The strength of the US dollar is forcing China down a path it has been trying to avoid for years, pushing it to slow the money machine that has propelled its economy since 2008.
The course of this path could mean strange and terrible things are in store for economies around the world. A slower, weaker Chinese economy — and the resulting weakness of the yuan — will create competition for other developing-market exporters in a race to the bottom.
This is a moment many China watchers have been waiting for — it just didn’t come how, when, or why they thought it would.
The money machine is China’s state-run banking sector. Through loans, the banks pumped cash into the economy at an unprecedented rate — as the rest of the world watched and worried. The International Monetary Fund harped on China’s debt for years, and across Wall Street, money managers have often gotten slaughtered betting on China’s demise (in one way or another) as debt climbed to 280% of GDP.
China’s leadership seemed to not hear these concerns until recently, when officials did something very strange: Party leaders got together to tell apparatchiks down the chain that they needn’t worry about hitting growth targets.
This means that a country infamous for its obsession with hitting the numbers is setting them aside in the face of mounting debt.
You can see where this change comes from: At the end of 2016, the US dollar started rising, the yuan started weakening, and people started to quickly take money out of the country to keep their savings from losing value.
Now “we are in uncharted territory,” Charlene Chu, a famed China analyst at Autonomous Research, wrote in a recent note titled “The war on outflows.”
We are now seeing that as the US gradually ends its postcrisis monetary easing program, China will be forced, in some measure, to do so as well. In many ways, though, the country is not ready.
To understand how it’s ever so slowly falling apart, we have to understand how the Chinese economy held together in the first place.
After 2008, the Chinese government kicked off its own program to avoid the global financial crisis. It did not do it the way the US did, though. Instead of having its central bank buy bonds, the Chinese government instructed its banks to lend. And they did, adding 30% or more credit to the economy every year, according to Chu.
Now there is 165 trillion more yuan ($23.8 trillion) in circulation than there was eight years ago. At the same time, the value of the yuan has remained virtually the same — an unnatural state in economics, to be sure.
The result has been an increase in purchasing power for Chinese people — a promise the Chinese Communist Party made and kept.
But it also created an imbalance between the increasing amount of yuan in circulation and the steadiness of the currency’s value that “will only continue to grow if the CNY does not weaken materially and China’s financial sector continues to expand at double-digit rates,” Chu wrote (emphasis ours).
Now, keep in mind that a double-digit expansion of the banking sector is something of a jog considering what China’s used to.
“Total banking sector assets in China will increase [by 30 trillion yuan] to [228 trillion yuan] in 2016 alone, and another [100 trillion yuan] will be added to this by 2020 if the banking sector grows at 10% per annum, which, we would note, would be the lowest growth rate on record,” Chu wrote.
Last month, $82 billion left China, as the government was forced to fix its currency lower and lower against the dollar and people worried about the value of their assets.
And despite the fact that China’s leaders have tried to tell the world that the yuan is now fixed against a basket of currencies, not just the dollar, it doesn’t matter. We still live in a dollar world.
Now instead of growth, the Chinese government’s main concern is keeping capital in the country. To do so, it has instituted several capital controls for individuals and corporations, but, of course, there are always ways to get around things like that.
Plus, holding the yuan steady comes at a cost. The Chinese government is spending its foreign-exchange reserves to prop up the currency. Right now it’s holding about $3 trillion, but Chu sees this working for only the next two quarters. A more permanent solution must be found.
So the government also has to think about attracting money to the country, and that’s where the gears of this great money-making machine start to ever so slowly grind down.
One way China can attract money is by raising interest rates, which would have consequences for all the borrowers who have taken on unprecedented levels of debt.
The flow of yuan around the country would tighten, cooling the property market. This is important. Property-market growth is part of what turned 2016’s rocky start into a net positive year for China.
“Liquidity and market risk vulnerabilities in the financial sector will be more on display,” Chu wrote. In other words, some of the hands that distributed yuan around China would be impaired, taking a toll on the country’s heavily indebted corporations.
This is why the Chinese government is being forced to prepare its people, and the world, for a slowdown. For the world, this ultimately means deflation — a force it has been fighting since the start of the financial crisis — as the yuan declines and other countries try to keep up (or down). All China can do in the meantime is what it’s doing right now: fixing the yuan higher, no matter what the dollar does.
Regardless, as the economy slows the currency will glide down. It will have to. Chu estimates that if the government continues to support the yuan against market pressure, it could blow through its foreign-exchange reserves in a couple of years.
Some caveats, of course
Two things to keep in mind here. First, the dollar could weaken.
“I do think that it’s likely to be supported by the Fed raising rates again, but I really doubt that the dollar [index] is going to make it above 120,” Jeff “Bond King” Gundlach of DoubleLine Capital predicted in his most recent monthly investment outlook presentation.
That, of course, would take pressure off the yuan and help with outflows. But this wouldn’t stop this process; it would only slow it. No matter what happens, the Chinese economy is building up dangerous debt levels that must be dealt with, and China has acknowledged that the economy’s growth will slow. The imbalance between the yuan in circulation and its value remains, and that in and of itself will push the yuan’s value down.
“One thing that is increasingly clear to us is that the world’s largest source of monetary easing since 2008 won’t be passing through in the way it has been, whether that is from a closing of the gates on outflows or a fall in the purchasing power of Chinese companies and individuals through a weakening of the exchange rate,” Chu wrote.
Second, this will happen incredibly slowly. The catastrophic credit event that Wall Street’s wildest minds have wondered about is unlikely to happen. The Chinese government has control over too much of its economy and can pull and push levers such as interest rates and manipulate the money supply however it likes.
Increasingly, economists think China will look like a poorer Japan, declining into drudgery in unexpected ways to ease its transition into a painfully slow-growing economy.
Either way, it isn’t entirely a mystery where we’ll go. What’s more unprecedented is how we’ll get there.
China has shown its hand. We now know what a dollar can do — and how little China can do to stop it.