Someone around here has been predicting this for quite some time
by Anne Stevenson-Yang and
March 14, 2016 12:17 p.m. ET
After initial declines in the Chinese market to start the year, the past few weeks have seen signs of what some would call a rebound. Lending in China rose by 67% in January, iron-ore prices initially rallied by 64% and housing sales in the top four markets surged. The yuan gained back half of the nearly 7% it had lost against the dollar since November, sending hedge funds that had shorted on the currency running for cover. And yet there remains no sign of life in the underlying Chinese economy.
More than $800 billion in credit that had been pushed into the economy in January failed to boost production or increase sales. Producer prices remained negative, dropping 5.1% in January-February, while the manufacturing PMI fell to 48 in February from 48.4 in January, indicating worsening contraction. That’s because the rally was the result of a coordinated government effort to restore confidence in the China Dream of limitless growth at home and glory abroad. The market, apparently, isn’t so easily convinced.
From hiding capital outflows to propping up real-estate values, manipulating futures markets and squeezing short-sellers of the yuan, Chinese authorities have been trying to bring back the old, quasisuperstitious belief in Beijing’s omnipotence. But the political desperation behind these efforts betrays a different story: that an impending currency crisis is a signal of the dream’s undoing.
That’s why in China getting money out of the country is now the major preoccupation of both families and corporations. Risk-averse individuals are trading out of the wealth-management products they used to buy for 10% yields and moving their money to safety in the U.S., Australia, Canada and Europe. Chinese companies are making extravagant bids for overseas assets such as General Electric ’s appliance division, the equipment maker Terex Corp. , the near-dead Norwegian web browser Opera, the Swiss pesticides group Syngenta, technology distributor Ingram Micro and even the Chicago Stock Exchange.
In the first six weeks of 2016, Chinese firms committed to spending $82 billion on such acquisitions. Last year saw nearly $1 trillion in capital outflows, including a decline of $512.66 billion in the foreign reserves. Although no one is sure how much of China’s reserves are liquid and available, it’s safe to say that, at this rate, China can’t afford capital flight for more than another year.
One way to stem the crisis would be through depreciation. That would be sound policy for the people of China, but it’s a dreaded last resort for a leadership that wants, more than jobs for its people, to bolster buying power and save political face overseas. Yet history shows that holding the line on the currency is a losing strategy. Tightened liquidity causes more pain to the economy and simply delays the inevitable.
National leaders, when faced with a disorderly adjustment, will inevitably resist markets, promise major structural changes (which are then slow to materialize), inject liquidity into financial markets and insist that everything is under control. But these measures rarely work and in fact have never worked when imbalances are as severe as they are in China today.
In other countries, currency crises usually followed a sudden and irreversible loss of confidence. The Asian Tigers were booming and then fell apart rapidly. Same in Russia. China faces the added difficulty of having little institutional memory and few tools to manage the economy in a time of capital scarcity. And there is no sign that capital-outflow pressure will ease.
And so a painful adjustment will be unavoidable: Property values will decline by an estimated 50% from the current reported average of $142 per square foot in tier-two cities, roughly equivalent to the national average in the U.S., where incomes are much higher. (Current price-to-income ratios in China are generally over 20, while the U.S. averages about three.) Excess industrial capacity will shut down. People will lose their jobs.
But Beijing still has a choice: Either let the yuan take some of the pressure of adjustment, or let all of it fall on the domestic market. Placed in such stark terms, a currency adjustment seems inevitable.
A likely depreciation of at least 15% against the U.S. dollar would take the renminbi back to where it was on the eve of the global financial crisis, before speculative capital inflows flooded into China and drove up the currency’s value. This would be a “reset event” globally. All forecasts for inflation/deflation, interest rates, currency crosses, growth and commodity prices would have to be ripped up and recalculated. It would likely lead to an emerging-markets crash. As a percentage of global gross domestic product, China today is nearly twice the size of Asia (excluding Japan) in 1997.
Commodities, emerging-market equities and multinationals with exposure to China have already started to realize significant losses. Soon major corrections will reach other assets boosted by the Chinese economy, such as property values in Hong Kong and Singapore. When this unfolds, U.S. government bonds may be the world’s only safe haven. The end of the China story is at hand.
Ms. Stevenson-Yang is co-founder of J Capital Research Ltd. Mr. Dougherty is chief investment officer of KDGF Asset Management.