China Devalues - Some Consequences

What Happened: People's Bank of China devalued the Rmb, setting the rate 1.9% lower on August 11, and a further 1.1% the next day - the biggest fall for the Rmb since the 33% devaluation in the first week of 1994, and seemingly an abandonment of prioritising early inclusion in the SDR over the needs of the domestic economy.

Why It Matters:  This is an important development both for China (its economy and politics), for the rest of Asia, and for the world economy.  Let's take them separately. For China, the decision to devalue marks the abandonment of two linked policy goals. First, and most obviously, it is an acknowledgement that the economic sacrifice made in demonstrating sufficient stability for the Rmb to be included in the SDR at an early date, is proving too burdensome.  Or, to be blunt, it acknowledges the error of allowing the Rmb to be dragged up with the dollar last year, without an aggressive easing in other areas of monetary policy.

Second, and less obviously, it marks the end of the carefully assembled illusion that sufficient foreign reserves and a sufficiently conservative set of banking policies could allow China to escape indefinitely from the monetary policy trilemma (the one which makes a fixed currency, open capital account and independent monetary policy an unstable triad).  Both of these mean that a serious policy re-think is now inescapable.

Politically for China, the stockmarket's fall followed by the predictable devaluation of the Rmb demonstrates two things: first, it tells the Party that it cannot control the Market; second, it tells the Chinese people that the Party cannot control the Market.  Given that the Party treasures control above all else, this represents a genuine political crisis.  So in short, this is a moment of profound challenge and, ultimately change, for China's political economy.

For Northeast Asia, the problem is very simple: China accounts for just over 70% of Northeast Asia's combined exports. If China is devaluing in order to maintain its export position (a subsidiary aim, with the principal aim being to raise utilization rates in an economy which has been driven by the growth of capital stock), then export prices will be cut for every other Northeast Asian trading partner and competitor. The deflation which so far has been largely confined to commodity markets, will spread more rapidly to Asian manufactures, starting now.  Within Northeast Asia, Japan is the most obviously vulnerable, having tried for two and a half years to ginger up its economy via devaluation. China has just trumped that strategy.

For the rest of the world, there is the uncomfortable fact that in dollar terms, during the five years to 2014, China accounted for 54% of the total growth in GDP for the G7 and BRICs combined.  Or put it another way, between 2010 and 2014, China's dollar GDP grew 71.5%, whilst the rest of the G7 and BRICs expanded just 9.8%.  Depending on how far China ends up devaluing, those numbers are going to change, and quite possibly dramatically.

And finally, and again obviously, China's devaluation is likely to trigger a whole new round of Asian-sourced deflation in the traded goods sector. Bond markets have made their initial reaction, western monetary policymakers will be re-casting their sums.

What Happens Next?   
We shall see. At present, Chinese sources are glossing the devaluation merely as an extension of China liberalizing its economy. Whilst one can't rule out completely that the end-result may yet be that, it defies belief that this is the motivation. Rather, for the reasons given above, this is a moment of profound challenge for China's policymakers, and how the various tensions, problems and opportunities will play out is, for now, anybody's guess.

China Devalues - The Trilemma Bites Both China and Japan

The announcement today of a sharp devaluation of the Rmb is a capitulation to strategic necessity which a) had already been quietly seen on the OANDA fx site since July 31st, though not, curiously on Bloomberg and b) was the inevitable outcome of the failure of the Xi Jingping Put.

To repeat: 
"The logic of the situation is that the damage inflicted on the financial system will force a clarity of policy which finally over-rides the deep desire to ignore the monetary policy trilemma.  In short, monetary policy can become truly expansionary, in which case there is a sacrifice to be made either of the short-term stability of the Rmb, or the phased dismantling of capital controls and other structures of financial repression.  The alternative is that the damage to the financial system is unrelieved by monetary policy, but policies to open the capital account and sustain the stability of the Rmb are maintained. Almost certainly that will now entail a hard landing. 

"In short, the choices have suddenly got both hard and urgent."

There are immediate consequences to think about.

