Keeping the Economy Afloat
Emerging economies face capital outflows. Between 2009 and 2011, low interest
rates in developed economies sparked massive flows of hot money into emerging
economies. The hot money fueled asset inflation and spiced up economic growth
too. The latter gave the perception of emerging economies decoupling from
developed ones and incited even more inflow. The asset inflation eventually
sparked general inflation, which slowed economic growth and diverted money from
asset markets. The resulting asset deflation further decreases economic growth.
Hot money is now leaving because it sees the unsustainability of the growth
dynamic in emerging economies.
The Indian rupee and Brazilian real have declined by one-fifth from their recent highs, reflecting pressure from capital outflows. Because China has a controlled exchange rate, the outflow has come later, as investors believed in the safety of a government-supported exchange rate. The weakening economy this year appears to have sparked expectations of yuan depreciation. The government support of the exchange rate has become an accelerator for capital outflow, as it is increasingly viewed as a subsidy for early leavers.
China's banking system is supporting the property market through rolling over loans for delinquent property developers. It distorts the price in a market with sales of 13 percent of GDP last year. This force is another subsidy for capital outflow, as developers cut sales to slow price declines. Because a large share of hot money has landed in the property market, the banks are effectively subsidizing its liquidation value. This subsidy is encouraging capital outflow too.
The sum of trade surplus, foreign direct investment and the decline of forex reserves totaled US$ 164 billion in the second quarter. It is a crude approximation of capital outflow. It doesn't include the interest accrual on the stock of forex reserves, which could add another US$ 30 billion to the sum.
The macro data are consistent with anecdotes on the ground. The difficult operating environment and uncertain outlook are prompting businessmen to emigrate en masse. Gray income appears to be looking for safety offshore. China's broad money supply is 93 trillion yuan, 4.5 times the forex reserves. In addition, there are considerable monetary assets outside of the formal banking system exceeding forex reserves too. The vacant properties alone could exceed forex reserves in today's value. The potential for a run on the forex reserves is significant.
Even though China's capital account is not open, there are many ways to take the money out. In 1998, for example, much of the decline in forex reserves could be attributed to over-invoicing or non-delivering phantom imports. Underground channels are well developed today. Macau's casino proceeds are four times Los Vegas'. The potential for capital flight through Macau is significant. A new channel is to acquire offshore assets funded by domestic loans with domestic assets as collateral. The capacity of capital outflow under the current system may considerably exceed US$ 100 billion per month.
Learning from the Asian Crisis
There are similarities between China today and Southeast Asia fifteen years
ago. China could learn from the latter's experience and control the financial
risk in today's uncertain environment.
Between 1992 and 1996 the low U.S. interest rate prompted a massive amount of hot money to flow into Southeast Asia. The money was mainly lent to the region's banks, which lent the money out for investment in commodity industries and property speculation. The tide reversed in 1997. It triggered massive devaluation and economic contraction.
When faced with capital outflow pressure, Southeast Asian countries used their forex reserves to defend the exchange rates. Like China today, they had controlled exchange rates. They had plenty of forex reserves when the outflow pressure began. But, after defending the exchange rates for an extended period of time, they couldn't back down from the policy until depletion of the forex reserves forced them to devalue. Some countries even borrowed considerable amounts from the International Monetary Fund to continue the wrong policy. All they achieved was subsidizing capital flight.
Without forex reserves, these countries couldn't support their financial systems. The financial collapse brought massive economic contraction and widespread suffering. If these countries had floated their currencies at the first sign of outflow pressure, they wouldn't have suffered as much.
The irrational, costly and sustained defense of fixed exchange rates had much to do with who was taking money out. It was the ruling elite taking their gray income out. This political force may partly explain why these countries were so resolute in defending their exchange rates.
Float the Yuan Now
China's forex reserves are massive in absolute amount. But they cannot really
be all deployed. If the forex reserves fall by one-fifth, it may trigger panic.
China's monetary assets are many times the forex reserves. A panic could exhaust
the reserves quickly. Even if the government institutes tougher capital control
to slow the outflow, as what occurred in 1998, the resulting confidence collapse
could do considerable damage to the banking system.
When Southeast Asian countries lost their forex reserves, their governments had little credibility to revive their banking systems. It was a factor in their economic suffering. They had to keep exchange rates extremely low to earn foreign currencies to reflate their economies.
Despite some revival in property sales in May and June, China's property market is in a multiyear adjustment. This dynamic casts a long shadow over the country's banking system. Credit expansion has been largely dependent on land appreciation. In an investment-led growth strategy, returns on capital are low. Hence, credit expansion depends on collateral rather than business cash flow. Because land is the dominant form of collateral, land appreciation and rapid credit expansion have been mutually supporting each other in the past decade, which had been in bubble territory for at least five years. When this dynamic runs its course, the reversal could severely damage the banking system.
