China's High Stakes Tennis Match

Faced with jetlag and having reached saturation with CNBC and CNN in the hotel room, I found myself watching an out-of- sorts Andy Murray playing in a match that on paper he would have been expected to win.

Friday, February 3rd 2017, 10:59AM

by Andrew Hunt

Even though the commentary was in Mandarin (my knowledge of which is limited to around 4 phrases), it was clear that Murray was struggling to gain the initiative and he was being bounced around the court by his opponent but it seems to us that China’s economic policymaking has entered a similar phase vis-à- vis the management of its economy.

For example, in 2013-14 the economy was strong and inflation was threatening and, so the authorities tightened aggressively. Naturally, as they tightened policy the economy slowed and, by early 2015, they had reversed

their stance and were easing (fiscal) policy again, apparently to little effect. Then came a much more concerted monetary easing in mid-2015 but this in turn pressured the currency, with the result that more and ever

more stringent capital controls were embraced. Then came problems with corporate indebtedness and bank solvency in early 2016 that resulted in a further easing of fiscal policy and even a de facto QE regime followed

during mid-2016. But, as the economy has re-accelerated in response to these measures and pressure on the RMB has mounted once again, the authorities have recently tightened their fiscal policy quite aggressively while at the same time becoming notably less generous with regard to the supply of liquidity to the banks. The government has also moved further down the capital controls route. Rarely have we witnessed such a high degree of policy instability.

This policy – real economy “tennis match” seems to have become all rather fraught with the authorities seemingly running from one side of the court to the other as they have endeavoured to keep the ball in play.

Clearly, in the latest exchange, there have been further moves by China to tighten controls on capital movements by closing a number of loopholes, including those centred around the treatment of education-related outflows and corporate MandA. Some of the new regulations are opaque but if the policies were to be successful, then we will likely see a switch in the nature of the recycling of the Chinese current account surplus back into the hands of the public sector (which tends to buy US Treasuries) and away from the private sector (which tends to buy risk assets, property assets and of course Hollywood). As a result, we can suggest that the rest of the world is not merely a spectator in this particular game….

In order to explain why the game has reached this particular crucial stage, and just why the authorities appear hell-bent on controlling private sector capital outflows, we must briefly consider the monetary implications of China’s recent aggressive credit booms. Whenever a loan is created (i.e. an asset for a bank, liability for the borrower) a deposit is also created at the same time (i.e. a liability of the bank but an asset of the saver who sold something to the debtor). As a consequence, we can suggest that over recent years China has created a great deal of ‘money’ through its credit booms.

Indeed, we would argue based on a fair degree of statistical analysis, that at present the Chinese domestic private sector currently holds huge excess money balances – that could be as large as US$10 trillion in size – and these are still rising. Conservatively, we estimate that the stock of deposits in China is perhaps 2 – 3 times as high as it should be in theory and it is also reported by the banks themselves that some 90% of these deposits are owned by the top 1 – 2% of the population. Moreover, since China’s stock of deposits is growing by US$2-US$3 trillion a year at present, this is a situation that must be continuing to deteriorate.

Worryingly, we also find some micro data that appears to support this hypothesis. According to what data we can find from the PBoC, Northwest University and elsewhere, in comparison to their peer group elsewhere in Asia, China’s wealthiest savers are heavily overweight domestic property (circa 70% of their wealth versus 50% elsewhere) and domestic deposits. The latter conclusion of course corresponds to the macro data quoted above. At the same time, we find that the Chinese household sector is notionally underweight domestic equities but its biggest underweight in relation to its peers is, unsurprisingly, foreign assets.

Crucially, across Asia, we find that most household sectors own a level of foreign assets that is the equivalent of between a third and 100% of their domestic deposits (Taiwan is close to 100%, Malaysia 50%, Indonesia is a little lower). The corresponding figure for China is only around 11%, despite the recent multi-trillion-dollar capital outflows from the PRC. Of course, while the domestic money supply has been inflating so rapidly, it has been hard to raise the ratio of foreign assets to domestic deposits owned but nevertheless we estimate that in order for China to reach even the lower band of its peer group in terms of foreign assets, the country would need to export around US$4 trillion of domestic savings over the next year at current FX rates. For financial markets in the West, the impact of such large inflows would be akin to ‘QE-on-speed’ and at the very least they would be highly destabilizing for markets the world-over.