For China,  there are two fundamental questions:
1. The Communist Party has discovered that it cannot control the market.  Given the unrivalled importance that maintaining control has in the Party's list of priorities, what does that mean for the future of the market in China?
2. The Chinese people have discovered that the Party cannot control the market. What does that mean for the economic choices to be made by China's households and companies?

For the rest of Asia, there is one very obvious question: what happens now to Japanese policy. Those of you who subscribe to my  Shocks & Surprises Global Weekly Summary will have read on its front page this week:

"In Asia, Bank of Japan’s monetary policy board meeting produced no new initiatives, but commentary from the bank’s governor which bordered on the complacent. In fact, Japan’s momentum indicators for domestic demand and the industrial sector are now flagging in a way not seen since the election of PM Abe. If one of the outcomes of China’s stockmarket collapse is a depreciation of the Rmb, Bank of Japan could yet discover new vulnerabilities in the Japanese economy."

To be plain, about 71% of Northeast Asia's exports come from China, and given the weakness of Western demand,  a 1.9% devaluation in the Rmb will quickly result in a 1.9% fall in the dollar price of China's export prices, which will inexorably be followed by matching falls elsewhere in Asia's export prices. Any Asian country which has been relying on devaluing its way back to competitiveness with China will feel the pressure. So there's more policy initiatives to come - and not leas from the Bank of Japan.

China's July Money Data - Rescue Funding

China’s July monetary data gives a coherent, if slightly complicated, picture of the attempt to staunch the financial bleeding from the stockmarket’s fall.  In total, it describes a rapid emergency financial re-intermediation by the banking system, whilst at the same time shows the financial system in total withdrawing funding from the real economy.  The hope must be that July’s data shows merely Part 1 of the rescue, with the crucial bit of Part 2, as yet unseen, being the banking system being willing to restore funding to the ‘real economy.’

The key data is the discrepancy between the Rmb1.48tr in new bank lending made in July - 1.7SDs above historic seasonal trends, and the strongest since June 2009 - and the miserable Rmb589bn in new bank lending recorded in the monthly aggregate financing series. Since the point of the aggregate financing data is to track financing made to the ‘real economy’, we are left to conclude that the difference between the two measures of banks lending - 891bn yuan of it - represents bank lending to non-bank financial institutions. The rescue funds, in other words.

In the short term, the good news is that the money lent to rescue financial institutions has been recirculated right back to the banks, with deposits rising 2.17tr yuan during July.  The less-good news for now is that:

• the banks are not lending that back into the ‘real economy’. Not only was lending to the real economy down at just 589bn yuan in July, the lowest since October 2014, but in addition, banks withdraw a net 331bn yuan of bankers’ acceptances during the same month. The net effect must be a sharp squeeze on corporate working capital. 
• the second bit of bad news is that the rise in deposits is accompanied by a sharp fall in liquidity preference (M1/M2) to a new record low as speculative and transactional demand for money is dulled by financial and economic uncertainty. 

China's Reserves - Hong Kong's Part in Their Downfall

Between the end of August 2014 and the end of June 2015 China’s foreign exchange reserves fell by US$275bn.  Where did the money go?  Probably more than half of it was accounted for loans being repaid to Hong Kong’s banking system: latest data shows that Hong Kong’s net lending to China fell by US$91bn between September 2014 and April 2015.   The huge inflow of Hong Kong bank lending, which saw loans to China rise from a low of US$122bn in September 2012 to a high of US$342bn in March 2014, went sharply into reverse just as the US dollar began to strengthen in the second half of 2014.

Part of the reason for this withdrawal is doubtless a change in perception of risk as the dollar strengthened.  But heightened risk aversion is not the only story: Hong Kong’s own liquidity situation has been sufficiently compromised that retrieving capital from the mainland was almost certainly a commercial necessity.

