Schrödinger’s Economy: China, Debt, and Yuan Depreciation

Schrödinger’s Economy: China, Debt, and Yuan Depreciation

This article discusses Chinese debt, state-owned enterprises, yuan depreciation, a potential global slowdown, luxury brands, and will China’s economy finally collapse or is it overblown?

If you are someone who follows the Chinese economy, you will have noticed China has  Schrödinger's Economy; the Chinese economy is simultaneously about to utterly collapse, and also at the same time, overshadow and control the world and you’d best learn Mandarin for our Chinese overlords. The real situation? It’s just another large, growing, and important economy, like the U.S., and the E.U.

This is a result of a news media that either loathes the U.S. and would love to see the Chinese take it down, versus a news media that loathes the Chinese and would love to see the U.S. take them down. The truth is somewhere in the middle. China certainly has many issues, but it is hardly about to fall apart. I’ll explain later.

My own position is simple; China has 20% of the world’s population, and regardless of how you see their politics or political system, an economic collapse of China would plunge a fifth of the world into famine and poverty, having a noticeable affect on the average prosperity of humanity, as well as sink the 60-70 countries depending on China to help improve their countries, as well as the millions of businesses depending on Chinese exports, or people investing in businesses relying on China, and if you would be genuinely joyful to see 1.4 billion+ people suffer to prove a political point, maybe you should re-examine your views.

A Catch-Up

First, another group confirms my estimate on Chinese GDP growth from a few months ago. Secondly, we discuss why the Chinese economy matters for everyone else, and the Chinese currency.

Around two months ago, I predicted that Chinese growth was actually lower than estimates; not surprising. But I correctly worked it out as being near 1.6-2% below expectations (Shepherd, 2019).

A paper released in April, 2019, by Chen et. al., (2019) has placed the real value at 1.8% lower than official stats; precisely in the middle of my estimate at a time when few sources would dare provide real data.

As with everyone, the issue is to find data that is unlikely to be altered, and use that to work out the final numbers. I used inflation and money supply; they have used the Value-Added Tax numbers from local industry reports.

Now, when people read this data, this does not mean that the Chinese economy is about to collapse. Consider what you are growing from. If I grow an orange tree from one orange, and that tree has 10 oranges grow on it, the first year has 900% growth (plus the value of the timber, etc). While 900% growth is amazing, it’s from 1 orange to 10.

In 2003, when double-digit growth began, China has an economy of $1.3 trillion USD. So growing by $130 billion is 10% growth (Koty, 2019).

So when your economy of $13 trillion USD grows by 4.4%, it’s still growth $572 billion in USD value (St. Louis Federal Reserve Bank, 2019). If we use price purchasing parity (representing the ability to purchase and consume in real, if generous, terms), $25 trillion at 4.4% is $1.1 trillion PPP, which is the entire economy of China in 1990 (World Bank, 2018). Growth is growth.

Source: LeeGillion, 2014

Upside for Currency Depreciation

China has recently allowed the yuan to depreciate past 7 yuan per dollar (D’Souza, 2019). Traditionally, China has never allowed the yuan to depreciate under 7 yuan to 1 dollar (Yeung and Huifeng, 2019). Traditionally, it has never made sense to. Having the yuan be so highly (some say too highly) evaluated has allowed Chinese investors to buy up companies, land, and investments across the planet, which is very useful for the rich and powerful of China, and friends of the powerful. A weak yuan destroys that buying power. It also weakens the attractiveness of the yuan as a trade currency, and to maintain current levels of lending requires larger amounts of yuan to match pre-existing U.S. dollar amounts.

Why does this matter? China has been pursuing an export strategy to increase the amount of capital in the country, which pays for the massive government programs that are underway. While a depreciating currency may be seen to reduce the profits made, it in turn makes goods cheaper.

Let’s say there is an American and a Chinese good of equal quality; both are $10 / 65RMB. The exchange rate is 6.5 yuan per dollar.

