A postcard from Beijing
Having visited China at least once a year over the last 10 years, two weeks ago I was back in Beijing, swapping my Bloomberg screen for a ‘real world’ view of the world’s second largest economy. Meeting with friends, academics, investors and policymakers, here’s my take on what I saw and heard.
The pollution in Beijing was horrendous, and in my view has got worse, not better, in recent years. The government is aware of the issue and local leaders are now evaluated on their efforts to reduce pollution. Unfortunately, passing through Beijing airport the smog was so thick that we only had 100-metre visibility.
On an economic front though, I noticed increasing confidence amongst locals in the Chinese government and policymakers’ ability to manage the economy for now. A Chinese journalist from a financial newspaper mentioned with some pride that the government looks at the reasoning of typical ‘China bears’ to identify and attempt to address problems early on.
Our own longer-term assessment is less positive. Even though the Chinese government is very aware of its problems, so far they haven’t been able to address the economy’s dependency on debt. We believe we are now at a stage that it will be very hard, if not impossible, to achieve this in an orderly way. The patient has built up an addiction and needs to go cold turkey at some point.
In our view, the big question of the last few years is not if the China risk will materialise itself in a chaotic way, but when. In this light, I note a broad consensus amongst academics, policymakers and local investors that China will do whatever it takes to create a stable economy in the run-up to the leadership summit planned for November 2017.
Looking at the yuan, Michael Pettis, Professor of Finance at Peking University, makes a case that resonates well with us. He states that given the acceleration in debt growth, there is no historical precedent of a normal rebalancing, with history precedents in the world strongly pointing towards a ‘chaotic’ rebalancing at some point.
The majority of people I met see further yuan weakness, although most see the yuan only weakening by 3 to 4%, which is in line with the currency forwards. One academic told me that although the People’s Bank of China (PBOC) “gets it” and is committed to a managed yuan, there are simply too many vested interest groups who would like to see the currency quite a bit weaker. He believes that at some point the PBOC will get the phone call from central leadership to give in and they will.
One other academic made an interesting observation that in his view policymakers must be a bit more comfortable with the process of managing the capital flows, the economy and the currency. He notes that China feels comfortable with capital controls so far and that the recent currency weakness has not led to any market panic, which he attributes to increasing policymaker credibility. We disagree with this sense of control.
Especially in times of US dollar strength, for instance because a Trump president prompts fiscal spending, the RMB is likely to come under pressure. In addition, if when US rates start to rise it could become more difficult for the Chinese government to manage capital outflows and prevent its currency from weakening.
The currency seems like the natural release valve in case things get chaotic in China. The government will do whatever it takes to support local asset prices and prevent defaults, so at some point it will need to print money, a lot of money. David Cui, a local analyst from Bank of America Merrill Lynch suggested that once the foreign currency reserves falls below a certain threshold, the chances of a one-off sizeable devaluation increase…by a lot. At the current rate of drawdown in China’s reserves there could be some time before this occur, possibly not until the end of 2017.
I also noted that that China seems increasingly worried about Taiwan. Unlike his predecessors, Taiwan’s current president has not acknowledged unification with China as the long-term goal, highlighting instead differences in national identity. Several locals, including a former Major General of the People’s Liberation Army, mentioned this as China’s most important geopolitical topic, with tensions in the South China Sea coming only second. It seems that increased military tension with Taiwan could be on the cards. Moreover, Tibetan tensions could also possibly resurface, with China seemingly keen to influence the current Dalai Lama’s succession path.