On August 11, China’s central bank announced the largest one-day devaluation of its currency in two decades, reducing its target level by 1.9% against the USD.
We believe this development is drastic and is negative for two key reasons:
- The devaluation is the clearest signal yet that the Chinese economy is deteriorating – and likely at a rate that is faster than Chinese policymakers ever expected; and
- The devaluation is the clearest admission yet that Chinese policymakers are unwilling to take the necessary steps to rebalance the nation’s economy away from being investment-led, to being consumption-led.
Chinese policymakers are opting for some short-term breathing space at the expense of some much bigger problems down the road. We expect the stresses in the Chinese banking sector (blog post comings soon) will only deteriorate further as a result of this decision.
What follows is a brief summary of the framework we use to think about the Chinese economy. The conclusions that we draw above are direct outcomes of our framework that we describe below.
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FRAMEWORK TO THINK ABOUT CHINESE ECONOMY
- China has been pursuing an investment-led growth model for many years now.
- China has been suppressing consumption for many years now to force up the savings rate (savings being the difference between production and consumption) to fund investment.
- The primary mechanism to achieve this was to place a cap on deposit rates (resulting in negative real returns).
- This transfers wealth from households to corporates.
- This mechanism also served to capitalize the banking system and ultimately fund losses of bad loans.
- In the long-run, underconsumption undermines the rationale for investing in order to expand productive facilities.
THE CURRENT STATE OF THE CHINESE UNION
- China has a highly indebted corporate sector and local government sector.
- Fixed asset investments are often not generating enough cash flow to service the debts that have funded them; new debt is being incurred to roll over maturing debt.
- Significant savings have ended up in speculative property investment, the prices of which are now starting to reverse.
- Underconsumption has undermined natural demand, which reduces the case for new productive investment.
TO REMEDY THE “UNDERCONSUMPTION” PROBLEM: REBALANCING
- Rebalancing the Chinese economy means increasing the share of Chinese economic output that stems from consumption; and reducing the share of output that stems from investment.
- For the imbalance to start to reverse, consumption growth needs to be higher than average GDP growth; and investment growth lower than average GDP growth. This is simply a mathematical truth.
- This actually means that slower GDP growth is a good thing for the reversal of the underconsumption issue that has led us to the current situation.
- Also, fixed asset investment growth needs to fall very sharply (which is negative for Australia, Brazil and other commodity producing economies).
- Higher deposit rates (and therefore higher interest rates) and a stronger currency are also, perversely, a good thing to boost households’ share of national income; and therefore consumption.
- Though higher interest rates result in a higher cost of capital for the entire Chinese corporate sector; and
- A strong currency serves to make Chinese exporters less globally competitive.
THEREFORE, CHINA SHOULD NOT DEVALUE ITS CURRENCY
- A weaker currency increases the cost of living for households, so reduces household consumption. This is the opposite of what needs to happen in order to rebalance.
- Also, lots of corporates have issued debt in foreign currency, so a weaker currency could increase the risk of default across the corporate sector.
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Of course, China has now weakened its currency. The message is clear: economic rebalancing is off the table. Watch now for retaliation from other nations.