Running out of puff: China can't inflate yet more speculative bubbles to disguise the structural problems in its economy
Andy Xie says China is running out of policy options in its attempt to maintain an impossible position
China's government has just cut interest rates again, demonstrating once more that monetary policy is the country's only meaningful response to the investment bubble bursting. The move comes just weeks after a massive operation to defend the exchange rate. At the same time, the government is propping up the stock market, the credit market, the banking system and all the industries suffering from massive overcapacities. Do the laws of economics apply at all in China?
The "impossible trinity", or trilemma, here says that a country cannot run an independent monetary policy with a fixed exchange rate and free capital flows. Some may argue that China controls its capital account. It is true that the government has shut down underground currency exchange channels, which has lessened some of the pressure on the exchange rate. But corporate foreign debt, cumulative foreign direct investment and offshore renminbi in total are similar to the forex reserves. These monies could all be withdrawn legally. Further, every person can buy US$50,000 of foreign currency from banks per annum. That's six times the per capita income. China's capital account is really open.
China's forex reserves fell by US$329 billion in the first nine months of 2015, while the country ran up a trade surplus of US$424 billion, which would have added to the forex reserves, during the same period. These two numbers roughly summarise the magnitude of capital flight. This is possibly the biggest capital flight in absolute and relative terms that the world has seen in the past three decades.
The government is not dealing with capital flight either technically or fundamentally. When renminbi leaves, the People's Bank of China hands over the dollars and puts renminbi back into the banking system, to stop interest rates from rising. The way to fight capital flight is to raise interest rates. Running down forex reserves doesn't solve any problems.
At the fundamental level, diminishing opportunities for profits is key. China launched a massive investment boom after 2008. It has led to overcapacity virtually everywhere, destroying profit opportunities. The government has manufactured profit opportunities by creating speculative bubbles in the exchange rate, property, credit and stocks, to keep money inside the country.
All these speculative bubbles, perhaps with the exception of the internet bubble, are bursting. The only remaining options are to raise interest rates and undertake a massive devaluation. The former makes it worthwhile keeping money in the country. The latter realises losses upfront, making it too late to run.
Yet, instead, the government chose a worse option: a small devaluation, which sparked panic without increasing the cost of capital flight. The subsequent surge in outflows was easy to anticipate. The outflows have eased lately as the government has been intervening in the onshore and offshore market to manufacture a mini trend of appreciation, which slowed outflows as people paused to wait for more appreciation. But, when the uptrend ends, outflows are likely to resume. The latest cut in interest rates further increases the incentive for taking money out.
China is employing two policy instruments that are not available in other countries: first, killing a chicken to scare the monkeys; and second, turning up the propaganda machine to manipulate perception.
The first option is usually reserved for someone who takes money out of the country illegally. The recent crackdown on underground money exchange channels falls into this category. In 1998, some influential people were caught up in this classic tradition of making an example out of someone. This hasn't happened recently, but probably will.
The trilemma is an impossibility when people are rational. Yet, the Chinese government seems determined to invalidate this assumption. The propaganda machine preys on people's struggle between fear and greed. Whenever people are about to run, the machine spews out all those stories of money-making opportunities and examples of people getting rich. When words alone don't work, the government spends money to manufacture an uptrend like a good pump-and-dump artist.
While the little people can be confused into inaction, those at the top won't be. A disproportionate share of China's wealth, mainly in property and cash, are in the hands of a small elite. They are driving the capital outflows. In 1997-98 a similar elite in Southeast Asia, not the little people on the street, chose to abandon ship and take their wealth offshore. If China wants to prevent a similar crisis, its anti-corruption campaign has to turn towards the core vested interest group soon.
The fifth plenum of the Communist Party's 18th central committee has raised hope for reforms, especially in the context of the new five-year plan. But recent announcements show there will be no serious changes, at least in the near future. China went through a round of radical changes in the 1990s that laid the foundations for its subsequent prosperity. Since 2002, the system hasn't been able to deal with emerging problems, so has allowed them to fester and has manufactured bubbles to hide the consequences.
The reality is that the political imperative is in conflict with economic needs. To move beyond an investment-led economy, China must cut taxes, shrink the government and reform state-owned enterprises. But political insecurity is driving resources further into the government's hands. The alternative model is for stability to depend on people's goodwill, not an iron fist. It is hard to see such a shift any time soon.
Andy Xie is an independent economist