The reason is that Hong Kong is no longer generating the private sector savings surpluses which historically  have funded the build-up of net foreign assets in Hong Kong’s banking system.  Whilst a savings surplus results in the private sector piling cashflow into the banking system, which by definition can only be invested in government debt or foreign assets.  By contrast, a savings deficit results in cash flow from the banking system back to the private sector, with the banks able to generate the cash only by selling government or foreign assets. 

In 4Q14, Hong Kong generated a private sector savings deficit of HK$56.4bn, equivalent to 9.2% of GDP, and this was followed by a HK$47bn deficit in 1Q15, equivalent to 8.2% of GDP. Now, Hong Kong’s private sector savings position is highly seasonal, with large deficits usually seen in 4Q, usually recovering to an offsetting surplus in 3Q.  However, the deficits of 4Q14 and 1Q15 were big enough to leave the 12m position as a modest deficit of 1.5% of GDP.    

The trade and government budget deficit/surplus for April-June are now in, so we can see the extent to which the underlying savings situation is developing.  Hong Kong’s reported a June budget deficit of HK$11.3bn, bringing the fiscal balance for 2Q  to a deficit of HK$15.92n, equivalent to an estimated 2.8% of GDP. Meanwhile, with June’s trade balance showing a deficit of HK$45.8bn, the 2Q deficit came to a deficit of HK$115.4bn, which implies a 2Q current account balance of approximately HK$8.4bn.  

Taken together, this suggests that Hong Kong produced a private sector savings surplus of HK$24.4bn, equivalent to 4.4% of GDP. This represents something of a recovery, as it compares with a 2% surplus in 2Q14, and a 8.2% deficit in 1Q15. However, on a 12m basis, the SAR is still running on a modest private sector savings deficit (equivalent to about 0.9% of GDP). Whilst this is hardly disastrous for Hong Kong itself, and implies little in the way of currency pressure or interest rate premiums to the dollar, it does mean that the now ‘normal’ conditions for Hong Kong is that it no longer produces a savings surplus that can  be re-invested in the mainland. Rather, Hong Kong’s underlying savings balances require that it sells down a modest portion of its accumulated foreign assets, which effectively means repatriated capital from the mainland. Hong Kong, in other words, is no longer a net source of capital for China in its own right, but rather is one of the factors generating capital outflow from China

Story of the Day - US Factory Orders & Japan Cash Earnings

Two things stood out from the day’s data:

1. The 1.8% mom rise in US June factory orders
2. The 2.4% yoy fall in June's cash earnings for Japanese workers

US June Factory Orders The 1.8% mom rise in June’s US factory orders allowed some slight improvement to the underlying ratios which influence short-term industrial dynamics, but without really making inroads on the underlying inventory and book/bill problems. With shipments up just 0.5% mom, the book to bill ratio rose 1.3% mom to the best since March - but even so, it remains 2.3% lower than in June 2014, and slightly below a 10yr average which includes, of course, the Great Recession. Meanwhile, inventories rose 0.6% mom (with no change in unfilled orders) whilst shipments rose 0.5%, so there was no improvement in the  inventory/shipment ratio, which returned to the highest since February, and is 1.1SDs above the 10yr average. Neither of these ratios are so bad they demand an urgent re-thinking of economic policy, but equally, whilst they remain unaddressed, they compromise short-term industrial prospects in the US.

Japan June Labour Cash Earnings  The 2.4% yoy fall in June’s labour cash earnings (for companies with more than 5 employees) and the 3.3% yoy fall in average earnings for all employees, makes quite clear that Japanese employers are not in the business of passing on competitive benefits of devaluation to their employees. For the wider measure, June’s payment fell 1.9SDs below what one normally expects in June. And June is an important month, because it is one of the two large bonus months of the year: last year, June accounted for 11.6% of total annual earnings, with only December being more important (representing 14.5% of earnings).  

With increasingly little in the way of monetary policy dynamics to offer immediate extra support, it’s difficult to be optimistic about the short-term trajectory of domestic demand. And that policy lacuna will become more important if the brunt of China’s stockmarket failure is borne by a sharp weakening of the Rmb (which seems a logical expectation).  At that point, Japan’s policymakers will be faced with the possibility that two and a half year’s worth of sharp competitive devaluation against its biggest Asian trading partner/competitor have not brought the benefits to Japan’s domestic economy which they could have expected. 

