Investors continue to overlook China’s weakening economy in the belief that Beijing will “do what it takes” to restore growth. But the Chinese economy is stubbornly refusing to react to stimulus efforts, and an increasingly overvalued currency may be to blame.
Last week, Beijing inadvertently put the yuan in the spotlight after speculation that the People’s Bank of China might become the latest central bank to resort to taking out the big bazooka of quantitative easing. This was hurriedly denied, yet it crystallizes Beijing’s dilemma as it seeks to loosen monetary policy to rescue the economy from a looming debt crisis and deflating property bubble.
Analysts are flagging the dilemma policy makers face as they increasingly bump up against the “Impossible Trinity.” This is a key economic theory that states that if a government has exchange-rate and interest-rate targets as well as free capital flows, it can only control two — but not all three — factors at the same time.
This rule might comes as surprise for a one-party state where authorities are used to exercising sweeping control across the economy and financial system.
Bank of America Merrill Lynch says that China is struggling with two conflicting policy objectives, on the one hand seeking to ease monetary conditions to support growth, but on the other seeking to have the yuan shadow the U.S. dollar DXY, +0.14% which is strengthening as America’s economy recovers.
The result is that monetary conditions have recently tightened because of the yuan’s appreciation, which has more than offset the cuts to interest rates.
Likewise, Merrill Lynch questions whether China can lower interest rates without allowing the currency to fall. The same would surely follow with quantitative easing, as experience elsewhere has shown such a policy is typically accompanied by sharp currency deprecation.
This situation marks a major reversal, as for decades the pressure on China’s currency has been upwards as it continually ran twin current-account and capital-account surpluses. While China still has a current-account surplus, this has been narrowing, and capital flows have been decisively reversing. The PBOC made foreign-exchange sales of 252 billion yuan (equivalent to $40.6 billion) in the first quarter of 2015 and 133 billion yuan in the last quarter of 2014.
Merrill Lynch reckons that as Chinese rates fall in response to monetary easing, capital outflows will resume or even accelerate. The other problem is that when China intervenes to support the yuan, it is effectively contracting money supply.
The official position, as outlined by Chinese Premier Li Keqiang, is that China does not want to see devaluation of the yuan, since this could lead to a “currency war.”
A strong yuan is recognized as a key policy goal of Beijing, since it supports China’s efforts to internationalize the yuan and achieve global foreign-exchange-reserve status. In the past, China has expressed frustration with the dominance of the dollar in the global economy.
But Beijing may need to rethink this stance if it risks tipping the economy into a deeper decline.
Over the past few weeks, new measures from tax cuts to fresh property investment have been announced, yet there are few signs the economy is responding. The latest official manufacturing Purchasing Managers Index for April came in unchanged at 50.1, meaning the key sector remains stalled, while an HSBC version of the PMI printed at 48.9, putting it below the 50 level and thus in contractionary territory.
These numbers follow March’s disturbing trade figures, which showed exports falling 15%, suggesting again that the appreciation of the yuan is now hurting Chinese exports as they become more expensive.
The official narrative is that currency strength is supportive of China’s economic rebalancing, since it should boost consumption as imports become cheaper. But imports were also weak in March, falling 12.7% to mark the third straight month of declines.
In fact, currency strength has been boosting Chinese consumption … just not in China. New data reported by the Financial Times estimates that overseas spending by Chinese tourists reached a massive 3.1 trillion yuan — or $500 billion — in 2014.
Meanwhile, the importance of growth for China is usually framed in terms of providing jobs to maintain social harmony, but an expanding economy is also critical for China to avoid being overwhelmed by its debt burden, particularly if entrenched deflationary forces in the industrial sector spread.
Looking ahead, it will be key to watch for further moves in fund flows. Merrill Lynch says not just a decline in interest rates, but also a slowing in the upward momentum of the domestic stock market, could encourage Chinese investors to move their money overseas.
If this happens, it could make it impossible for Beijing to ignore the “Impossible Trinity.” A strong currency might need to be sacrificed to allow monetary policy to be effective. Surely, few would be surprised if China becomes the latest large country to resort to quantitative easing.
In such circumstances, watch out for mainland Chinese funds going into Hong Kong dollar assets (both property and stocks), as this could also pressure the currency peg upwards.