The lifecycle of your liberalised yuan | FT Alphaville

The lifecycle of your liberalised yuan

The assumption for a long time has been that when a free floating yuan is finally born step 1 on its journey would be a joyous rush of capital inflows sweeping it upwards as foreigner investors finally got to jump into China with both feet.

But, as we’ve been arguing for a while, that might not be true anymore. Diana Choyleva of Lombard Street seems to agree:

The global financial crisis has changed the rules of the game. Over the past five years China has lost its competitiveness and the yuan is currently overvalued against the dollar and on a trade weighted basis. China’s export sector is reeling as not only the global trade pie is growing at a much slower rate, but China’s ability to carve out ever larger parts of it is gone.

China’s current account surplus has gone down to 2.2% of GDP in the third quarter of 2013 from 10.1% in 2007. The direction of causation between the current account and the yuan has been consistent since China joined the World Trade Organisation in 2001. Current account surpluses led to pressure on the yuan to appreciate. In July 2005 the PBoC moved to a managed peg, allowing a gradual appreciation of the currency. Capital inflows were enticed despite the closed capital account and the PBoC continued to intervene in the FX market and pile on huge foreign exchange reserves.

But during the five years since the financial crisis the story changed as real GDP suffered a sharp structural slowdown, which we’ve explained in numerous publications. As domestic investors lost faith in the economy, 2012 saw the largest capital outflows on record. The economy reached a major crossroads. The need for reform became acute if China is to avoid a major financial crisis within two-three years time.

And so we got a plenum within which liberalisation, sans timetable, plays a seemingly large part. Choyleva’s bet, like ours, is that once the capital account is fully open capital outflows will outstrip capital inflows, driving the yuan down — helping the economy rebalance but severely inconveniencing those who benefitted from the status quo, be it through corruption or otherwise.

As Izzy argued the China demand trend from consumption goods to store of value goods (based abroad) is notable and suggests that China’s purchasing power is excessive in relative terms and has to be abated through soaring prices as those status quo powers in China pay a premium to get cash out.

Choyleva also asks, if not answers, a rather good question to end: will the outflow of yuan that we think is on the way be politically acceptable in the rest of the world even though it will be driven by market forces? We’d suggest: probably.

Why will capital outflows exceed capital inflows? For starters, it’s worth putting the magnitudes in perspective. The US national savings are 2.7 trillion US dollars and Japan’s 1.3 trillion US dollars. China’s are larger than the two combined. Foreigners’ current enthusiasm about China is based on the false perception in our view that reform means growth and opportunity in the short term. The adjustment over the next couple of years is more likely to be accompanied by weak growth, corporate defaults, financial instability and potential social unrest if the leadership doesn’t back off reform. All of the above will discourage foreign investors from piling in.

Meanwhile, domestic investors will be offered the opportunity to diversify their assets abroad in a legal manner rather than trying to evade capital controls. So while capital outflows will not be something new, their size will be much larger if the capital controls are lifted. Chinese people will look to diversify their assets buying foreign assets in search of return and the rule of law. Domestic interest rates will rise which together with the potential success of the reforms could entice capital inflows back into China. But that will be the second step, not the first step. And given the current overvaluation of the currency China needs a lower yuan to help smooth the transition from investment-led to consumer-led growth

Related links:
The China-Debt Syndrome - New York Times
Asian buyers are now major players in the London property market – FT
Why $3.4tn in foreign reserves is not China’s escape hatch – FT Alphaville
Too much appreciation too soon for the renminbi? FT Alphaville