How yuan devaluation inflates China’s liquidity bubble and kicks structural reform down the road
Andy Xie says the trade war is an opportunity for China to make long-overdue economic changes, such as tax cuts, rather than resorting to pumping in liquidity yet again
China’s renminbi is declining precipitously, down by 6.3 per cent since mid-June and about 10 per cent since April. In the same period, interbank interest rates have fallen sharply. The combination implies that the currency movement is a result of monetary policy change, not external factors.
There is a strong case to be made that China is devaluing the renminbi by choice in response to the trade war with the US. If devaluation is to be the main tool for blunting the impact of the trade war, there could be a lot more to come.
While there are many arguments as to why China should do this, the result would be to pass all the costs of the trade war to the household sector by depressing households’ real income and purchasing power. The government and the state-owned enterprises won’t adjust. Hence, the economy will become more unbalanced. This lays the seeds for more conflicts with China’s major trading partners.
The trade war has increased uncertainty about China’s future. The risk premium on buying from or investing in China has shot up. While some countervailing economic measures are needed to stabilise the situation, these measures shouldn’t create bigger problems down the road.
Investors or buyers are not foolish. If they think that the stabilisation measures would worsen the problems eventually, why would they pay much attention to their short-term stabilising impact? Devaluation is like that. It may induce a sugar high temporarily, but the situation will worsen later.
Cutting taxes and other overheads boosts the economy in the short term, makes it more efficient in the long run and reduces the imbalance within and without. The current situation is an opportunity to implement some long overdue reforms. Personal income taxes, the value-added tax and the social welfare contributions from workers and their employers should be cut by one third.
This would address the fundamental imbalance in China’s economy – low disposable personal income (42.5 per cent of per capita GDP in 2016). To live in harmony with the world, China’s personal disposable income should be raised above 60 per cent of gross domestic product.
Since 2002, wherever there is an economic challenge, China has resorted to liquidity pumping. This inflates property and other bubbles, and the economy then recovers. While this outcome seems to validate the effectiveness of the liquidity policy, distortions accumulate.
These include rising inequality and social resentment over unaffordable housing, shrinking shares of household income and consumption in the economy, overcapacity and the resulting business dependency on subsidies, mushrooming non-performing assets in the financial system, and dependence on speculation for credit creation. These problems force the government to keep pumping in liquidity to keep the house from falling down. The government has been riding this tiger for over a decade.
A big country’s economic policy has global impact. China’s policy of allowing a liquidity bubble to maintain short-term stability is suppressing return on capital worldwide and triggering decapitalisation everywhere else. It leads to big trade surpluses for China that sustain its liquidity. A big blowback from the world against China is just a matter of time.
Devaluing the renminbi means China is going back to its liquidity bubble. This may fuel the property boom again and boost government revenues to fund more investment. The economy may tick up for a few quarters, which would validate the policy effectiveness for some. But it worsens the existing problems.
China’s housing stock is probably over six times GDP value, just as Japan a quarter century ago. Household debt is already 115 per cent of household disposable income and, if the trend continues, will hit 200 per cent in seven years.
Even if the country can sustain the bubble for another seven years, the global blowback could destroy speculative confidence. The current stock market crash is a sign of that. The stock market didn’t adjust fully after it popped in 2015. The government used its own money and coercion to keep the market up. So, the current market crash just reflects the unfinished business from 2015.
Still, a crisis of confidence is the trigger. Far more serious is when this confidence crisis spreads to the property market. At least half of China’s credit is backed by property. The property market could easily fall by over half on valuation normalisation, which would lead to a full-blown financial crisis.
The trade war is an opportunity to address China’s structural problems, not an excuse to extend the liquidity bubble. Any new policy should decrease the structural imbalances within and enhance harmony with the world outside. One obvious effect of devaluation is to destabilise emerging economies that have been China’s friends.
This is the time to strengthen, not break friendships. Structural reforms, not devaluation and bubble inflation, is the way forward. And the required structural reforms are much fewer than in 1998.
When the 1998 Asian financial crisis occurred, the value of China’s trade competitors’ currencies dropped massively. The government then recognised that tit-for-tat devaluation would amplify chaos and hurt China in the end. The right way forward was to restructure the economy to improve efficiency. It led to privatising housing, recapitalising banks, corporatising state-owned enterprises and joining the World Trade Organisation. These reforms laid the foundation for the rapid growth in the next two decades.
China needs to shrink the share of the state sector by half, a must for the country to live in harmony with the world. Domestic politics seems to have a powerful influence on determining economic structure. It appears impossible to change the status quo. But not rising to the challenge means chaos and collapse down the road. Change is inevitable, whether it is chosen or forced.
Andy Xie is an independent economist