The 2008 financial crisis hit China hard, and every policy Beijing enacted thereafter promoted internal credit and investment into an economy already at overcapacity. The failure of economic officials to maintain stability in China's once insulated equity and currency markets has perhaps shocked some of China's more complacent observers. But those who have been paying attention know that officially, growth is slowing; unofficially, it may have stopped altogether.
The Flight of Chinese Capital
It's clear that the Chinese economy is in a cyclical downturn. Growth is weak, and markets are volatile. But is it clear that the downturn will turn into a meltdown? Many Chinese are not hanging around to find out.
In fact, capital has started to flee China. Nearly $1 trillion is believed to have left the country in 2015, with the rate of outflow accelerating in the final quarters. Much of that money has found its way to foreign real estate markets. In one stark anecdote, the National Bank of Canada says buyers from China accounted for one-third of all purchases in Vancouver's housing market in 2015.
Though reliable statistics are hard to come by, several signs appear to corroborate the flight of Chinese capital. Import/export discrepancies with Hong Kong have widened, and there have been more errors and omissions logged in the current account. Gaps and inconsistencies in current account data suggest covert efforts to expatriate capital, bypassing China's rigid capital account controls, and they imply that capital outflow may be even higher than estimated.
However capital leaves the country, capital flight is taking its toll on China's reserves, pegged as the yuan exchange rate is. At first glance, the fall seems modest, especially considering that reserves still stand at some $3.2 trillion. But as a proportion of yuan money supply and commercial bank assets, reserves are in a free-fall, having already decreased by 50 percent. And since relatively little is truly known about the details of the reserves, they may well be tied up in sovereign wealth holdings or covering nonperforming loans. More still could be in highly illiquid assets. The U.S. Treasury, for its part, records only about $1.2 trillion of its liquid securities in Chinese possession. And so, if one could feasibly dismiss half of the reserve pile, then that pile is much less impressive in the face of a potential $100 billion-per-month depletion.
But from Beijing's perspective, there is an even darker side to the drawdown in reserves: It drains liquidity from the banking system, effectively tightening domestic monetary conditions. This is a problem for the People's Bank of China, whose No. 1 priority is to keep the debt-saturated financial system afloat and issuing more credit. It is the pursuit of that priority that has led the bank to actually lower interest rates (and to generally keep financial conditions accommodative) despite the outflow of capital. In 2016, the bank has shied away from cutting interest rates further for fear that doing so would increase capital outflows and negative yuan speculation. But given China's increasing amount of debt and the current risks of deflation, policymakers are likely to cut those rates, and as they do they will drag the People's Bank of China into the same zero-interest quagmire in which their Western counterparts dragged their banks.
Falling interest rates, coupled with rising capital outflows, show that China is as addicted to debt as any of the other major world economies. Since 2008, Chinese bank loans have increased by more than the entire stock of U.S. banking assets to fund the massive expansion of infrastructure and industry. (Bill Gates once marveled that China has used more concrete since 2011 than the United States did in the entire 20th century.) But bad investments abound. An official government study estimated that around half of Chinese internal investment since 2008 — a staggering $7 trillion — was probably misallocated. China's now famous ghost cities are an obvious but by no means exclusive sign of its parodic excess.
Such an enormous and rapid buildup of bank loans has never ended well for any country. The past 10 years of China's money supply growth corresponds with the scale of excess in the 10 years before the Asian crisis of the late 1990s. If history is any guide, capital simply cannot be allocated efficiently in such large quantities over such a short time. Clusters of error inevitably turn a boom into bust. Instead of getting rid of debt, China has taken on more.
An Indispensible Component
And as China accrued all this debt, its currency held firm, at least for a while. JP Morgan's emerging market exchange rate index was recently down nearly 30 percent since the start of 2014. The yuan, however, depreciated by only 9 percent in 2015, when it reached the height of its weakness. When gauged by a real trade-weighted basket, the yuan's 11-year bull market has merely been tempered, not reversed.
But the yuan's peg to the dollar is under duress. Capital outflows, plummeting reserves, increasingly loose monetary policy and an overstretched banking system are a recipe for a currency crisis. Beijing insists that it will not let the yuan depreciate despite its current overvaluation and despite calls to float it.
The reason for Beijing's intransigence is simple: An overvalued yuan helps to achieve several strategic imperatives. Devaluation would sink many firms loaded up on dollar debt, risking a systemic debt crisis. And with China trying to transition away from an export-oriented economic model to one geared toward consumption, currency strength guards the purchasing power of tens of millions of newly minted middle-class households. Beijing needs to keep this upwardly mobile, asset-owning constituency politically in its corner. While maintaining an overvalued yuan creates real estate and equity deflation risk, a credit crisis sparked by devaluation could create a complete collapse in household net worth.
Externally, China is trying to spread its influence into Eurasia, fund military expansion, acquire strategic foreign assets and build up trust in the yuan as a stable reserve asset. Beijing is arguably also buying time for elites to diversify their wealth through the acquisition of offshore assets. Yuan weakness would seriously undermine these objectives.
To reap the benefits of an overvalued currency without forcing systemic deflation, the People's Bank of China has to keep pumping money and credit into asset markets. Maintaining buoyant asset price inflation in housing and equity markets is the indispensible component of China's central economic plan. Running fiscal stimulus while getting state-compliant banks to keep readily cheerleading the debt binge is thus not only the path of least resistance for Beijing but also the path of near-term political stability.
China has a strategy in place. But is Beijing in full control of its fate? The uncertainty surrounding this question has caused investors to discount the premium they had once placed on Chinese exceptionalism. A lot could go wrong if China stumbles. A disorderly Chinese financial crisis and yuan devaluation would show that the stability in the monetary and financial system remains unresolved, potentially prompting global market panic and a rush into safe-haven assets such as gold, high-quality real estate and undervalued blue-chip stocks.
An old market adage about the dollar is that it is America's currency but the world's problem. The ensnaring frostbite of the dollar liquidity winter is bearing this out. Similarly, it may be China's debt, but it's everyone's problem.