Synopsis: How should China deal with its economic problems?

This post combines two articles by The Economist. Click here and here to read them.

Discussion:

These two articles discuss the current problems China is facing, potential solutions and its consequences.

China has been showing cracks in its economic structure for the past six months, and with the stock markets crashing on January 4 2016 and an increased debt-to-GDP ratio of about 300%, the problems with the Chinese economy are now being closely watched by everyone. According to the article “Rocks and Hard Places” (RHP), however, it is the foreign exchange market that bears watching for those wishing to know about the state of China’s economy.

China’s pegged exchange rate is much higher than its exchange rate would be in a floating system, and many believe that devaluing the yuan and bridging the gap between the real exchange rate and the current one would ameliorate the economy.

Asian countries during the Asian financial crisis faced a similar predicament to the one China is facing – According to “Fight or Flight” (FF), investor outlook turned from bullish to bearish, resulting in a great outflow of capital. Thus, reserves dwindled and the governments could no longer maintain a pegged currency. The key difference between those Asian countries and China is that China has, and has had for a while, tight capital controls. According to FF, during China’s great boom in the 2000s, foreign direct investment (FDI) was permitted while hot money was tightly controlled.

These preventive measures did not stop the depletion of China’s reserves – now down to $700bn, “thanks to capital flight and sinking asset values” (FF). An increase in China’s outward FDI paired with a decrease in inward investment resulted in the lowest net flow of inward investment since 2000.
​
While China wishes to impose tighter capital controls to prevent a dwindling of reserves and tightening of domestic credit (explained in ‘context’), there is “no painless way to do so” (FF).
In terms of exchange rates, the Chinese can either keep the exchange rate steady or devalue the exchange rate. Keeping the exchange rate steady is a feasible option as China has $3.3tn in reserves. Here are the consequences for either action:

In terms of strengthening capital controls to reduce leakages, the Chinese government is already cracking down on banks in Macau and Hong Kong to keep them from helping leak money from China. If leakages increased, the government could decrease the cap on foreign transfers. This, however, would deter foreign investors, which would undermine growth.

However, according to RHP, these trade-offs to rebalance the Chinese economy are only short-run. Strengthening capital controls by locking down the capital account in the long-run could be vastly beneficial: free from the pressures of the global markets (explained in ‘context’), the government could “clean up bad debts and push through structural reforms needed for long-run growth”. In fact, locking down the capital account would result in unfreezing those accounts during a time when the Fed is not raising interest rates, which would deter investors from moving their money to the U.S.

Chances are, however, that if capital accounts were locked, the government would do little to implement structural reforms but would instead use it as an excuse to “rollover bad debts and delay reform” (RHP), i.e. following the Japanese path (explained in ‘context’).

In fact, despite the fact that locked capital accounts would allow for more flexibility in China’s monetary policy, the government “would find itself cornered” (RHP): once interest rates and reserve ratios were near zero, QE would lead to a further imbalance in the economy. The government would have to respond with massive fiscal stimulus or depreciation to allow for further monetary policy, all of which are irreversible actions for a few generations to come.

Instead, China may have a slightly less bitter pill to swallow. Given its capacity for lots of fiscal stimulus (government debt is low; thus, the government has room to borrow and then spend), it could force banks to “recognize bad loans, close insolvent businesses, and use that capacity to ease the pain on creditors and shore up banks” (RHP). This, still, may result in a sharp slowdown of growth, and perhaps even a recession. However, these are pills that other countries have followed and survived through. The question is whether the Chinese government was built to cope with such drastic measures (explained in ‘context’).

At the current time China is not facing an imminent crisis. It has “ample reserves, capital controls, trade surplus and a determinedly interventionist state” (FF). Increased purchase of foreign securities may, in fact, decrease the effect of depreciation on debt (explained in ‘context’). However, it remains that should China ever come to face such a crisis, its results would be disastrous.

Key Terms:

1. Capital account: a sum of private and public investment flowing in and out of a country.

2. Reserve ratios: a ratio of all deposits into a bank that must be held by the central bank. China’s reserve ratio is currently at 7.5%.

3. Bullish vs. bearish: Bullish means upward trending while bearish means downward trending.
4. Hot money: money that can be liquidated immediately. This is unlike FDI, which can be liquidated after a set amount of time (usually a few years).