The Failure of the Xi Jinping Put

Since 12 June, the Shanghai Composite index has fallen by just under 29%, and the Shenzhen Composite has fallen by 33%.  Measuring in terms of market capitalization, the Shanghai Composite crash has cut 12tr yuan off capitalization, whilst the Shenzhen has cut 10tr yuan from capitalization.  China’s nominal GDP is currently around 64.4 tr yuan, so the combined loss of capitalization from these two markets alone is equivalent to slightly more than a third of annual GDP.

There are two chief methods by which such a crash is transmitted to the domestic economy: first, by a negative ‘wealth’ effect, and secondly, by its impact on those credit institutions which had been financing the run-up and the impact on their clients. To the extent that these two effects can be separated, the second is the most important. Probably no-one, including those inside China’s banking system, really knows the extent to which recent bank lending has been used to finance stockmarket positions. However, the really explosive phase of China’s stockmarket frenzy started in November, and between November 2014 and May 2015, new bank lending amounted to 6.84tr yuan.

Even at the latest valuations, Shanghai and Shenzhen index levels are approximately 50% above end-Oct 2014 levels, soon paper that leaves plenty of scope for margin positions to be paid down without catastrophic pain. But of course, that’s not how margin-position finance works - their very essence is leverage and concentration of positively correlated risk. We can very confident that at least some financial institutions will be in deep trouble, and it be a brave analyst who asserted that none of those risks would develop into systemic threats.

The need to respond to this market disaster finally brings into focus the traditional monetary policy trilemma which Beijing has successfully finessed over the last decade. The monetary policy trilemma is that it is in theory impossible at the same time to pursue a currency target, an independent monetary policy (or, to put it another way, to use monetary policy as a purposeful and effective instrument of economic policy) and to maintain a free capital account.

Over the last 10 years or so, China’s preference was to allow financial repression sufficient to fund an extraordinary growth in the stock of fixed capital, whilst keeping the currency weak enough to allow it to find overseas markets for the resulting surplus production. In response, once-strict capital controls were gradually eroded (both officially and unofficially) as investors sought to buy the undervalued currency, and in response, China both amassed nearly US$4tr in foreign reserves, whilst partly sterilizing the capital inflow by raising reserve ratios on Rmb deposits from 7.5% in 2006 to a peak of 21.5% in 2011.

This strategy was not able to remove the trilemma, but it took the sting out of it, by granting policymakers time to react to changing conditions.  But what was gained in policy-flexibility was lost in policy-clarity. Essentially, different financial system actors were independently free to pursue policies which were not necessarily complementary.

That fundamental lack of policy clarity was publicly visible only times of economic stress, when PBOC’s monetary policy were abruptly overturned by State Council decisions - the most obvious example being the credit-splurge mandated at end-2008/early 2009.

It is in this strategic context that China’s stockmarket collapse can be understood. During the first half of the year, policy aims included;
i) maintaining a stable Rmb in order to hasten the day when it is included in the IMF’s SDR;
ii) loosening capital controls whilst sequencing a gradual liberalization of banking and financial markets;
iii) ensuring a sufficiently loose monetary policy to allow nominal growth to sustain the sort of growth previously financed via the financial repression which was in the process of being dismantled.

Even in the best of circumstances, these divergent priorities would bring the policy trilemma into sharper focus. But the trilemma has become increasingly urgent owing to the extraordinary strength of the dollar (and thus the Rmb) between October 2014 and May 2015: the priority of maintaining stability in the Rmb meant there were strict limits on the ability to loosen monetary policy aggressively enough to maintain economic momentum, whilst all the time, the sequencing of loosening capital controls meant the policy mismatch became increasingly obvious.  The initial response was logical: ignore the trilemma and buy time by selling foreign reserves (which fell US$238bn between August 2014 and March 2015), and inject cash back into the financial system by cutting reserve ratios by 2.5pps to 17.5% by end-May, with each percentage point cut releasing approximately 3tr yuan back to banking markets.   In addition, PBOC put in place schemes extending finance to banks on the basis of specified lending criteria.

