Concerns that an economic hard landing in China could force Beijing to massively devalue the renminbi have receded since the start of the year but remain in the background. Such a development would send shockwaves through global financial markets. Some investors continue to wonder whether Beijing is losing control of its economy and currency.
If we focus on the traditional macroeconomic indicators, such as growth in industrial output, electricity consumption, freight volume and steel and cement output, they do paint a hard-landing scenario for China by showing either anaemic growth rates or outright contraction. However, they only represent China’s old industrial and manufacturing-based economy. The new economy, which is represented by the service-based tertiary sector became the largest category of GDP in 2013 with a share of 46.1%, while the secondary sector still accounts for a sizeable 45.0% of the country’s total output. This development suggests to me that creative destruction is underway. The traditional macroeconomic indicators have failed to capture the structural changes. The fact that China is going through a difficult transition from the old to the new economy with some setbacks in financial reforms does not necessarily spell an economic crisis.
The dichotomy in China’s economy is also apparent in electricity consumption and railway transport. While electricity consumption by the old economy has been contracting, usage by the new economy has been growing steadily. Meanwhile, passenger traffic (which is related to the new economy of personal travel and domestic tourism) has been growing briskly but freight traffic (which is related to the old economy of transportation of industrial goods and materials, etc.) has been falling. The trouble at this stage is that the new economy is neither large enough nor strong enough to offset the contraction of the old economy. This argues for a policy-easing bias until economic momentum stabilises.
Further, China’s progress on economic restructuring has been accompanied by setbacks in its financial reform, notably the bursting of asset bubbles and a clumsy renminbi policy shift. All this has led to an exodus of capital recently. However, setbacks do not mean crises. Beijing is walking a fine balance between sustaining GDP growth and implementing structural reforms. The resultant creative destruction is dragging on growth and creating volatility. This situation should not be seen as a sign of Beijing losing control of the economy.
What about the currency? Some market players have used the Impossible Trinity theorem to argue that with capital fleeing China, it is not going to be possible to maintain a stable renminbi and ease monetary policy at the same time. If Beijing wants to cut interest rates to stabilise domestic GDP growth, it would have to allow a sharp devaluation in the currency, the pessimists argue.
However, the application of the Impossible Trinity analysis to China is flawed. I do not see signs of capital flight. Otherwise, one should have seen a significant depletion in domestic deposits, which has not been the case. More crucially, the Impossible Trinity is not as pressing a constraint on China as many have claimed. Despite the seemingly big strides that China has taken in recent years, its capital account is still relatively closed. Most of the liberalisation measures have been aimed at institutional and official institutions’ investments. Beijing has only been opening up the capital account in an asymmetric fashion by allowing capital inflows but still restricting capital outflows.
Sure, China lost about USD 700 billion in currency reserves last year, despite a surplus in its basic surplus (current account balance + net foreign direct investment inflows). But a big chunk of the decline came from the valuation effect, Chinese companies repaying their foreign debt and a one-time transfer to recapitalise the policy banks (three new “policy” banks, the Agricultural Development Bank of China (ADBC), China Development Bank (CDB), and the Export-Import Bank of China (Chexim), were established in 1994 to take over the government-directed spending functions of the four state-owned commercial banks). There is no denial that there are capital outflows from China, but they do not signify Beijng losing control of the renminbi. Since there is still no full capital account convertibility, China’s monetary policy will only be partly compromised if the People’s Bank of China wants to keep the control of the renminbi in the medium-term.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.
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