I finished up yesterday’s essay saying that China has the most to risk in this ongoing trade war. To explain why, I want to show you where it all started…the yuan’s peg to the US dollar.
There’s a long and complex history to all this. So I will keep it simple and generalise to make my point.
It started back in 1994 when China devalued its currency overnight by more than 30% against the greenback, to 8.7 yuan to the dollar. The yuan then strengthened a little, but the People’s Bank of China (PBoC) managed the exchange rate and kept it more or less tied to the dollar up until 2005.
This currency policy formed the basis of China’s mercantilist economic expansion. Holding the currency down allowed it to build up export competitiveness and foreign exchange (FX) reserves.
How does this work in practice?
Well, as now, China ran a large trade surplus with the US. Under a freely floating currency system, those excess US dollars (used to buy goods from China) should put downward pressure on the value of the US dollar versus the yuan.
As a result, the value of the yuan should rise. This in turn would put pressure on China’s export competitiveness and encourage consumption of imports. In other words, the trade imbalance would be moderated a little by the relative change in currency values.
But by maintaining a peg with the US dollar for a decade, this natural adjustment never occurred. Instead, Chinese exporters took their US dollars to the banks to exchange them for yuan. The banks printed yuan (instead of getting the currency from the existing supply) in order to maintain the peg. In this way, the supply of yuan grew.
The PBoC recycled the US dollars back into the US economy by buying US treasuries. The treasuries ended up as FX reserves of the PBoC. You can see in the chart below how these reserves accumulated rapidly following China’s peg to the US dollar in 1994, and especially after its entry into the World Trade Organisation in December 2001.
Source: Trading Economics
The thing that not many people understand about FX reserves is that they form the reserve base of the domestic banking system. They are an asset in the PBoC’s balance sheet, offset by the liability that is domestic bank reserves.
China’s state owned domestic banks utilise these reserves to create domestic credit.
Remember, the US dollar is the world’s reserve asset. It replaced gold in this role in the 1970s. Absurd as it sounds, the US dollar was/is as good as gold. The vast pile of US dollar reserves that China sat on allowed it to crank up its domestic credit machine post the 2008 crisis.
China now has a total debt-to-GDP ratio of 303%, which equates to total debt across households, governments and corporate sectors of more than US$40 trillion, according to Reuters.
Corporate debt accounts for well over half this total. This is where the ticking time bomb lies for China. And it’s where the currency comes back into it.
From 2005 until the start of 2014, the yuan strengthened by around 25% versus the dollar. This occurred via political and financial pressure. As I said, when a country generates large trade surpluses, its currency should naturally strengthen to help correct the trade imbalance.
Over a decade, Chinese authorities allowed the yuan to strengthen within the confines of a ‘managed’ currency peg.
But from 2009, China’s own credit boom took off. This resulted in the creation of huge amounts of domestic currency. Suddenly, China’s currency wasn’t looking so strong.
To see what I mean, take a look at the chart below. It shows the performance of the US dollar versus the yuan since 2008. As I mentioned, the yuan strengthened from 2010–2013. This reflected the initial China boom, resulting from massive stimulus efforts post-2008.
Then the slowdown kicked in, and the yuan gave back all its gains, especially after an official devaluation in 2015. It rallied again in 2017 and weakened in 2018, as the trade war got under way. Now, with the trade war intensifying, the yuan is under pressure again. In yesterday’s Asian trading session it fell to 11-year lows against the dollar.
Although it might not seem like it from the chart above, don’t forget the yuan is still a managed currency. Some say the recent weakness is deliberate, in retaliation to Trump’s tariffs. Some think it’s due to capital flight.
Who knows, it could be both. But I do know that weakening the currency is a high risk play for China.
This brings us back to the debt. Most of it is denominated in yuan. But there is a decent chunk of corporate debt denominated in US dollars. As the yuan declines, the burden of this debt increases. According to Bloomberg:
‘The foreign debt built up by Chinese companies is about a third bigger than official data show, adding to the pressure on the country’s currency reserves as a wave of repayment obligations approaches in 2020.
‘On top of the $2 trillion in liabilities to foreigners captured in official data, mainland Chinese firms have around another $650 billion in debts built up by subsidiaries overseas, according to Bloomberg calculations. About 70% of that debt is guaranteed by entities such as onshore parent companies and their subsidiaries, the data show. The amount of maturing debt will rise in coming quarters, with $63 billion due in the first half of 2020 alone.
‘The prospect of Chinese companies rushing to find dollars to service liabilities comes at a time when authorities have already allowed the currency to sink below 7 per dollar amid a trade war with the U.S. The nation now risks a reprisal of what happened after the yuan’s devaluation in 2015, when foreign-debt servicing contributed to a rapid decline in the country’s foreign-currency reserves.’
If you go back and have a look at the first chart above, you’ll see that China’s FX reserves peaked around 2015. It spent around US$1 trillion dealing with the capital flight that occurred around that time.
And while it no doubt still has significant reserves, remember they support around US$40 trillion in total debt outstanding across the Chinese economy.
US$3 trillion of reserves supporting US$40 trillion of debt tells you the banking system leverage ratio is around 13 times.
If China blows another US$1 trillion fighting this trade war, the leverage jumps to 20 times. That is a hugely risky banking system. China is a developing economy heavily reliant on ongoing credit growth. The question is whether China could manage capital flight in such a scenario without resorting to drastic measures.
This is why Trump is fighting hard in this trade war. He knows China is in a precarious position. It has limited options.
While this will be good for Australia in the long term, it could cause us significant short-term pain. Keep that in mind when managing your portfolio. Commodities have likely ended their two-year plus bull market…
Editor, The Rum Rebellion
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