5. Hard currency is the name for dollars, euro, yen, i.e. the more important currencies.

Context:

​1. What is the relationship between reserves and a pegged (or fixed) exchange rate? An exchange rate is pegged by the central bank’s buying or selling the domestic currency.

Let the supply and demand for yuan be denoted by S and D respectively. This results in a quantity of yuan in the market Q and exchange rate E. A decrease in the demand of yuan from D to D’ would lower the exchange rate to E’, where the quantity of yuan in the market is Q’. For the PBOC to increase the exchange rate back to E, where it was earlier, it has to decrease the supply of yuan. To do so, it has to sell other currency that the PBOC keeps in its reserves in exchange for the yuan, leaving less yuan in the market at S’. The exchange rate is once again E.

Thus, if China wishes to maintain its exchange rate, it must keep selling off its reserves, i.e. a depletion of reserves.

2. Why is there capital flight in China? This is because of investors’ fear that China is slowing down and their subsequent wish to withdraw investments from China and invest elsewhere.

3. Why do tighter capital controls lead to a “tightening of credit”? The amount of bank deposits will decrease, so banks cannot make as many loans; thus, credit conditions tighten.

4. If a decrease in exchange rates would not increase exports, why did China do so well during its more prosperous periods? When China faced good growth, it wasn’t the devaluation of the yuan that made it so successful (the yuan held steady). At that stage, there was enough capacity for exports to grow, with enough demand. After the GFC, China could not export as much because of decreased demand. They turned to investment, which is now faltering.

5. Why does purchase of foreign securities “hedge firms with foreign-currency debts against depreciation”? If firms have foreign currency debts and the currency depreciates, the debts increases. If firms have foreign assets, then it would reduce the impact of the debt.

6. Why would locking down the capital account free China from the “pressure imposed by global markets”? Without the capital lockdown, at sight of a higher interest rate in the U.S., investors would take their money from China and invest in the U.S., but with the capital lockdown, whatever the global market decisions are, a certain amount of investment stays in China.

7. How would China follow the Japanese path should they fail to implement structural reforms? Before Japan’s deflationary spiral, Japanese banks had bad debt and didn’t have them written off, leading to deflation.
​
8. Why would China not be built to deal with the drastic measures proposed by The Economist? The problem is that China is communist: they’ll give people jobs, security, etc. as long as they don’t question the government. A loss of jobs thus leads to a criticism of the Chinese government, a risk China may not be willing to face due to fear of political reform.

Synopsis: What China’s recent devaluation has to say about the state of the Chinese economy.

Click here to read the original article.

Discussion:

This article discusses the recent devaluation of the Yuan by the People’s Bank of China (PBOC). The reason behind this could be twofold: either to move the Yuan towards the market rate, thus moving the economy towards reform, or to make exports more competitive, thus helping China’s poor growth recover. Both are equally plausible: China is facing a more pressing need to shift its economy from an export-led one to a domestic demand one. Moving the Yuan towards the market rate helps shift the economy. However, as China has been facing increasingly disappointing export rates, the devaluation may help pick it up. Future moves by the PBOC will tell which one China is more concerned with. Such moves may include how China reacts to a market rate appreciation or how it reacts to future problems that could be solved by currency manipulation.

This move causes major political repercussions. The Fed’s interest rate hike is likely to happen in September, but this devaluation may postpone this increase. Therefore, the subject is bound to occupy many presidential debates. Furthermore, China’s leadership has been hoping to become an official reserve currency, which is less likely at the face of the devaluation.

Context:

1. It is important to understand, firstly, how devaluation could help the export sector of the economy. A currency that has been recently devalued causes the prices of all domestic goods and services to be relatively cheaper in foreign countries, thus encouraging foreign countries to purchase more domestic goods and services, i.e. the domestic economy is now exporting more.

2. In the second paragraph, the article cites “many other efforts to boost the economy”. These efforts are mainly:
      1. Cutting interest rates 5 times in the last 12 months. The interest rate is currently 4.6%. Note that this is expansionary monetary policy.

      2. Cutting the bank reserve ratios. Reserve ratios are a legally mandated percentage of all deposits that must be held with the Central Bank. In other words, if I were to deposit some money into a local bank, a certain percentage of that deposit must be held with the Central Bank, while the rest can be given out as loans by the local bank. In China, this percentage is 18%. Reducing the reserve ratio means that more money can be lent out by the local bank, thus encouraging spending and boosting up GDP and growth.

