China's credit tide recedes to reveal 'naked swimmers'

Policymakers Is In a Bind About Renminbi's Value, Trump's Ascension Add To Woes

Those wondering how China's financially overleveraged economy might fare in 2017 will have no difficulty sympathizing with naked swimmers caught in receding tides. In the post-2008 era, the Chinese government has relied mainly on massive credit creation to prop up the country's growth. Between 2008 and 2016, total debt as a share of gross domestic product rose from 150% to around 260%, a staggering increase of $11 trillion in absolute terms.

This tidal wave of credit has kept economic growth buoyant, but also allowed a vast army of naked corporate swimmers -- unprofitable and debt-laden state-owned enterprises, insolvent local government financing vehicles and bankrupt real estate developers -- to continue frolicking in a sea of seemingly endless renminbi. However, several critical recent developments suggest that good times are about to end. In late December 2016, a ferocious sell-off spooked China's $9 trillion bond market, sending yields to their highest level since September 2015 and forcing the People's Bank of China to inject $86 billion into the banking sector to avert a potential meltdown. Although the exact cause of the rout in China's bond market remains unclear, the most likely culprit is the weakening of the renminbi, which has fallen to its lowest level against the dollar since 2008.

The prospect of a depreciating renminbi, in turn, is fueling a torrent of capital outflows. In the last two years, Chinese foreign exchange reserves have dropped more than 20% and now stand at $3.05 trillion. This hoard of hard currency, while impressive, could be depleted to a dangerously low level if capital outflows continue at the same pace as in the last two years.

Although the government has not hit the panic button yet, recent measures taken by Beijing suggest that Chinese leaders are becoming increasingly alarmed by the prospects of a financial crisis. In the annual Central Economic Work Conference, which was convened in mid-December, Beijing listed the prevention and control of financial risks as one of its top policy priorities for 2017.

One of the policy tools deployed to stave off a potential financial panic is tightening capital outflows. At the end of November 2016, the Chinese government announced it would scrutinize outbound investments worth $5 million or more. Foreign companies in China have also begun to notice the extra delay in transferring money out of the country.

In all likelihood, Beijing's attempts to reduce capital outflows and shore up the value of the renminbi will only further reinforce the expectations of one-way depreciation. As long as the Chinese government refuses to address the fundamental causes of devaluation, such as the excessive build-up of debts, massive non-performing loans in the banking sector, and persistent growth slowdown, sensible investors would be foolish not to get their money out of China before the renminbi plunges in value.

Conundrum

The renewed pressure on the currency has created a nearly impossible policy dilemma for Chinese policymakers. They can, of course, maintain the current course -- a combination of restrictions on outbound investment, gradual depreciation, and a loose monetary policy. However, this policy not only may fail to stem the outflow of precious foreign reserves, but also can produce even worse medium-term consequences.

For instance, clamping down on outbound investment has only a modest effect on capital outflows. Total outbound investment from China in 2016 was about $150 billion. Cutting this amount in half would stop $75 billion from exiting China -- about the same amount of foreign reserves China lost in November 2016 of $69 billion.

In desperation, Beijing may resort to reducing the amount of foreign currency each Chinese citizen is currently allowed to convert per year ($50,000). The PBOC has just announced that Chinese citizens cannot use their allotted foreign currency to purchase real estate or securities overseas. In addition, foreign currency purchases in excess of $7,000 must be reported. Besides inconveniencing middle-class Chinese families who want to visit other countries or send their children to study in Western universities, this measure will not deter the truly affluent and well-connected who are determined to get their money out of China. In any case, since the bulk of capital flight occurs through trade in the form of under- or over-invoicing, whatever Beijing does will not stop unauthorized outflows.