude oil.

We have been warning of such an outcome in the aftermath of the global crisis of 2008 and the refusal of policymakers around the world to allow forces of capitalism to play out. They have interfered and tampered with that process with their bailouts, zero interest rates and asset purchases. Now, they have stepped into even more unknown terrain of negative interest rates. Doomsday awaits the world economy.

In the light of this ‘cheerful’ outlook for global growth, China’s continued dependence on external demand bolsters the case for a devaluation of the Chinese currency, whose prospect we discuss later in this brief.

Stock market boom erupts in China
In the meantime, China is witnessing a frenetic stock market boom and bubble that is putting America’s and Europe’s to shame. It has virtually popped out of nowhere in utter defiance of China’s macro-economic and corporate fundamentals. In a recent report analysing the balance sheet strength of Indian, ASEAN and China corporations, Standard & Poor’s found that Chinese corporations had the worst leverage ratio. Nearly a quarter of the top 200 Chinese enterprises had a leverage ratio of over 5 (Chart 3).


Chart 3: Leverage ratios of top corporations in India, ASEAN and China
(Source: ‘Myth Busted: India’s Top Corporates Are Hardly Regional Weaklings’, Standard & Poor’s, 25th March 2015.)

It is also clear from the chart below (chart 4) that the leverage tendency of the median corporation in China has not been down but up. Of course, since most of the top 200 enterprises in China are government-related entities, they feel that they have an implicit Government bailout and, second, because of this faith in government bailout, banks lend relatively more freely to them. Nonetheless, the fact is that the leverage ratio (Debt-to-EBITDA) of a median Chinese corporation among the top 200 has been rising.

Chart 4

Chart 4: Median leverage trend comparison of top Indian, Chinese and ASEAN Corporates
(Source: ‘Myth Busted: India’s Top Corporates Are Hardly Regional Weaklings’, Standard & Poor’s, 25th March 2015)

It is not a surprise, therefore, that the return on capital for a median Chinese company in the top 200 corporations is far lower than that of a typical Indian corporate (Chart 5).

Chart 5

Chart 5:  Median Return on Capital of top Indian, Chinese and ASEAN Corporates
(Source: ‘Myth Busted: India’s Top Corporates Are Hardly Regional Weaklings’, Standard & Poor’s, 25th March 2015)

It is unbelievable that in the face of such starkly weak corporate fundamentals and weakening economic growth, investors in China are flooding stocks with money. The stock market bubble in China is spectacular both for its size and for the speed with which it has grown. It is not just technology stocks that are on fire although the average Chinese technology stock has a price-to-earnings ratio 41 percent above that of U.S. peers in 2000. The use of margin debt is at an all-time high and more than two-thirds of new investors have never attended or graduated from high school. More worrying than valuations in technology stocks are perhaps health-goods-from-deer-antlers producer on 70 times, the seamless underwear manufacturer on 90 times or those school uniform and ketchup makers on 330 times.

Given how things work in China, the stock market bubble must have the blessings of the China government. Almost nothing of such size and significance can happen without their knowledge and consent. That said, it is hard for us to figure out the intent of the policymakers in China. Perhaps, they feel that they need to provide a buffer to households against the slowdown in the real estate and the price decline there. Second, it is possible that they are reluctant to push businesses to pay higher wages to boost consumption since the profitability of Chinese enterprises is already severely crimped. Hence, the short cut for policymakers –as is the case elsewhere in the world – is an asset price bubble. That is what they are encouraging. However, this is a very dangerous game. Chinese stock market bubbles get bigger quickly and they burst spectacularly too. It happened in 2007. It will happen again. Investors typically overstay their welcome in bubbles. They do not treat this as an unexpected bonus – as a substitute for wage increases – and take profits. Greed takes over and they linger on, to regret at leisure.

China’s stock bubble has inflated at a time when its money supply growth rate (M2) has fallen to below 10 percent. Hence, the stock market bubble has already discounted Quantitative Easing (QE) in China. Otherwise, in the face of bad and worsening economic and corporate fundamentals (high debt and low return on capital), there is not even a fig leaf of justification for the stock market bubble in China as in the case of the United States and Europe. On cue, over the weekend (April 18-19), the People’s Bank of China cut the Reserve Requirement Ratio by 1 percent, the largest RRR cut since 2008. (Reserve Requirement Ratio (RRR)’ refers to the amount of cash that commercial banks must deposit with the Central Bank as a proportion of their deposit liabilities. A reduction in that ratio releases more funds for the banking system to lend). It releases around RMB1.3trn of liquidity. Just in case someone thought that the PBoC had not run an irresponsible monetary policy by implementing QE, they should not forget that China had been doing its own version of QE even before 2008 except that it had bought the government paper of the United States mostly and not that of its own sovereign. The impact on the domestic money supply has been the same. The size of the balance sheet of the PBoC is around 50 percent to 60 percent of GDP and is now eclipsed by that of the balance sheet of the Bank of Japan. Talk of Asian values.

China’s economy is no longer walking on the edge. It has fallen except that we do not see it in the official statistics. Despite that, China’s stock market is now sprinting towards the edge of the cliff. When it falls, it will be spectacular. The consequences for China are going to be severe and far-reaching for the rest of the world when (and not IF) it happens. At that time, when a stock market bubble compounds an ongoing slowdown in an economy weighed down by too much debt (Chart 6) and too much investment, currency devaluation will be the only safety valve left for the release of both economic pain and social tensions.