Now if China drops the yuan to 7 yuan per dollar, the new price is still 65RMB for domestic production costs, but the international price is $9.3. This makes the Chinese goods competitive, and they will sell more as long as stocks last.

Not only that, but if a Chinese worker costs 6,800RMB per worker per month (TradingEconomics, 2019a), then their international price is $1,046 per worker per month. But with a lower exchange rate of 7:1, the new international wage is $971 per worker per month. That’s about a 7.2% drop in cost for no difference in efficiency. This makes Chinese workers more competitive.

There is even discussion of reducing the exchange rate even further, to 7.2 yuan to a dollar (Yueng and Huifeng, 2019). This would reduce the international wage of Chinese workers to $944 per worker per month, which would be a 10% drop from the original rate; a bargain! It would also offset the U.S. 10% tariffs.

So Chinese workers become cheaper; Chinese factories become cheaper, and Chinese goods become cheaper. It also makes the foreign bonds held by China worth more money.

If you are a free market capitalist, you are also likely happy that China is providing goods and services cheaper, and that investment into China got cheaper as well.

We could expect a large increase into exports into the following countries: United States (minus that tariff business), Hong Kong (China), Japan, South Korea, Vietnam, Germany, India, Netherlands, and the United Kingdom (whose pound is depreciating, so maybe we won’t see cheaper goods) (World Bank, 2019). All of these countries will have cheaper goods for their own population (minus their personal currency issues).

There is also another rising advantage for farmers; as China is moving to feed its population without U.S. agriculture, other food producing countries are likely to benefit; chief among them being Brazil, Argentina, Myanmar, Thailand, Russia, Australia, New Zealand, Germany, France, and Spain. Countries who have to repay China in raw materials due to loans from One Belt One Road, such as food or metals, will now find it easier to repay China (Grill et al, 2019). In turn, this means that Chinese returns on loans may now lessen.

Also, with recent laws reducing the amount that a Chinese citizen can invest abroad, this currency devaluation will make the prospect less attractive (Yeung, 2019).

Downsides for Currency Depreciation

China is importing more and more meat, such as pork, and chicken, from abroad to make up for domestic shortfall due to disease in local animal herds. An unseen benefit to this is that China relies less on U.S. soy exports, as China now has less pigs to feed, thus giving a small relief to China’s side in the trade war (Chan, 2019).

Why is this worrying? Because increases in costs for food, unlike luxury or technology, are extremely inelastic in their change in demand; people cannot choose to not buy meat, and so an increase in price for meat is a decrease in the disposable income for Chinese people, who are already struggling to consume. This means that Chinese consumption will drop. China is now struggling to feed its population, and pork prices and food prices in general are inflating up to 40% y.o.y.

I’m not the only one to notice this; Premier Li KeQiang has said he will slice interest rates to boost consumption (Yeung, 2019). The problem is that Chinese citizens have higher and higher Engel co-efficients, and so an interest rate cut will boost the consumption of businesses and the rich, but I wonder how effective it will be on the middle-class and below?

The currency devaluation has a long-term side effect: if you are someone trying to bring jobs home to your country, then a Chinese public who 1) cannot buy your goods and 2) is now more competitive in wages is not a good sign for America. China having among the largest middle class in the world, as well as being a tourism exporter, are important customers for many markets. We shall explore this later in this article.

However, a sufficient weak yuan may end up hurting Chinese exporters as profits become non-existent with a weaker currency (Yeung and Huifeng, 2019). Not only that, but total new orders has decreased in the meantime (Reuters, 2019a). It seems that domestic demand alone cannot support the entire Chinese industry.

There is also another problem; during the credit crunch with the 2008 Financial Crisis, it was partly Chinese capital expenditure, loans, and deals that allowed the world economy to keep ticking (Grill et al., 2019). Should the world have a downturn now, China will have less ability to prevent or reduce a collapse with a weaker currency, as well as larger existing debts than 10 years ago.

