Trinity

China’s (Im)Possible Trinity : When An Autocracy Manages A Capitalist Economy

Sanjeev

Sanjeev

The Impossible Trinity is the trade-off between 3 diverse objectives of macro-economic management:
  • A fixed exchange rate vs a market-determined exchange rate.
  • An independent Monetary Policy vs A Dependent one, i.e. one that reacts to external capital flows rather than manages them.
  • Free Capital Flows vs Capital Controls

Declaimer: This article written was originally in February 2016, and some of the data points may be outdated.

All three, i.e., a fixed (or managed) exchange rate, an independent Monetary Policy, and a Free Capital Flow regime are not possible. Most countries make do with a compromise with one or the other of these objectives, mostly in the Exchange Rate regime that they follow.

The breakdown of the Exchange Rate Mechanism (ERM) in 1992, when currency speculators led by George Soros “broke the back of the Bank of England”, is a good example of how The Impossible Trinity is now part of the economic gospel. The Bank of England (BoE) tried to keep the Pound inside the band decided by the ECB, but its inflation levels were running at 3 times the German Inflation Rate and it was facing the aftermath of the Lawson Boom, the collapse of a real estate bubble caused by the (monetary) expansionist policies of Nigel Lawson.

China, today, is going through the same situation. Multiple bubbles have burst, first commodity investments in steel/aluminum, etc., then real estate, and now the stock market, and it needs to follow expansionary (monetary) policies to hold up the economy in the aftermath. These policies are impossible if you want to keep the Yuan’s fixed peg to the Dollar, and therefore, China must devalue…..the question is when and how. While there is no George Soros on the other side, given their huge Fx Reserves, China needs to shift its Yuan peg to a basket of weaker currencies like Euro/ Yen, etc.

 China is facing an army of investors, mostly from within, directly or indirectly

In place of George Soros, China is facing an army of investors, mostly from within, directly or indirectly. The name being used right now is ‘capital flight’, and it has already resulted in about a $ 1 trn reduction in their Fx Reserves. Mind you, this is in an economy that is running a Trade Surplus of over $ 500 bn over the same period, although even that should reduce substantially. Nothing to worry about so far, but there IS a Lehman moment around the corner. And that will happen when either China will clamp capital controls, or go into a huge devaluation. The former will internalize the pain, while the latter will try and export the pain to the outside world, leading to a huge global (market) instability.

I personally think that we will see a bit of both, some form of Capital Controls and some devaluation, as China tries to bring its half-engine economy down into a soft landing. Lower Interest Rates are needed to get its consumer economy moving, to fill in the gap created by the implosion of the Commodity/ Investment Demand economy. It will not be a soft landing, either for China or for the global markets.

With all these moving parts, it is very difficult to say anything with certainty, but one thing is for sure, China will NOT follow a dependent (on external flows) Monetary Policy. That is one thing we can assume for sure. Thereafter, how will it control the aftermath of its actions, especially Capital Flight, as it drops Interest Rates? Either through direct, brutal Capital Controls, which would destroy its credibility as an aspiring Reserve Currency…..or by a sharp, vicious devaluation, which might trigger a Currency  War.

My bet is that even if it chooses the first option, it will only be for a while. China is a nationalist country, more than most. Nothing in their past suggests that they will hold back on their direct interests. The implication for world currency markets is then a wave of volatility, as we adjust to the new China.

For somewhat overvalued currencies like the Indian Rupee, there is just a one-way ticket to Rs.75, maybe. Yes, I am trying to shock you, just to prepare you for a number that you cannot imagine just now.

Are there any mitigating factors just now?

Are there any mitigating factors just now? Yes, there are, and only China can do it. In sectors where there is no hope of any (economic) revival, China is not taking the “Japan Option” of keeping zombie companies held by zombie banks. This was what caused the Deflation-Depression that led to the ‘Lost Decade’ of Japan. China is doing some serious restructuring of its coal, steel, and aluminum sectors, for example. In steel, it has announced the closure of a whopping 150 mn tons of capacity, shortly after acknowledging that 90 mn tons of capacity has already been closed. That means that a combined 240 mn tons of capacity will go off-stream, and (hopefully) the related debt will be written off. No new capacity is being allowed, a relief for the rest of the sector. If we estimate a surplus of, say, 360 mn tons, then this should have a salubrious impact on global steel prices; the timing of this restructuring has not been spelled out, but it should have an impact on sentiment.

China is responsible for the global commodity blowout, and since almost 40-60% of global capacity is within its borders, it has a vested interest in reviving the fortunes of its producers. It will be nudged into doing this further, if it triggers global protectionism, as it tries predatory pricing to enter foreign markets by dumping its produce. Enough countries have not pushed back. In our own specific case, despite a clearly articulated “Make In India” policy, we have failed to protect ourselves against Chinese dumping, leading to huge NPAs with our Banks in the steel and metals sector.

It makes sense for China to follow a calibrated policy that is a mix of tactics, rather than take a dogmatic stance in favor of some hubristic Fixed Exchange Rate Policy, for example. At one level, it takes the write-offs from its devastated commodity sector, recapitalizes the Banks for losses, and prints the needed Yuan. This will loosen its Monetary Policy, but it is a one-time shock rather than a continuous ‘zombie’ policy that is simply averse to taking the pain and the resultant job losses. This is what democracies are prone to do, as we saw in the case of Japan.

In the short run, when this form of QE takes Interest Rates down, it will probably impose Capital Controls, either explicitly or in some implied form. Plain administrative controls are possible in a totalitarian economy, something that one cannot think of in a democracy. Hence, only China can do it….this is what got them into this soup in the first place, and this is what will get them out of it.

Meanwhile, keep letting out the steam by small doses of devaluation, that do not trigger a Currency War…like bullies who push you on the school playground, but not enough that you go get your elder brother. A full-fledged Currency War will degenerate into a race to the bottom, especially in Southeast Asia and Japan/ Korea.

In a world full of uncertainty, one thing is for certain. China is at the heart of the global Recession, and until its consuming economy can replace and make up for the hole created by its manufacturing economy, there is no alternate engine that will take up the slack in the interim. Yes, India is an aspirant, but it is coming off a very low (relative) base; the developed world is simply too exhausted. While it is not the end of the real economy, it does mean markets are almost universally overvalued and need to correct further if they want to price in a long U-style downturn. Surprisingly, the upside will come from the given-up-for-dead commodity sectors, while the downside will come from the ‘profitable growth’ sectors where valuations have simply too high. This is therefore a market valuation problem, not a real economic problem.

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