When the China tide goes out
The central bank isn’t in a position to inject liquidity to replace all the departing hot money. Because the Federal Reserve is likely to tighten for three years to come, printing money to replace all the hot money that is leaving would put the country’s exchange rate under mounting pressure to devalue, which may trigger a full-blown financial crisis.Andy Xie doesn't believe a crisis is necessary though:
The bursting of the speculative bubble has had a limited negative impact on the livelihood of the people. China’s position as the factory of the world is solid. The export weakness is due to weakness in global demand, not competition.This is the goal of the new leadership, but the big question is whether it is already too late to transition. What happens if growth slows further, or global trade contracts, or if trade barriers start choking off trade?
As exports are still rising at twice the pace of global trade, China’s economy has a solid cushion from any downturn.
The country is experiencing an acute shortage of manual labor. If the property market contracts, it won’t lead to widespread unemployment.
College graduates are having difficulty finding jobs, but, this is mainly due to the current economic model, which drives growth through construction and factory production. Only changing the growth model can solve China’s problem with insufficient white-collar jobs.
Indonesia printed money to finance capital flight in 1997 and 1998. The country collapsed afterwards, bringing down the government and the banking system. China must learn from this lesson and control money supply.China's problems were much smaller in 1998. Taking bad loans off the balance sheets of banks back then was easy, especially with the economy growing at 10%. Xie goes on to identify what I believe in the main flaw in China's financial system:
In 1998, China refused to print money and devalue. It reformed to deal with the pressure, which gave the country a decade of economic boom. The same could happen now. Just control money supply and reform to handle economic difficulties.
Since the yuan is de facto pegged to the dollar, the outflow is greater than what Brazil or India faces, as hot money outflow is not discouraged by a lower exchange rate.The yuan can resist devaluation for a long time, until it cannot. China can experience greater volatility and appear more stable, but if volatility reaches an extreme, it is China that will experience a cataclysmic event because the rigid systems that maintain stability today will break, just as Thailand's peg broke in 1997.
Another factor working to devalue the yuan is the run-up in money supply:
Further, the rampant monetary growth is losing impact on the real gross domestic product growth rate. M2 rose by 6.1 trillion yuan and the net increase in all sources of financing rose by 6.2 trillion yuan in the first quarter of 2013. But the nominal GDP increased by only 1.1 trillion yuan from the year before.And then we come to the crux of the crisis, why I suggested that the Chinese Yuan Could Devalue 50% Or More:
If China insists on pumping liquidity to replace the outflow of hot money, it encourages capital outflow by holding up asset prices artificially high. As its money supply is five times the country’s foreign exchange reserve and the annual growth in money supply alone is two-thirds of forex reserves, replacing capital flight by printing money can go disastrous quickly.I believe a devaluation is inevitable because I do not see deflation being contained, financially or psychologically. There will be a major decline in social mood that will lead to a crisis of confidence. Whether justified or not, the entire globe will question the Chinese model of growth, just as the world questioned American capitalism in the wake of 2008.
In 1997-98, Indonesia did just that. It even borrowed lots of money from the International Monetary Fund to finance capital flight. When the U.S. dollar reserves dried up, the currency and the financial system collapsed.
When a country faces what China faces now, it can either raise interest rates or devalue the currency. Avoiding both just creates a bigger disaster.
Longer term, I'm optimistic like Xie, but I believe his economic arguments lack the psychological impact of slower growth. For instance, he says lower property prices will only hurt the speculators and corrupt officials holding millions of empty apartments. This is like saying subprime will be contained to California or other markets. When a system swings into reverse, the impact reverberates across the entire economy. All of Chinese business will lose confidence if the market, which has moved for so long in one direction, suddenly starts moving the opposite way.