The debt problems in the US have provided challenges for China but, according to Jonathan Wu, there is every sign that the Chinese Government will adopt an appropriate response.
The events of the past few months have created a whole new level of volatility in the markets which, although not reaching the levels of the global financial crisis (GFC), has served to create ongoing uncertainty.
Since the striking of the “deal” with the US debt problem in early August, the market is still pricing in a lot of uncertainty and still lacks visibility – with Europe still playing a game of musical chairs with its own debt.
The question we pose at this point in time is, with the US credit rating being slashed from ‘AAA’ to ‘AA+’, what is the impact in reality? This article discusses its impact on China, and potential strategies the Chinese Central Government could utilise to deal with the challenges that lie ahead.
First and foremost, let's provide some context. The Chinese Government now holds over US$3.2 trillion in foreign reserves, of which just over US$1 trillion is in US Treasury bonds. Most countries need only around six months of reserves to cover import needs, but China is well in excess of this.
China is a very unique case when it comes to dealing with its accumulation of foreign reserves. As Chinese companies are selling their goods outside their own borders, they are usually paid in US dollars.
In most other nations, the bank which receives this foreign currency has the flexibility to find the best return.
But in China, the banks need to exchange this money with the PBoC (Peoples Bank of China) or our equivalent RBA into yuan, which then moves it to SAFE (the State Authority for Foreign Exchange), which has the power to control the flow of these reserves.
This process is very important to understand, as the Government will continue to face challenges related to this “sterilization of yuan”.
Trade surpluses over the years have largely been a factor of an undervalued Chinese yuan. This has meant that as Chinese exports are cheap, and competitive, they will exceed the level of imports.
Given the fact the country already has such vast reserves, there is no real requirement to keep building them up, and this in itself does pose a tough situation for the Government on many fronts.
On one hand, as part of China’s five-year plan starting this year, they want to be able to run a trade surplus of zero by 2015. This will solve the accumulation issue of foreign reserves, but appears very ambitious.
The one major problem keeping them from doing so is the internal printing of RMB, due to that aforementioned conversion system by the PBoC and SAFE (this is very different to the US printing money though).
To keep the RMB undervalued, the printing of excess RMB causes inflation to feed through into the economy as liquidity is abundant (especially compared to their Western peers). This is the situation that China has been facing consistently for a number of years. There is no ‘magic pill’ or policy to solve this, but we’re not here to talk about inflation.
The Chinese now have a tough choice to make. From a political perspective, the Chinese population now understands the concept that the Chinese have effectively funded the latest rounds of the US war machine, the endless spending, and the massive social security safety nets the US public live off – and they are not happy.
China’s official news agency Xinhua stated on 6 August, “the days when the debt-ridden Uncle Sam could leisurely squander unlimited overseas borrowing appeared to be numbered.” The population simply doesn’t want to continue funding the US with little or no return (especially with the long-term structural decline of the US dollar).
China, in the last few months, has diverted its foreign reserves to buy Japanese sovereign debt. But this creates two problems flowing on from the political perspectives.
With less support for US bonds and thus demand, the US dollar declines, and the $1 trillion in US denominated bonds that the Chinese already holds devalues. This doesn’t directly impact the internal Chinese economy, but certainly deteriorates the paper value.
For the US, if the above strategy is taken, the impacts are far more wide reaching. With the drop in the US dollar value, this will lead to a further bulk sale of US treasury bills, which then would lead to bond prices dropping, coupled with the natural increase in yields.
The tragic consequence of this is the fact that mortgage rates are determined in the US by government bond yields, which will make housing affordability worse than it already is. Rubbing salt into a wound, by comparison, seems like a better option! Ultimately, this will lead to a further devaluation of US property prices.
Over time, the Chinese will diversify their US-denominated assets, but any meaningful diversification will still take at least a decade.
One must always keep in mind that there aren’t many ‘safe’ haven sovereign bonds left in the world.
So ultimately, the Chinese do need to move to a zero trade surplus strategy. In the past five years, China has learnt a lot about how to ‘not’ manage an economy, and avoid the traps seen in the West.
Now that a lot of spending has occurred in infrastructure and utilities, the Central Government is trying to increase disposable income at least at the speed of GDP growth to ensure the movement from an export-orientated economy to an internal consumption one chugs along solidly.
Without this, the Chinese Government can foresee that external economies will not, or may not, be willing to save China if that day was to come.
China, fortunately from our perspective, still has a potential to operate a strong export market, as well as to boost discretionary spending through an increase in disposable income. The aim would be to move manufacturing from the coast into the interior (which reduces labour costs, but increases income for those in rural areas, thereby increasing disposable income).
This is already beginning. The Government has launched subsidy plans for relocation of production plants, as well as tax holidays for those to have the motivation to move.
Finally, comes China’s environmental cost of continuing to drive the manufacturing market in order to generate higher consumption internally.
Even with solar, wind and nuclear power investment, the country’s increasing standards of living mean many will also be consuming more power resources, putting more pressure on the environment.
What we need to see developing is a way for China to move more GDP to service-based and high-tech industries to offset losses in manufacturing production. We haven’t seen this move very much in recent times, but we will wait and see.
So even with China’s growth roaring strongly, there are still headwinds to consider which will also have flow-on effects into Australia. These headwinds, no doubt, will iron out over the long -term, and if there is anything we need to convince investors of in this environment, it is to re-focus on the long-term.
Jonathan Wu is associate director of Premium China Funds Management.