3. This article also mentions China’s wish to be an “official reserve currency”. All countries hold reserve currencies in the form of GBP, USD, Yen, Euro and SDRs. SDRs, Special Drawing Rights, are a concept created by the IMF, and act as a currency that can be used in foreign markets. The IMF explains it here. China wishes to be an official reserve currency.


4. The Treasury Department, U.S. Congress and some American businesses all claim that the Yuan is artificially low – that it should be higher. It is important to understand that this has no economic backing, but is used as a political tool to gain support. According to the IMF and international markets, the Yuan is moving closer to the market rate by being devalued.

5. According to this article, China’s cabinet has been “[offering] tax breaks and other incentives to help the trade sector.” These tax breaks and other incentives fall under the umbrella of fiscal policy.

Synopsis: Are on-off capital controls really a good idea?

Click here to read the original article.

Discussion:

This article discusses the flaws with having on-off capital controls. Capital controls (defined in ‘Key Terms’) are, and have been, a big debating point. Currently, Russia is trying to soften the blow of the oil price’s plunge on the rouble by “imposing limits on currency conversions”, and Iceland is easing the restrictions on its capital controls after the financial crisis.

For a long time, capital controls were frowned upon, until 2012, when the IMF gave its stamp of approval, saying that it is okay “under certain circumstances”. Many argue that the problem with capital controls is that it “breeds inefficiency”, i.e. those who have excess savings cannot give it to those who need the money for investment. It is, they argue, a form of allocative inefficiency.

In the 1990s, when Mexico and Asia were faced with a sudden influx of cash, they realised that this influx led to uncontrollably high exchange rates and asset prices. Furthermore, when it finally exited these economies, it damaged financial stability.

Now, there is general consensus that capital controls are needed, and that they should be “targeted and limited”, such as having minimum stay requirements or taxes on short-term borrowing. Additionally, many believe that capital controls should be counter-cyclical, which is to say that when there is an influx of cash, controls should be tightened, but when there is an exodus of it, controls should be loosened.

While this solution may seem neat and tidy at first, there are three major underlying problems with it.

The first is that many can find ways around capital controls. One example of this is in China, which has very stringent controls, and little tolerance for short-term borrowing. Yet, the Bank for International Settlements (BIS) has found that, in June, international bank lending to China has reached $1.1tn. This is because many investors are sneaking around capital control laws by issuing debt via foreign subsidiaries, and thus, loans are being disguised as FDI. This point is explained in more detail in ‘Context’. Furthermore, as the amount of FDI going into China is already extremely high, it is not hard for firms to disguise loans as FDI; nobody will notice.

The second biggest flaw with counter-cyclical capital controls, i.e. on-off capital controls, is that it ignores the revealed preference of the countries. Records have shown that many economies prefer easing barriers to outflows.

Joshua Aizenman of the University of Southern California and Gurnain Kaur Pasricha of the Bank of Canada (quoted in the article) have studied 664 cases of changes in capital flows and have found that governments much prefer easing restrictions on outflows, which happened 274 times, substantially more than any other type of change. While, in theory, easing restrictions on outflows has the same effect as blocking inflows (net inflows decline), the former shows confidence in the economy through a looser leash on the economy.

The third point against counter-cyclical capital flows is that there is little relationship between capital controls and inflation or growth, i.e., they are not counter-cyclical. During the global financial crisis, in fact, some countries such as China and Indonesia loosened restrictions as their economy boomed, which is not counter-cyclical at all.

Furthermore, in 2009, Brazil tried increasing capital controls to slow down the real’s appreciation, by imposing taxes on debt and equity flows. In fact, the real appreciated at the same pace as before the capital controls were in place. Instead, as seen by the sudden increase in FDI, investors just found other ways to get the money past the barriers.

In all, while in theory counter-cyclical capital controls seem like a good idea, it is not so.

Key terms:

Capital flows: This is the flow of capital in and out of a country by investors investing in assets. For example, if the British economy is doing very well, investors in America would want to buy assets, e.g. houses, by trading in USD for GBP. This is an influx of capital. When the British economy is not doing as well, the American investors would sell the houses and trade GBP back for USD, which is called an outflow.