Chinese bank stocks are very cheap. Even the low prices reflect the market's hope for government support at some point. The faith in the government depends on the large forex reserves, which lends credibility to the government's financial power. The market's faith in the government's financial power is the anchor for China's financial stability. Otherwise, a full-blown financial crisis would have occurred.
China should float the exchange rate now and lock away its forex reserves. The commitment to not buying or selling dollars by the central bank will remove a big risk to the country's economy. It was a big reason for the inflow of hot money and, hence, a big contributor to the bubble. It has been a contentious point in China's economic relationship with the West. In one stroke, the country could remove this irritant in the domestic economy and international relationship. Of course, it safeguards the government's credibility in supporting the financial system.
Investment May Rebound …
Beijing's policies for growth stabilization rely on pump-priming investment
projects. Despite the economic slowdown in the first half of 2012, total net
fund-raisings increased by 1.7 percent to 7.78 trillion yuan (34 percent of GDP
in the same period), and broad money increased by 13.6 percent compared to an 11
percent increase in nominal GDP. While the perception is that the downturn is a
result of policy tightening, the facts speak otherwise. Liquidity and financing
conditions are quite loose. The economic downturn results from the property
bubble bursting under its weight, not really from any policy
The cash shortfalls are mainly in property and land sales. The two are related. Last year, property sales were 15 percent of GDP and land sales 6 percent. The official statistics say property sales declined by 10 percent in the first half. As property sales are often booked with a lag and many developers had cashless sales this year, the real shortfall is much greater. I wouldn't be surprised that the real shortfall there exceeded 1 trillion yuan in the first half of 2012.
While statistics are spotty, it is fair to say that land sales collapsed in the first half. China's property industry profits from land appreciation, not from developing property per se. When the price of land is declining, developers won't have money to buy land. While property sales can be sustained through cutting prices, land sales cannot.
The cash shortfall for investment due to property market adjustment could be 3 to 5 percent of GDP. It is a big number but could be mostly offset by the increase in fund-raising elsewhere. For example, local government funding vehicles are on the move to raise more money. The corporate bond market is likely to grow quicker in the second half. It appears that investment may rebound in the second half.
… But Confidence Won't
China experiences overcapacity in most industries. Rising costs have further
weakened businesses' ability to earn profits. The economy has been
disproportionately dependent on land appreciation as the source of profit. From
banks to loan sharks, the financial sector is highly dependent on land
appreciation for sustaining lending margins. Commodity industries have been
subsidized by commodity traders who earn profits from loan-sharking to property
developers. Equipment suppliers depend on local governments' ability to pay.
That depends on land sales. Of course, this model of sustaining profitability is
a bubble. As the bubble bursts, profitability will be squeezed all around.
Sustaining investment through increasing other sources of financing won't change
When businesses see shrinking profitability, they are likely to shrink businesses. If there is no hope for any profitability, they may liquidate and, in many cases, emigrate. In addition to declining profitability, businesses also feel the squeeze from local governments that try to increase revenues elsewhere after losing most land sales. That squeeze is frightening. It has the potential to squeeze out all the past profits of the existing businesses. So for many closing down and leaving is the best option.
Business confidence ultimately depends on the prospect of making a profit.
Land inflation worked for a while. But, it was just a bubble. Profitability
ultimately depends on a rational balance between consumption and investment. The
government manages the economy by pushing investment. Investment-led growth
inevitably leads to overcapacity, low profitability and bad loans. The
investment push can be stretched by creating a bubble, i.e., investment
profiting from investment. When such a bubble bursts, the financial system is
inevitably saddled with tremendous bad debts.
China has serious legacy costs from the property bubble bursting. If the policy is to cover up the fallout, for example, extending loans to delinquent borrowers forever, the economy could become like Japan's after its property bubble began to deflate in 1992. Unlike Japan, China has the chance to grow. The per capita income in 2012 is likely to be US$ 6,000. It is about 15 percent of the Organization for Economic Co-operation and Development level. If China improves productivity, the pie could grow sufficiently to dwarf whatever financial costs the deflating bubble may inflict.
As I have written numerous times before, China needs to cut taxes and shrink government spending to boost consumption and incentivize businesses to improve technology and quality. The latter needs China to have proper cost of capital. The low interest rate in the past decade has incentivized businesses to focus on speculation rather than technology or quality. Cutting taxes can decrease the national savings rate, which boosts the cost of capital and eliminates excess capacity.
If China wants to incentivize businesses and households to keep money at home, the government should cut taxes substantially and shrink the state sector with numerical targets and timetable. Otherwise, capital outflow is likely to continue.
The author is a board member of Rosetta Stone Capital Ltd.
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