While the sell-off in currencies of emerging markets with insufficient foreign exchange (forex) reserves and wide current account deficits — such as the Argentine peso and the Turkish lira — is still picking up steam, there is relative calm in China. The yuan is trading well off its recent multi-year lows.
On the surface, the yuan has plenty of forex reserves (over $3 trillion) and its current account has been in surplus for over 20 years. But under the surface, it very well may have some serious issues.
The natural question is: If there is no need for external financing, why did China lose $1 trillion in forex reserves between mid-2014 and mid-2016 before briefly arresting that decline? The decline has now resumed (see chart).
Danger for China
I think America’s escalating trade war with China is more dangerous for China than it is for the U.S., given the trade balance in favor of China (see chart). Still, in a bad trade war, there are no real winners, just various degrees of losers. While I agree with President Trump that the U.S. has been taken advantage of by China in bilateral trade, I am not sure the Chinese are the kind of people to be slapped on the front page of the Wall Street Journal with tariffs on $50 billion worth of imports. This is as far from the “saving face” modus operandi of Chinese diplomacy as it gets.
The point is that a trade war could escalate dramatically, which neither Trump nor President Xi should want.
‘Milton, you’re right’
In 2002, Ben Bernanke, then a governor of the Federal Reserve, helped celebrate the 90th birthday of Milton Friedman. Here is a notable line from his prepared comments:
“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton … regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
When referring to the Great Depression, I doubt Bernanke was thinking only of the mistakes of the Federal Reserve in 1929 and subsequent years, when the central bank tightened monetary policy at a time when they should have been doing the opposite. He most likely was also thinking of the Smoot-Hawley Tariff Act of 1930, which collapsed global trade. At the time of the enactment of the tariffs, U.S. unemployment was 8%. At the time of Smoot-Hawley’s repeal a couple of years later, the unemployment rate was 25%.
I do not believe that a sitting U.S. president who wants to “Make America Great Again” wants to repeat that Great Depression’s economic record, but neither did Sen. Reed Smoot or Congressman Willis Hawley, who together sponsored the tariff act. Unintended consequences happen and, given the precarious situation in China, they may happen again in the latest tariff imbroglio. President Trump is like the man at the wheel of a kerosene truck, whose brakes are not entirely in order, speeding toward the bonfire burning in the Chinese financial system (see photo).
While it is possible that he would be able to stop at the very moment before reaching the point of no return, it is also possible that he has underestimated the momentum of his payload of $375.2 billion in bilateral trade imbalance that is likely to hit another record high in 2018.
There is a bonfire burning in the Chinese financial system because the bulk of rampant dollar borrowing in emerging markets in the past 10 years has come from China, because of the sheer size of the Chinese economy, which was $11.94 trillion in 2017 — second largest in the world. Furthermore, unlike in India where GDP growth is driven by self-sustainable internal domestic demand, in China GDP growth is driven by accelerating dollar borrowing (see chart) and aggressive mercantilist tactics.
Chinese over-leverage
Furthermore, unlike in India where GDP growth is driven by self-sustainable internal domestic demand, in China GDP growth is driven also by accelerating yuan borrowing. As Chinese GDP has grown 12-fold over 20 years, its total financial leverage has grown over 40-fold. That means the GDP-to-total-debt ratio in China has grown by a factor of nearly 4 times. Such estimates include shadow banking leverage, which is excluded from all official figures, but by estimates from credible sources including the Brookings Institution is as large as the official Chinese economy (see report).
If a trade war were to escalate, the fragile balance in the Chinese economy could be tipped and we may very well experience a second Asian crisis, which ironically, was also driven by rampant dollar borrowing. The important difference here would be that China’s GDP is many times larger than the total GDP of all countries involved in the first Asian crisis in 1997-1998 (when China’s GDP was barely above $1 trillion).
While the sell-off in the Turkish lira and Argentine peso is generating headlines at the moment, it is hard for the Chinese yuan to get the same attention as there are still plenty of forex reserves to stop the yuan from depreciating further. One could say that because of the bigger war chest of the People’s Bank of China, the yuan is not necessarily a similar market indicator to other emerging markets currencies whose central banks are in considerably less fortunate positions.
The key here remains forex reserve outflows, in which a pickup similar to what we saw in 2015 after the crash of the Shanghai Composite (and faster than the present pace) would be the major red flag.
Other market-driven indicators
The Shanghai Composite Index SHCOMP, +0.27% has fallen this week already to as low as 2,907 points. It sure looks to have experienced a bad “crack” in 2018. I have previously referred to the rally off the January 2016 lows of 2,650 as “the mother of all dead cat bounces,” or MOADCB, a bear market rally that could not recover in two years what it lost in a single month (January 2016). The index is now unwinding that MOADCB rather expeditiously (see chart).
I am aware that the Shanghai Composite is not as good a reflection of the Chinese economy as India’s Sensex is for the economy of India, as China’s economic growth does not necessarily translate into profit growth due to the much bigger government intervention in the economy in the best interest of “social stability,” as the Chinese like to say. Still, the troubling developments in the Shanghai Composite cannot be ignored when forex reserve flows have resumed and there is a rather unconventional man at the wheel of a kerosene truck headed for the blazing bonfire of the Chinese financial system.
This year promises to be a more different year for financial markets than 2017, as it is driven by unilateralist “Make America Great Again” policies that frankly have resulted from the failure of the multilateralist approach of several previous administrations.