The conventional method to prevent such large private sector outflows would be to allow the RMB to decline. A 30% decline in the RMB would arithmetically raise the level of foreign asset ownership amongst households to 20%, of their deposits, thereby implying that China might only ‘need’ to export another $1.5 trillion to achieve a more ‘typical’ asset allocation. If the currency were to fall by a massive 50%, then there would be no further need for capital outflows and this was of course the route that was chosen by the other BRICs recently. However, the impact on the global economy of a 30% or more depreciation of the RMB would be immensely deflationary, while presumably being inflationary for China (as import prices rose).

Given this situation, it is easy to see just why most global policymakers seem to support the notion of China’s greater use of capital controls, even if it represents a step backwards in the reform process. Clearly, the West would not view either large capital outflows from China, or a weak RMB, as being particularly welcome developments

But, if China were to succeed in its capital controls initiative, then it will not have solved the ‘problem’ of the US$10 trillion of excess money balances within the economy that we referred to earlier – these will still have to
go somewhere. Moreover, we might suggest that as China’s currency becomes less convertible rather than more convertible, the (savings) demand for money will tend to fall. Such events usually result in very high rates of
domestic inflation.

In an extreme theoretical example, if China’s demand for money were to fall to such an extent that absolutely no excess balances were desired to be held, then according to our model, nominal GDP in China would be obliged to rise by RMB72 trillion in short order, an assignment that in the past has usually been achieved by other countries through the relatively simple expedient of domestic inflation rates soaring well into double-digits.

In a practical sense, if China’s savers were to begin dumping their excess money holdings, we would expect their first ports of call to be property, commodities, and equities. This is of course already occurring but as

property and commodity prices rise, they naturally affect the cost of doing business and even living in China - and hence we are not surprised to find that even China’s published rates of inflation are rising.

Moreover, if these latest price rises lead to an increase in expectations of inflation in general, then there will be a further incentive households to ‘dump’ their excess money holdings at an even faster rate, perhaps even by
purchasing mainstream goods in a scramble to beat price increases. Such cycles do not usually end well.

Viewed in this light, China’s latest and widely welcomed consumer boom looks to be rather more worrying in nature than one might have expected at first sight.... Indeed we must wonder of China’s tightening of capital controls has already led to a sharp and potentially difficult to control expansion in nominal GDP.

Crucially, it seems that China’s authorities have not been blind to these risks and events – the latest development in the policy tennis rally has been to tighten fiscal policy and to leave the banking system short of funds, with the result that interest rates have increased and private sector credit growth has slowed. Moreover, given the Chinese economy’s high degree of credit dependency, it would be tempting to suggest that the weaker credit situation will result in slower growth from 2017Q2 onwards and this may well turn out to be the case with regard to corporate spending but at the same time we must also be aware that, if it is indeed the case that China’s household sector is now embarked on a policy of attempting to reduce its excess money balances, then it is quite possible that an inflationary consumer boom will persist until such time as the authorities react even more aggressively, or the rising rate of inflation so undermines real incomes that the boom falters of its own accord - and China enters a period of profound stagflation.

There are of course still many unknowns over the outlook for China but to continue our tennis analogy, the authorities are out of position and on the defensive, with the result that 2017 looks set to be a difficult year for them and, while in the short term the crowd may welcome the sight of a consumer boom and some ‘thrilling play’, this may not be the way to ‘win’.

In terms of investible ideas, we believe that one of this year’s surprises will be much higher Chinese inflation, while China’s impact of ‘flation in the rest of the world will depend on the timing of just when the RMB finally

succumbs to its current overvaluation problem. Consequently, although the world may currently be focussed on the White House, we believe that investors should also keep a weather eye on events in Beijing.

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Andrew Hunt International Economist London

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