Monday, December 12, 2016

What's going on in China?

I'm not a macro follower, but the current situation in China is interesting.

Following years of trade surplus, China has accumulated the world's largest stockpile of foreign currency reserves. At its peak in 2014, China held almost US $4 trillion of reserves. However, over the last two years, reserves have declined to $3 trillion.

This could be caused by a combination of weaker trade flows, stronger US$, and major capital outflows. Since China is running an annual current account surplus of over $500 billion, capital outflows may have exceeded $1 trillion annually over the last two years. Should this continue, China's reserves would be depleted in only a few years. The decline in reserves has also affected the RMB which fell from a peak of 6 RMB/USD to 7 RMB/USD today.

China seems to be aware of this and has taken action to clamp down on outflows by reinforcing capital controls. New measures included banning large overseas M&A, clamping down on dual currency credit cards, stopping large cash transfers, etc.

See: What China has done to stop massive amounts of cash from fleeing the country

One has to wonder how effective these controls will ultimately be in such a large economy.

Why is this happening anyways? I think there may be two reasons, both of which are driving down returns of domestic RMB assets. As returns decline in China, it makes sense to sell RMB assets to invest overseas.

1) China is in a real estate bubble fueled by massive credit expansion
2) Over-investment in fixed assets and a slow economic transition to consumption-based economy

In China, the lack of investment options forces savers to invest in ever greater quantities of real estate, driving prices up and returns down. This has become a Catch-22. The country is wary of letting prices drop, which may lead to mass unrest. Yet, elevated prices cause poor capital allocation to proliferate.

At the same time, outflows will likely continue as long as the huge pricing discrepancy exists between domestic Chinese assets, like Tier-1 city real estate, and foreign assets. Why hold real estate in Shanghai at a large premium to prices in the US or Australia or Canada?

It's hard to say how this will end. China's response seems to be to clamp down on outflows and adjust the currency downward to sustain exports. The reserve figures and exchange rate suggests this may not be enough.

The consensus is that China is led by extremely capable leaders and has multiple levers to control the economy. This may or may not be true. If that was the case though, how did China end up in this situation in the first place?

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