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Trump’s Yuan Mistake And A New Global Debt Crisis

Business, China, Company Strategy, Economics, US
By John Richardson on 16-Jan-2017

ChinaPPMon16Jan

By John Richardson

DONALD Trump is right when he says that China is manipulating its currency. It is just that he misunderstands the direction in which the currency is being manipulated.

Ten years ago, he would have been correct to accuse China of manipulating its currency downwards. Today, though, the opposite applies as China tries to prevent its currency from depreciating any further.

China is no longer worried about making its exports artificially cheap in order to stimulate export-focused manufacturing jobs. Here is why:

  • As last year’s Chinese export data showed, exports as a driver of economic growth are becoming less and less important as wages rise. Higher labour costs have reduced China’s ability to compete in some lower-value manufacturing chains. Another issue for China is a slowdown in global trade growth because of ageing populations in the West.

China is instead propping-up the value of the yuan against the US dollar in an effort to reduce the pace of capital flight Excessive capital flight is bad for economies  as it reduces domestic liquidity and so threatens economic growth. Investors have been pouring money out of China because of concerns about the country’s debt problems and lack of new investment opportunities. This has led to yuan deprecation.

Investors have become convinced that the Chinese currency will further weaken, leading to more capital flight as a hedge against this weakness – and of course further declines in the value of the yuan.

Despite China’s efforts to support the currency, the yuan still fell in value against the greenback by 7% in 2016. It is now at an eight-year low.

Because of interventions to prop-up the yuan, China’s foreign reserves have fallen by a quarter to $3tn since their June 2014 peak. Its reserves are as a result approaching the $2.6tn level which is thought to be the minimum required for day-to-day operations of the economy.  China is therefore very close to exhausting its ability to use reserves to support the yuan.

Another tool it has used to support the yuan has been clamping-down on currency speculators through raising short-term interest rates. Rates for offshore yuan trading were last week at above 80%.

High interest rates cannot be maintained forever because this is raising debt servicing costs during a period when China faces major debt repayment problems.

“From 2009 to 2015, credit grew very rapidly by 20% on average per year, much more than growth in nominal GDP,” wrote the IMF in a December  2016 working paper.

“What’s more, the ratio of non-financial private credit to GDP rose from around 150% to more than 200%, or about 20-25 percentage points higher than the historical trend,” it added.

China’s “credit gap” – the gap between credit growth and the rise in nominal GDP – was comparable to those countries that had experienced painful deleveraging, such as Spain, Thailand and Japan, said the IMF.

 

Emerging Market Debt The New Subprime

The third tool being used to limit the yuan’s rise is capital controls. But is this just another version of the “whack-a-mole” game that Chinese authorities have to constantly play in general against the country’s speculators? Given the constantly adapting nature of speculation in China, can the regulators ever truly really win?

In a sign that the answer to my first question is “yes with the second answer quite probably “no”, it is estimated that some $1.5trn in illegal corruption money made its way out of the country between 1995 and 2013.  This is an addition to the $2trn that has been legally moved offshore over the last few years.

It thus seems inevitable that China will at some point decide to let the yuan free float in value – i.e. it will stop all intervention in order to allow international markets to entirely set the currency’s value.

The theory here is that the yuan will find a floor in international markets. Its stability at a lower level will then limit capital outflows to manageable levels.

How will Donald Trump react, though? A yuan at say 7.3 to the US dollar  -or perhaps even lower as the dollar strengthens on US fiscal stimulus and tax cuts – might well be enough for him to formally label China a currency manipulator and launch a US-China trade war that quickly becomes global.

Or Mr Trump might say, “Hey everyone, look, I was wrong about China and its currency,” and change direction. I would rate this is as a very unlikely response.

It is therefore realistic to prepare for the possibility of a global trade war. This would lead to a vicious downward spiral of an ever-stronger dollar versus the yuan and other currencies – and higher global interest rates – as investors panic and retreat to the safety of the greenback.

The focus will switch to a return of capital rather than a return on capital as it becomes apparent that much of the debt built-up globally since the 2008 global financial crisis (GFC) will not be repaid.

What’s the scale of the potential fallout we are talking about? Corporate dollar-denominated debt in emerging markets doubled to $3.2trn between 2009 and March 2016, according to the latest data from the Swiss-based Bank for International Settlements (BIS). The BIS acts as the central bank for the world’s central banks.

This debt build-up is the result of flawed US Federal Reserve stimulus policies designed to compensate for the impact of the global financial crisis (GFC). These policies had until very recently depressed the value of the dollar and kept interest rates very low, encouraging lenders to lend very aggressively to emerging markets in the search for decent returns. Borrowers in turn overcommitted themselves because debt was so cheap.

“Massive capital flows from advanced economies have contributed to accommodative liquidity conditions in a number of Asian emerging markets,” said the BIS.

“To the extent that this has led to a region-wide accumulation of imbalances, the eventual correction in one country would likely trigger investor retrenchment from its neighbours and test the region’s loss-absorbing capacity,” it added.

China in Q3 last year had foreign currency borrowings of $1.2tn in Q3 last year, more than half which were in US dollars.

This feels very much like the GFC in 2008. But on this occasion, it could be cheap overseas dollar-denominated debt rather than subprime US mortgages that may be the root cause of a new global recession.

As always, we need to model the potential impact on petrochemicals. See above two scenarios for just one year, one product and one country – 2017, polypropylene (PP) and China:

  1. In the ICIS Consulting Supply & Demand database “base case”, demand will rise by 6% over 2016 to around 25m tonnes. Domestic capacity will be at 22m tonnes/year and operating rates at 94%. This will lead to an import requirement of 3.7m tonnes.
  2. My downside cuts demand growth to 3% on the impact of a global recession (is this pessimistic, realistic or optimistic?). The weaker yuan makes imports too expensive and exports more competitive. Local producers thus run their plants at 98%, resulting in imports of 2.3m tonnes.

This is an example of the scenario work we conduct across a wide range of petrochemicals products and regions. For more details contact john.richardson@icis.com.