FEBRUARY 2017 : CHINA: WHAT’S AHEAD FOR THE ROOSTER YEAR?
INTRO – The People’s Bank of China (PBC) has confirmed, according to its January data, that foreign exchange reserves of the country have fallen to a historically low level of 2.998 trillion dollars, contrasting with the the all-time high of 3.993 trillion dollars in June 2014.
CHART 1: RMB’s exchange rate and foreign reserves evolution since 2009 – Sources: Trading Economics.
WHY IS THIS STATEMENT MORE ALARMING THAN IT SEEMS?
The contradictory policy of the opening of capital account and maintaining a relatively fixed exchange rate has led to an outflow of capital and massive investment of Chinese citizens outside China.
Since 1990’s capital flows have largely increased, and since 2014, capital outflows overtake capital inflows despite restrictions of the PBC. This accumulation of outflows has dragged down the RMB exchange rate and forced Beijing to take measures. For now, The People’s Bank of China can keep the exchange rate by intervening in the foreign exchange market, and buying/selling yuan to arrange the RMB FX rate, relying on the capital and current account surplus accumulated over the past three decades. But these sterilization policies create distortions in the market, and increase the risk of China running low in reserves. At some point, the currency would fall. Even with 3 trillion dollars in reserves, the government can’t afford to spend $100 billion a month indefinitely.
BUT WHY DO CHINESE CITIZENS INVEST OUTSIDE OF CHINA?
The Chinese banking and financial system is not as developed as Western countries ones and presents major weaknesses. The low returns offered by the yuan, combined with citizens’ lack of confidence in their own currency have led to this increasing amount of capital outflows. Today’s Chinese upper-middle classes’ households invest outside of China for portfolio diversification, but also for merely capital flight. This phenomenon is also caused by the current stagnation of wages, and the quasi-inexistence of social safety nets and retirement pensions which explains the willingness of Chinese citizens to pour their money out of China to secure future greater income.
CHART 2: China’s capital outflows, trade balance and FDI – Sources: The Economist.
WHAT CAN CHINA DO TO PREVENT ITS FINANCIAL DOWNFALL?
A first interpretation would be to come back to a controlled capital flows system. However, in our globalized world this would harm China as much as it would harm the rest of the world. Should China proceed then to a full liberalization of its exchange rate? The Chinese financial system is still too immature to handle such risks. Financial liberalization is an objective but it will take time and must be achieved gradually. Therefore, to tackle this situation, a really interesting set of policies has been enunciated by Ben Bernanke, former Fed chairman: Development of services and intern consumption must be used to counterbalance these outflows, through an active and well-targeted fiscal policy that will help, according to him to « reduce distortions in the taxation system unduly biased toward tradable sector, absorb excess liquidity and make more active spending intern consumption ».
By targeting government spending and tax measures, pressure on capital outflows could be limited, and the rebalancing of the economy could be achieved without too many damages on the maintaining of growth. Rather than spending on traditional infrastructures which are part of the current model, this idea could aid China’s transition in a new growth model. As it has been previously mentioned, due to the lack of a strong social safety nets, Chinese citizens have to rely on themselves to cover costs of health care, education and retirement, which greatly influences outflows.
Fiscal policies could aim at increase income security, strengthen the pension system and would enhance consumer confidence and consumption. Besides, tax cuts or credits could be used to enhance households’ disposable income and deter Chinese citizens to pour their money into USD denominated securities and investments. This temporal alternative approach to financial liberalization could ease outflows and pave the way for China’s transition towards a new growth model, turned towards services rather than industrial activity.
IN A GLOBAL CONTEXT
With the recent election of Donald Trump as president of the United States and its supposed protectionism and anti-china policy, the amount of foreign reserves of the PBC might be even more jeopardized and will force China to act immediately to avoid further dilapidation of its reserves. The Rooster year will be determinant in the Middle Kingdom’s future, but also for the rest of the world economy.