Context:

1. In 2012, the IMF gave its approval for capital controls under the correct situation. Before that, during the Asian Financial Crisis, the IMF had aided the damaged economies by giving them loans, under conditions that government spending decreases, taxes increase, etc., and that there were no capital controls. Malaysia’s Prime Minister at the time, Mahathir bin Mohamad, had disregarded the IMF’s terms, and imposed capital controls anyway to protect its economy. The result was that Malaysia recovered at around the same time the other countries did, but the Malaysian economy suffered much more during the Asian Financial Crisis. People who support capital controls often cite this argument.

2. What does the phrase “issuing debt via foreign subsidiaries” mean? First of all, a subsidiary is a company that is either partially (50%+) or fully owned by another company. With that in mind, this phrase can be best described by the diagram below:

In this diagram, we can see that a subsidiary is offshore, i.e. outside the country. In this example, the country is China. The foreign subsidiary borrows from a foreign bank, which has much lower interest rates than China does, and gives the money to the holding company as an equity investment. An equity investment is a type of FDI where the subsidiary purchases an asset from the holding company, such as a factory or a machine. China does not like domestic companies borrowing money from other countries under the fear that, especially because the loans are usually short-term, they will not be able to pay back. China does not mind FDI, as it is in the form of equity investment. So, cash comes in from the subsidiary as FDI but is actually a loan. As pointed out in the article, the holding company must find a way to return all the money to the subsidiary plus interest, so that the subsidiary can return the money to the foreign bank. That is a large challenge.

Synopsis: Is China’s productivity slowing down?

Click here to read the original article

Discussion:
This article discusses the source and extent of China’s productivity slowdown. In other words, to a large extent, China’s slowing economy can be blamed on disappointing growths in productivity. For the past few decades, China’s boom was caused by an increase in labour and capital, as opposed to an increase in efficiency. The measure of where the source of GDP is from is TFP (total factor productivity), which is, according to the article, “subtracting the change in capital and labour deployed from the change in overall output.” I will discuss the problems with this statement later.

Between different people are differing opinions on China’s TFP. Mr. Harry Wu, an economist who has done a lot of research on the shortcomings of Chinese official data, has a pessimistic opinion (which, itself, faces a plethora of problems given the assumptions he made) and cites a negative TFP, while the World Bank’s more hopeful one shows a slowdown in TFP, even if it is positive for the time being.

Exacerbating China’s problem with a showdown of productivity is China’s bad lending and investment decisions. China’s best firms do not have the credit they deserve. With TFP and ICOR (explained later) increasing, China is likely to face large problems.

Key Words:
1.       ICOR: Incremental Capital-Output Ratio is the measure of how much investment is needed to increase growth by a percentage point.
2.       TFP: Total Factor Productivity, as I said earlier, is stated to be the difference between the change in capital and labour and the change in overall output. Math students will understand the problems with this statement. What does subtraction mean? (The figures in the following tables are not based on actual data).

Does this mean the TFP is 20%-10%=10%? Because this is what the article says. What I have calculated is the change in GDP and the change in input, and I have subtracted the two, as per the instructions of the article.

This is how TFP is actually calculated:

TFP Calculation 2:

So, the TFP is now 2.1818/2=9.09%

The difference between the two methods is that firstly, there is no subtraction in the second calculation, and secondly, it is not the change in GDP per year by the change in input per year as the first table would suggest, but rather, the change in ratio between GDP and input per year.

The difference between 9.09% and 10% from both tables might seem negligible, but on a large scale, this could make a large difference.

This is not to say that the writer did not understand how TFP was calculated; his or her phrasing was merely meant for readers to understand the general concept. I think it is important to notice these small differences, though.

Discussion:
This article describes the influx of Chinese investment on Europe.  As part of its outbound investments model, Chinese investment has increased multifold.

One problem the Chinese are facing with investment abroad is the presence of labor and environmental laws. Usually, such laws are overlooked in China. Nonetheless, it is likely that investment in Europe will steadily increase.

Still, Europe may be getting in its own way, in that it might be discouraging the Chinese from investing in the EU. The EU has so far been benefitting with the influx of investment, especially into those countries who have been hit the hardest by the debt crisis (the PIGS countries – Portugal, Italy, Greece and Spain). But Europe is unwilling to sell China it’s more advanced technology and does not have much else to offer China.

Regardless, it is clear that private investors are entitled by the reduction in asset prices in Europe, and it is clear that Chinese investment in Europe will increase with time.