As Chinese leaders attempt to guide their slowing economy into a soft landing, they’re counting heavily on People’s Bank of China Governor Zhou Xiaochuan to keep conditions stable. It’s a daunting task. Firming U.S. growth is increasing the odds the Federal Reserve will boost interest rates soon. Europe, meanwhile, is on the precipice of renewed turmoil as Greece spars with euro-area finance ministers. Japan is limping out of recession slower than hoped (growing an annualized 2.2 percent in the fourth quarter), raising the chances of additional Bank of Japan stimulus.
With 560 basis points worth of monetary ammunition to use before interest rates go negative, Zhou would seem well-armed for the challenge. But what if he has fewer options than optimists think?
Comments over the weekend by Guan Tao, head of international payments at the State Administration of Foreign Exchange, suggest Zhou's ability to ease may rapidly be evaporating. The problem? Fast-rising "uncertainty and instability" for capital shifts -- conditions, Guan warns, that are eerily reminiscent of the 1997-1998 Asian financial crisis.
As China’s currency watchdog, SAFE normally operates under a cloud of secrecy. For Guan to speak out so publicly suggests there’s good reason to be worried about the kind of sudden and massive outflows that flattened Indonesia, South Korea and Thailand nearly two decades ago.
For the last 12 years, the PBOC has faced exactly the opposite problem: what to do with all the cash flooding into the country as Tokyo, Washington and Frankfurt slashed rates. That pumped up China's money supply and required some fancy monetary footwork from Zhou, who had to introduce special securities to mop up liquidity. Now, with the dollar is rising and the yuan coming under pressure, incentives to move money out of China are growing. The government’s anti-graft crackdown is adding to the problem, as crooked cadres scramble to shift their ill-gotten gains abroad.
The weakening yuan severely limits Zhou’s room to lower rates. Since the 2009 financial crisis, China’s massive credit buildup has led to overcapacity across industries and too many unproductive investments. (And the bubble continues to grow: China’s broadest measure of new credit rose $328 billion in January, the third straight monthly increase.) Something similar happened across Southeast Asia and South Korea in the 1990s; then, once currencies plunged, dollar-denominated loans blew up.
Today, China can't boost exports by letting the yuan fall, for fear that untold numbers of foreign-currency deals might unravel. What really worries investors about Kaisa Group, a previously little-known property developer that missed a coupon payment last month, is that no one knows how many other developers may default if the yuan weakens. While the Bank for International Settlements estimates Chinese companies owe about $1.1 trillion, neither Zhou nor Chinese President Xi Jinping know for sure.
These risks belie the conventional wisdom that the PBOC will be cutting rates early and often this year. By Guan's logic, any significant moves could do more harm than good. It helps, certainly, that the yuan isn't full convertible. But then, neither is it formally pegged to the dollar. As China faces capital outflows in the neighborhood of $50 billion a month, as former PBOC economist Ding Shuang has estimated, currency stability will be hard to maintain. And to leaders in Beijing, stability is everything.
China isn't necessarily headed for a crash in 2015. But those counting on the PBOC to prop up growth need to reconsider their confidence. The further China slows below 7 percent, the more likely it is that the government will have to add fresh stimulus itself. That means a credit bubble that surged $20 trillion between 2007 and 2014 will continue to swell. For all Xi's talk of epochal change, today's China finds itself much where Asia did in 1997 -- dependent on exports and excessive borrowing, and at the mercy of markets that have no trouble seeing through government spin.
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