A declining yuan alongside declining forex reserves is powerful evidence of significant capital flight. Investors, individuals, and corporations apparently wish to reduce their exposure to the Chinese economy, and that's why the demand for yuan is falling. This problem won't be solved until the dollar value of the Chinese money supply declines by enough to match the decline in the demand for yuan. That can be accomplished by 1) shrinking the monetary base and the money supply, 2) devaluing the yuan vis a vis the dollar, and/or 3) inflating the Chinese price level. Alternatively, China could take steps to boost confidence in the yuan (e.g., by allowing the monetary base to shrink) or boost the demand for yuan (e.g., anything that improves China's long-term economic growth potential).
China's forex reserves are declining because the central bank is selling its foreign assets (mostly held in dollar securities), in an effort to try to support the currency; in effect the central bank is accommodating capital flight. The fact that the currency continues to decline suggests that forex sales have not been sufficient to stem the decline. It's not too hard to see why: the central bank is not allowing the decline in reserves to shrink the monetary base, and indeed, the amount of yuan in circulation continues to rise. Ordinarily, capital flight that is accommodated by central bank sales of forex would result in a shrinkage in the money supply, and that shrinkage would eventually bring the supply of yuan back into line with the declining demand for yuan.
To make matters worse, the ongoing increase in the amount of yuan in China, despite the decline in the demand for same, means the central bank is selling dollar assets and buying Chinese assets, thus “degrading” the quality of the yuan and allowing the oversupply of yuan to continue. The central bank is not allowing capital flight to shrink the monetary base. Replacing dollar assets with yuan-denominated assets in the monetary base is eroding the effective quality of the yuan, and that does little or nothing to maintain confidence in the yuan.
China is not taking adequate steps to address the decline in the demand for yuan. This means that the problem of capital flight and the decline in the value of the yuan will continue, despite China's best efforts to physically stem capital flight. It also means that Chinese inflation is likely to rise. Unless properly addressed, these problems will persist, and they will further weaken the Chinese economy. That is not good for China or for the world. It's difficult to see how exactly this will play out, and what impact it could have on the U.S. economy.
A crisis is not likely imminent, however, since China still sits on a virtual mountain of forex reserves, and the dollar value of Shanghai Composite Index is up over 15% since January. But as John Cochrane muses, and today's WSJ op-ed points out, there are disturbing things going on that bear watching.
At the very least, this makes Trump's demand that China boost the value of its currency vis a vis the dollar a virtual impossibility.
The chart above summarizes the central facts. As it suggests, the persistence of capital flight is forcing the central bank to devalue the yuan.
Despite the yuan's decline in recent years, it is still very strong against a basket of trade-weighted, inflation-adjusted currencies.
Scott,
ReplyDeleteOn China issues there is a very good blog of prof. Michael Pettis.
http://blog.mpettis.com/
He claims that a big adjustment, i.e. transfer of more wealth to China citizens is necessary.
But China has many options (altough every one is very difficult one), and a financial crisis in the mean time is not as obvious as common opinion suggests.
Best,
Interesting post. Probably the solution is not really that painful---let the yuan drift lower.
ReplyDeleteThe People's Bank of China strikes me as well operated.
Remember, it was the US financial system that collapsed in 2008, not China's. Since 2008 the China economy has about doubled in size.
They are well below their 3.5% inflation target.
I wonder why they are in effect propping up the yuan when they should be letting it slide.
Interesting post. Probably the solution is not really that painful---let the yuan drift lower.
ReplyDeleteThe People's Bank of China strikes me as well operated.
Remember, it was the US financial system that collapsed in 2008, not China's. Since 2008 the China economy has about doubled in size.
They are well below their 3.5% inflation target.
I wonder why they are in effect propping up the yuan when they should be letting it slide.
Btw S&P at 26 times trailing 12 month earnings...
ReplyDeleteRe S&P 500 PE: Bloomberg reports an adjusted PE vs trailing 12 month earnings of only 21. I have always trusted Bloomberg on this.
ReplyDeleteRe "propping up the yuan:" The central bank is not propping up the yuan. They are in fact letting it slide, as the chart clearly shows. If the central bank were not selling dollar assets, the yuan would be falling much more than it has been; I guess in a sense they are "propping up" the yuan because they are slowing the yuan's decline.
ReplyDeleteScott Grannis, yes that is what I meant---Chinese monetary authorities have been retarding the slide of the yuan, is my understanding. "Propping up" until recently, and now slowing the slide.
ReplyDeleteSome buzz about fear of "hot money" leaving the Far East to search for higher yields in the US.
On PE's
http://www.wsj.com/mdc/public/page/2_3021-peyield.html
The Wall Street Journal guys say S&P 500 at 24.87 trailing 12 months. I am not sure why the difference between Bloomberg and WSJ. I can't even seem to find Bloomberg's p-e ratio on the web. Are you on a Bloomberg terminal?
Either way, I think the market is fully priced, along with property. No bubbles. though I guess to fall from even just 21 times earnings to 15 times earnings (the long-term average) would be a haircut for stockholders….
Not to belabor a point, but John Cochrane says China has been "propping a currency up."
ReplyDelete:Why bring it up now? Well, in today's Wall Street Journal Lingling Wei reports that "China's banks are hiding more than $2 Trillion in loans," In the lead editorial rightly making fun of currency manipulation, the WSJ notes that China has already dumped $1 Trillion dollars of its reserves (likely US Treasuries) and facing $100 billion per quarter capital outflows. China is imposing strong limits on its citizens ability to move capital out of the country (translation: sell Chinese currency, bonds, bank accounts and get same in dollars abroad). At the start of the new year, individual Chinese will be allowed to take out their yearly allotment. I would guess they do it soon.
All these are signs of propping a currency up, not pushing it down; declining demand for currency and bonds that will be needed if China wants to do a massive bailout of bad debts."--Cochrane.
Re Bloomberg's PE ratio. I have been using a Bloomberg terminal since 1980, and have consistently relied on their calculation of PEs. They do make an adjustment of sorts to reported profits, but they do it in a consistent manner. I think it has to do with taking out non-recurring events, things that aren't related to the normal operations of a firm. I doubt this is available to the general public, but I could be wrong.
ReplyDelete