Into this environment emerged a stockmarket frenzy. This rapidly became at the very least a useful tactical adjunct by which the policy trilemma could once more be finessed. Specifically, an irresistibly-booming domestic stockmarket to which the authorities could gradually grant foreign access would generate a predictable capital inflow which would allow the pursuit of the Rmb’s inclusion in the SDR to be maintained with rather less negative stress on domestic monetary policy.  In addition, of course, growing the stockmarket’s role as an allocator of savings is consistent with the broader policy of a phased dismantling of the structures of financial repression.  As time went on, it even became possible to imagine, or at least hope, that the wealth-effect alone might mitigate the dour economic consequences of monetary policy settings.

The crash not only wipes out that way of finessing the monetary policy trilemma, but by generating a whole new generation of yet-to-be-calculated bad loans and savings-destruction, it makes it a whole lot worse, a whole lot sharper, and a whole lot more urgent to recognize. 

This is why an almost full-deck of policy measures were announced in the hope of shoring up the market. What one might call the Xi Jinping Put consisted not only of last weekend’s 25bp cut in deposit and lending rates, and a 50bp cut in deposit reserve ratios for commercial banks stretching to a 300bp cut in RRRs for finance companies and non-bank companies, but also the State Council unveiling a draft law to remove the 75% loan-to-deposit ceiling for commercial banks, and official draft guidelines allowing the official pension fund to invest up to 30% of its net assets in equities.

But so far the Xi Jinping Put has failed: on Tuesday, the Shanghai Composite rallied 5.5%, but gave back the entire gains on Wednesday. By end-Friday, the market was down 13.8% from Tuesday’s highs, and - as is usual at this stage of a crisis - the hunt is on for ‘market manipulators’ to blame.   Most probably it failed because at some level the market recognizes that whilst the trilemma is unresolved, the Xi Jinping Put cannot be definitive.

One way to see this is to ask: ‘what is missing from the package?’  One thing which is conspicuous by its absence is PBOC injecting money into the market. Weekly totals of PBOC’s open market operations show that from end-April to mid-June PBOC was entirely absent from the market - its net injections of liquidity were . . . zero. Only in the last weeks has PBOC injected cash into the market, adding a paltry Rmb35bn in June 25th auction, and Rmb50bn in the July 2nd auction. 

Rather, the job of supplying liquidity to the private sector has been quietly subcontracted out to the Ministry of Finance, which has almost entirely checked the usual seasonal growth of the deposits it keeps in PBOC. In the 3m to May, central government’s deposits in PBOC were down 7.4% yoy , doing this, effectively releasing approximately 250bn yuan of cash to the private sector directly, although the opportunity-benefit in the form of reduced treasury takings will be higher.

So what happens now? The logic of the situation is that the damage inflicted on the financial system will force a clarity of policy which finally over-rides the deep desire to ignore the monetary policy trilemma.  In short, monetary policy can become truly expansionary, in which case there is a sacrifice to be made either of the short-term stability of the Rmb, or the phased dismantling of capital controls and other structures of financial repression.  The alternative is that the damage to the financial system is unrelieved by monetary policy, but policies to open the capital account and sustain the stability of the Rmb are maintained. Almost certainly that will now entail a hard landing. 

In short, the choices have suddenly got both hard and urgent.

Innocence & Experience & 'The Wealth Effect'

One of the popular and current rationales for why the US economic expansion has never quite developed the normal panoply of cyclical accelerators is that the ‘wealth effect’ of a surging stockmarket has been far less than previous calculations suggested.

The observation is important, because as of March 2015, the US household sector was keeping 31.1%  of its total financial assets in equities or mutual funds, compared with only 19.5% in bank deposits & credit market instruments. In fact, the proportion kept in equities and mutual funds is the highest since end-2000.

