China Crisis?

It’s crunch time for China … or for the hedge funds betting against it

2016 is the year when China bites the bullet, the experts say. One way or another the debt is now so large it has to be addressed, no choice – deleveraging, rebalancing of the economy (and much lower growth), or a reckless dash for even more debt-for-growth. The question is, which way will China decide to break?

This matters for India. China is its heavyweight neighbour, used to throwing its weight around. It is a trading rival and a political-strategic competitor, a partner in balancing power – the very definition of a frenemy. India in the old days of fresh independence under Nehru naively believed that China was its best friend: ‘Hindi-Chini bhai bhai’ (India-China best brothers!) was the slogan as the 1960s opened. Then in 1962 Chairman Mao bitch-slapped India when Chinese forces invaded the north-east territories and shredded India’s brave but ill-equipped troops. The country suffered a nervous breakdown it has perhaps never quite recovered from. India even today is still ginger and over-accommodating not only in its dealings with China but Pakistan, too.

Nevertheless, the gearing of growth and progress between the two nations is reversing. After four decades of break-neck development, fully built-out and almost submerged now under nightmare debt, China will slow down and India, fresh out of the traps and with demographics in its favour, will begin to catch up. This is reality.

China mostly owes money to itself: it prints yuan and can dissolve its debts – at least on paper – by printing more. As it needs to deal with its debts a lot more yuan seems logical, but this will destroy the currency’s value, and there will be terrible and painful economic compression in the process, mostly borne by the workers of enterprises that are closed down.

Yet Chinese President Xi Jinping’s rebalancing, which aims to make the Chinese people richer and develop internal markets and a more service-based economy, requires the exact opposite of this debt-destroying strategy.

The hedge fund world is shorting the yuan like crazy. Logic would decree that an economy with so much debt (up to 400% of GDP), desperately needing to deleverage now that there is only excess capacity being added from new investment, would need to devalue – as indeed has been happening since summer 2015. The Yuan appreciated 35% since 2011, pegged to an ever-stronger US dollar; it is now around 6.5 to the USD and might go out to 8.3-8.7, where it used to be in 2005. One can imagine that there are voices in China crying out for this (as they hurriedly snap up assets in the West before it happens).

These Western hedge fund ‘China bears’ say that the yuan needs to go down by between 30% to 50% pretty soon to avoid disaster. Such a devaluation would mean internal hardship and would export deflation around the world – not to mention that it would also be disastrous for a country trying to establish its money as a reserve currency – but, say the bears, there is really no choice. This is the settled view of conventional or establishment economists and speculators: It’s a simple you-can’t-lose bet.

Or is it? We hear that after the minimum reserve ratios for Chinese banks were lowered at the end of 2015,  credit creation reached half a trillion US dollar’s worth in the first two months of 2016. Instead of slowing debt creation, China has apparently decided to stave off the inevitable contraction by getting into even deeper debt at an increasing rate. Yet despite this things may not be quite as they appear.

There is a possibility that China is doing something very daring and strange. A few weeks ago Alasdair Macleod wrote a very interesting piece titled ‘Shorting the Yuan is Dangerous’, and it looks as if the hedge funds have just found out it is true.

Could there be a way – apparently flying in the face of the laws of mathematics – that China could keep growing and yet respond to the president’s policy targets of enriching the population?

Macleod presciently noted that while the consensus was that China would have to plough through its dollar reserves to prop up the yuan – as indeed it had been doing – the massive fall in commodity prices worldwide meant that China’s balance of payments was actually sitting pretty. Devaluation cheapens a country’s exports so that it can earn more money from abroad; but what if it doesn’t need to because its input costs have collapsed? What if it doesn’t care right now that foreign demand has contracted by 25% in a year?

As Macleod says, ‘[China’s] total trade surplus for 2015 at $613bn was a record by a very large margin. A devaluation is definitely not required on trade grounds.’

Cheap inputs (commodities and raw materials) mean China can pay its debts in the short-term without dipping much further into its forex reserves (as long as Xi manages to stem capital outflows – watch this space!) and without having immediately to devalue the yuan. Theoretically this leaves breathing space for some rebalancing to begin while letting the yuan readjust and settle over a period of years. Meanwhile, the hedge funds’ put options eventually go ‘pouf’ and they eat losses at every meal.

What if, wonders Macleod, the Chinese authorities have not been hoodwinked by the jejune Keynesian assumptions of Western macroeconomists? What if, instead of beggaring their citizens through ever lower interest rates and devaluations, the Chinese actually want to allow their citizens to build wealth? Macleod guesses the Chinese don’t care a fig for Western theories. Instead, he laconically observes that ‘you do not win a financial war by undermining your own currency. Instead, you should undermine the enemy’s currency…. This is precisely what China is doing to the dollar.’

It would be strange indeed if, after trying so hard and for so long to get renmimbi recognised as a reserve currency, the Chinese would squander their achievement by effectively turning it into the Italian lira of old. China may well be betting that with the Fed out of policy options and with an insupportable burden of debt on it back, the US may be the nation to suffer a currency devaluation this year. So while the US hedge funds short China, China is shorting the USA.

And it looks as if the hedge funders have started to bleed.

The question for India is where it should pivot if this all take place. China could prove to be an untapped and lucrative market for its goods in the years to come if it does actually grow wealthier beyond a privileged elite. The USA is flirting with inevitable recession and is ever deeper in debt. If Trump becomes president and erects trade barriers, maybe India should shrug and turn away eastward both commercially and politically – which is something I recommend not only India does, but the UK as well.

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