China’s liquidity trap
China’s huge forex reserves conceal a series of very real problems coming from low returns on invested capital, reliance on foreign capital for growth, a low value-added percentage in Chinese exports, and very high debt levels during a period of hyper-growth, when debt should be reduced. We take a look at articles in the FT and the Telegraph which give us some interesting background.
In the course of a fascinating article in the FT about Treasury Secretary Snow’s quiet diplomacy in getting a yuan revaluation, we discovered several nuts to squirrel away for future use:
A recent paper prepared for the Bank For International Settlements found that capital inflows aside from foreign direct investment have accounted for nearly half of China’s huge forex reserve accumulation since 2003. Countless individuals and companies using a range of tactics from simple cash smuggling to false corporate accounting to evade tough capital controls. And much of the inflation-fuelling funds flow into sectors such as property that may already by experiencing speculative bubbles….
China mainly assembles imported parts and components manufactured elsewhere. The local value-added in its exports is as low as 15 per cent. Any loss of competitiveness from a stronger exchange rate would be largely offset by cheaper imports. Even a 25 per cent revaluation would raise prices of many Chinese exports by only about 4 per cent.
But the main reason for China’s surplus is its savings rate. At more than 40 per cent of GDP, and 25 per cent of household income, it is among the world’s highest and vastly exceeds existing investment needs. While that imbalance remains, so will the current account surplus.
The imbalance is aggravated by China’s primitive financial markets and state-owned banking system. Because the choice of domestic savings vehicles is narrow, and strict exchange controls limit capital outflows abroad, much of the excess savings ends up in bank accounts paying meagre rates of interest. That provides a huge pool of low-cost capital for investment. However, it is invested inefficiently: to increase economic output by $1, China has to invest $5, a very high ratio by international standards. That is largely because its banks are still struggling to modernise and are plagued by corruption and fraud.
China has huge amounts of money sloshing around in its central bank, but that liquidity masks some serious problems. It has $700 billion in forex reserves, much of it from the aggressive investments by Western and Japanese firms in China. But the investment money has not been very productive as the 5:1 ratio shows. Moreover, China’s value-added to its exports appears to be quite low, perhaps only 15%.
As investment returns continue to decline in China from their already low level, capital flows decrease significantly. This normally leads to problems in countries with export-led growth, and China is already highly leveraged, even with its two decade track record of 9% annual GDP increases. George Trefgarne in the Telegraph spells it out for us:
By pegging the yuan to the weak dollar, the Chinese authorities have caused a massive misallocation of capital. Foreigners have poured fixed investment into the country. And the locals have responded by opening up factories of their own. The result is oversupply in sectors such as electronic goods and textiles. The situation has been made worse by Chinese banks, which are all state-run, and which offer cheap loans to well-connected local entrepreneurs. Many small Chinese companies are struggling to pay their debts. Although the official debt to GDP ratio is just 25 per cent, if you add in bad debts hidden in the banking system, it is nearer 65 per cent. For every British chav, there are several Chinese workers employed by a businessman whose cousin is close to some local Communist bigwig, hoping that the bailiffs do not come knocking…
We began saying earlier this year what Barton Biggs has been saying for three years or so: China’s growth under these circumstances is unsustainable without a blip to correct the imbalances that excessive liquidity and poor capital allocation generate. Usually, but not always, these corrections occur when there is a tightening of monetary policy; in any event, they nearly always take people by surprise when they happen. Perhaps the yuan revaluation could lead to such a triggering event. Hard to say. We’ll wait and watch.