Now, the S&P500 has attained a CAGR of 14.7% over the last six years, and as it has done so, the amount of wealth households have tied up in the S&P has risen from $8.2tr in 1Q2009 to $21.56tr in 1Q2015.

How much is that? Well, in the national accounts, compensation of employees currently runs at $9.477tr pa, and it is growing at about $380bn pa.  Given the tally of of equities and mutual funds held by households, it would require a rise in equity values of just 1.75% a year to generate that $380bn pa pay rise.   Or put it another way: the $13.36tr rise in the value of households’ equity and mutual fund investments is equivalent to just over one and a half year’s worth of average employees’ compensation during the same period.

So how households’ do with that new wealth plainly matters, a lot, to the economic cycle.

Looking through the literature on why the wealth effect is failing, I’m struck first by the certainty which allowed economists and econometricians to assume that ‘the wealth effect’ would be stable over time.  I’m also struck by the absence in the literature of any reference to the permanent income hypothesis  (the idea that a person will adjust his spending according to the his life-time income expectations  - or alternatively that his spending pattern will itself reveal that life-time income expectation).

It seems to me very likely that the proportion of the ‘stockmarket wealth’ a person is prepared to spend will not be stable, but rather will be informed by (and reveal) his underlying expectations about the likely volatility of those holdings.  If a person’s long-developed experience is that the stockmarket only goes up, he is likely to spend a higher proportion of the gains than if his experience has led him to believe that a significant portion of it is likely to be given back in the near future.  In other words, people will only ‘believe’ a portion of the increase in their wealth. How much they ‘believe’ it, will depend on their recent experience.

Now these ‘beliefs’ are likely to be developed as a result of long experience, and are likely to change over time as those experiences change. Here’s a  very simple (primitive, even) model: the ‘belief’ in the secure return of stockmarket investments is formed over a 10yr period, with more recent years having greater weight than in previous years. In the chart below, I’ve averaged a straight-line declining balance of years, so the change in the most recent year has 100% weight, the year before than 90%, the year before 80% etc.

What this chart suggests is that very sharp stockmarket falls may have a strong and long-lasting negative impact on people’s beliefs about what proportion of a stockmarket’s subsequent gains can be ‘believed’. And in turn, those beliefs may be incorporated into permanent income calculations, and hence spending/saving decisions.  Thus in 1999, the experience of the previous 10yrs would have led to an expectation of ‘safe’ gains of 11.1%, during a year in which the S&P rose 19.5%.  By contrast, in 2014, the previous 10 years would have taught that only 5.7% gains were ‘safe’, and any excess gains were unlikely to be factored into spending/saving decisions. Adjusted for the changing base, one would thus expect the impact on consumer spending of a rise in the stockmarket in 1999 to be approximately double what it was in 2014. 

If expectations are formed over a long period of time, no-one should expect ‘wealth effects’ from the stockmarket to be stable. But they might, given more investigation along these lines, be not entirely mysterious. 

Meanwhile, the other insight into how households actually think about their ‘wealth, or financial situation, is revealed in the household saving rate.  One would expect that when lengthy experience has led households to believe more strongly in the security of their stockmarket gains, their saving rate would decline; when they become more sceptical, one would expect the savings rate to rise. And, in general, this does appear to be the case. 

What can one conclude? That stockmarket investments are not money in the bank, and repeated warnings that prices can go down as well as up are understood, albeit that belief is moderated by experience over an unknown length of time. If that time is lengthy, as one would expect, then the impact of a sharp fall in equity values, or a series of sharp falls, will compromise the ‘wealth effect’ of subsequent rises for years to come.  In 1999 the S&P rose 19.5%, and households perhaps ‘believed’ that 11.1% of the rise in wealth would stick, and could thus be spent. In 2014 the S&P rose 11.4%, but households perhaps believed that only 5.7% of it would stick.  And one other thing. . . given a fair wind and no catastrophes (how I wish!) the wealth effect of a rising stockmarket is likely to gradually recover, but only as the disasters of 2008 recede from memory.