Winners in the Slowdown

While the purchasing power of the Chinese consumer base has waned, anyone who has lived in China can guess the luxury goods which are doing well; foreign luxury cars, beers, and beauty products (McKinsey and Group, 2019). For the wealthy of China, these goods are quite inelastic in their purchasing habits; if you have the money, you get a foreign car, or Dior make-up. Ask a young Chinese woman about this: the fervour for foreign cosmetic goods above domestic goods is quite impressive.

Not only that, but half of new luxury consumers are new consumers in general; unaware of traditional or legacy luxury brands, they are also ripe for new brands to establish themselves in the Chinese market. Legacy brands cannot rely on that alone anymore (McKinsey and Group, 2019).

Another winner for this group; part of Li Ke’Qiang tax plan is a cut-down on luxury tax rates domestically, so the Chinese may begin buying domestically than abroad, which will help the Chinese market, and foreign brands indirectly (McKinsey and Group, 2019).

Another potential winner is China’s domestic stock market. With increased restrictions on foreign investment out of China, and Hong Kong suffering issues, the Chinese are preferring to invest domestically. The restrictions on capital movement away from China means that Chinese citizens will only be able to realistically invest within China, and the foreign investment is less attractive (Yueng, 2019). That means that more and more Chinese citizens shall place their savings wholly into the Chinese market, and be unable to move savings to other countries to provide diversity in their portfolios, and provide financial security. Good for Chinese companies, but I am reminded of the old tale of eggs and baskets.

There is an argument to be made, however, that the Chinese government forcing investment into the domestic stock market will help boost stock prices and domestic company funding (as choice is limited for the investor). As such, this could provide long-term capital supply for technological innovation, and therefore long-term growth

Other issues involve increased political education by S.O.E.’s to their employees (Kawase, 2019). When companies spend more time focusing on non-profit seeking activities, it in turn reduces the total factor productivity of those companies, as companies work to align themselves with ‘Xi thought’ instead of business. The reason for this? The trade war is likely to cause the Chinese some stress, and the Chinese government has decided to tough out the difficulties, calling it the ‘New Long March’ agains the United States and this trade war. China is preparing for a long, dug-in economic war with the U.S., and it is beginning by ensuring the S.O.E.’s are in the trench (Perper, 2019).

Huawei’s CEO Ren Zhengfei: “We sacrificed [the interests of] individuals and families for the sake of an ideal, to stand at the top of the world” (Perper, 2019).

Of course, with all of the money printing focused on large Chinese state-owned enterprises, the S.O.E.’s continue to do well, as we have seen in previous articles. With the slowdown continuing, there are calls for further quantitative easing, which will help these companies further (Reuters, 2019a). Indeed; there has been a pick-up in onshore bond purchasing from local companies and governments (Reuters, 2019b).

Schrödinger’s Economy: Chinese market collapse?

China provides a lot of goods for a lot of people; China also sells a lot of goods for a lot of people. However, it is slowing down; for over a quarter, Chinese factory activity has dropped, as well as a small rise in unemployment over the same time period (Reuters, 2019a). However, even as trade slows down, the domestic service sector has been increasing and holding the fort for the Chinese (Reuters, 2019a). Not only that, but with a massive public debt based abroad (through One Belt, One Road), there is a small safety jacket placed on the Chinese economy as foreign repayments will continue to trickle into China.

If the Chinese economy were to collapse, one economist, Robing Xing of Morgan Stanley, predicts a global recession within 3 quarters (Yeung and Huifeng, 2019). Issues regarding Hong Kong also have seen a downward pressure on global growth, with Hong Kong being one of the global trade centres in Asia (Bloomberg, 2019a).

The Chinese economy is also very tightly linked with all of it’s neighbours, as we have seen. As such, we have seen a drop in the currencies of China’s neighbours, such as South Korea and India.