Chart 6

Chart 6: China’s debt has grown much faster than the economy
(Source: China’s Financial System – Highway to the Danger Zone, Bank of America – Merrill Lynch 13 April 2015)

In his “Breaking Views” column, Andy Mukherjee wrote that the lightness of China’s growth had not become unbearable because it had desisted, so far, from devaluing the currency. Their restraint may not last long. So far, they have been tiptoeing around the periphery of the decision but eventually, economic weakness might really leave them with no option. They have resisted the temptation to address domestic economic weakness with currency devaluation for three reasons. One is that there is excessive capital outflow. In 2014, about USD198bn is estimated to have left the country. (JP Morgan estimates capital outflows as the difference between the change in Foreign Exchange (FX) Reserves and the Current account balance. Under normal circumstances, if there are no capital inflows, the change in FX Reserves should equal the current account balance. If it is greater than the current account surplus, then there is net capital inflow. Conversely, if it is less than the current account surplus, then there is net capital outflow. In 2014, China’s FX reserves went up by only USD21.7bn while China’s current account surplus was USD219.7bn.)

China’s rich are taking their money out. Currency depreciation might hasten the outflow and put further pressure on China’s foreign exchange reserves, which have come off USD4.0trn already. Pressure on the currency, capital outflows and draining of foreign exchange reserves will not sit comfortably with the pursuit of a seat at the high table of global reserve currencies and membership in the SDR basket. That is the second reason why Renminbi devaluation has not been pursued until now.

The third reason is the oft-discussed change in the monetary policy stance in the United States. In her most recent speech, Ms. Janet Yellen, the Chairperson of the US Federal Reserve Board, had indeed hinted at her preference to get the Federal Funds rate off its zero base sooner rather than later. That much comes through despite all the qualifications and exceptions in her speech. China has substantial short-term (residual maturity of less than a year) external debt that needs to be rolled over (Chart 6). Comparable figures for India and Indonesia were 21.7 percent and 18.3 percent respectively as of end-2013.

Chart 7

Chart 7: Share of short-term debt (< 1 yr.) in total external debt
(Source: World Bank)

Higher US interest rates and a cheaper yuan make servicing foreign debt costlier and push some marginal cases into debt default with the risk of a bandwagon effect on domestic debt too. Therefore, we should note here that China is biding its time to devalue the Renminbi rather than foreclosing on that policy option. In fact, as Andy puts it, when China’s growth slowdown becomes truly unbearable, devaluation will be firmly on the table and will be carried out. Currency devaluation by China will become inevitable sometime in the next twelve months.

That will have huge impacts on the vain attempts being made by the United States, Europe and Japan to resuscitate their economies through their musical-chair game of currency weakness. That game will come to naught. India will be affected badly. Its already uncompetitive exports vs. China will be even more so. It has not been able to take advantage of the growing uncompetitiveness of China’s exports. Its productivity or, more precisely, the lack of it is the problem. As much as Swachch Bharat India probably needs a Kaam kar Bharat campaign. A country of free riders – as Prof Raghunathan put it in his book, Games Indians Play, will depend on the uncompetitiveness of others, forever.

India woefully underprepared
For all the impressive measures on labour markets and in coal and mining sectors that this government has taken, it also manages to take two steps backward. It needs huge capital investments to improve infrastructure in the country. Without that, the government cannot achieve its goal of improving the share of manufacturing in the economy and providing employment to millions. It needs domestic savings to rise and foreign capital to reach India. Yet, it is sending ambiguous signals to foreigners with its tax demands and puts off middle class Indians with a highly intrusive tax form. It is not clear if there is a single conductor of the government policy orchestra who knows the notes and the music that he wants his orchestra to produce.

That is why all the chest-thumping in India over the predictions of the International Monetary Fund that India’s growth rate will exceed that of China’s in the next two years is comical. Warts and all, as per the latest World Economic Outlook database of the International Monetary Fund, China’s nominal GDP is around USD10trn. India’s GDP is around USD2.0trn. It is natural and even essential that India’s GDP grows faster and that China’s GDP growth were slower. In fact, the reverse would be a problem. When would Indians learn to keep their head down and just go about doing their business conscientiously and productively, instead of looking for bragging rights and cheap thrills? From corporate debt to environmental pollution to water shortage, India has all the problems that China has and may be even worse while its economy is a fifth of China’s and its productivity far lower than that of China. Conference Board in the US gives us Total Factor Productivity Data for countries in the last two decades (Table 1). No comments required.

Table 1

Table 1

(Note: Total Factor Productivity Growth measures the Growth of GDP over the combined contributions of total hours, workforce skills, machinery and structures and IT capital. Growth rates are based on the annual percentage difference of each variable. Averages of yearly growth rates are shown for 1996-2005 and 2006-2010.)
(Source: The Conference Board Total Economy Database, Summary Statistics 1997 – 2014, January 2014 (Tables 9 and 12). Conference Board, USA)

China’s stock market bubble will burst. Its economy – even according to official growth estimates – will grow at 5 percent or less. Foreigners will lose confidence in the economy as the currency devalues. Yet, India will be far from ready to take advantage of it economically. Worse, China’s economic woes might also result in elevated security risks for India. In sum, India is not ready to step in as China’s economic engine stutters and stops. Both India and the rest of the world look set to realise it only belatedly.