One of the biggest drivers of growth in China are the young (McKinsey and Group, 2019). Watch them; if they stop buying, we’re in trouble. One of the largest areas in which they purchase heavily are luxury goods. Notice also that China is perhaps one of the largest consumers of luxury goods; Chinese consumers are estimated to buy 65% of the world’s additional luxury goods by 2025 (or 40% in total); they already represent a third of all luxury spending (despite being a fifth of the planet, meaning they are punching above their weight) at $115 billion in 2018 (McKinsey and Company, 2019).

The young are optimistic; many new graduates are delaying their graduation by a year to avoid this market, and because they believe that the economy shall be better in a year (Bloomberg, 2019b).

However, the young have many upcoming problems; housing, healthcare, education, all of which are generally seen as inelastic (I mean, not many people will choose to let people die over saving money) which all drive down that spending.

So Is The Chinese Economy Really Slowing Down?

Yes. This isn’t in debate at all, even the most pro-Chinese economist admits this. The real question is how much.

It’s not unknown that the real GDP figures are false, and even a quick examination of the numbers will prove this. The Chinese government itself only uses GDP as a measure of assuring growth to the people. A metric used by the Chinese government is the Li Ke’Qiang Index; an alternate measurement that is less likely to be manipulated:

Source: Norland, 2018

In the above graph (Norland, 2018), we can see that the Li Ke’Qiang Index matches the 3yr-10yr yield curve even better than most other measurements; it also predicts many commodities such as platinum, industrial metals, and so on.

The Li Ke’Qiang Index uses the following measurements:

40% Bank Lending

40% Electricity Consumption

20% Rail Freight

Why? Bank Lending for the financial sector also represents the movement of money, investment, and purchasing of goods, services, and wages. Electricity is used by both citizens and businesses. Rail Freight represents the movement of goods across the country; a representative of business. It is also more honest, as these numbers are less likely to be covered up; notice at 2015-2016, Chinese growth dropped to nearly 0.5%, which matches the money supply and changes in inflation found here.

Notice, however, that this measurement also uses every part of One Belt, One Road (money lending, rail freight, and electrical production of goods to send abroad).

But even with these figures, you’ll find that China’s economy is slowing down fast, and certainly still heading down long-term (but we don’t have the 2019 numbers yet).

Debt and Credit Crunch

Some reports suggest China has 300%+ of public debt, or 15% of the global total of debt (Reuters, 2019b). Other numbers include $40 trillion.

The debt looks like this (Lee, 2019).:

Household debt (54% of GDP; we covered this before, and why)

Government debt (51%)

Non-Financial Corporate Debt (155.6%)

Financial Sector (41%)

Why is the non-financial corporate debt so high? Because companies are encouraged to take these loans in order to work, expand, produce goods for domestic and foreign goods, expanding into Africa, South America, Asia, and so in through One Belt One Road, and all around drive the economy through consumption and investment (Rothman, 2019).

There is also another thing to consider; how you count the debt. You will see, if you look it up, that U.S. public debt is 77%, and U.K. public debt is 80%. What if we count these countries like we count China’s?

Source: Rothman, 2019

As we can see from Rothman (2019), if we counted everyone the same way, China has actually about 50% of public debt, as the U.K. has 80%, and Japan has over 200%, and the U.S. has 77%. China remains below even the G20 average.

So Chinese debt has been overblown; it’s spending a lot, certainly, but its issues are regarding trade and exporting, not debt. As long as people expect that China can pay back its debt, and China continues to sell to either other countries (One Belt, One Road and being the world’s largest trade partner) or itself (20% of the world’s population), the debt really isn’t a problem. As long as the economy keep ticking, it isn’t a problem in the short term.

If you want to be worried, we should be worried about two factors for China:

1) The growing elderly population

2) Chinese disposable income being reduced via inflation (a side-effect of the debt, mind)

3) China losing trade with wealthy countries

4) Foreign countries being unable to pay back their debts to China

China has tried to correct this debt: If you remember, about 2 years ago, China’s public sector was under massive pressure from the government to reduce spending. I’ve met one of the guys who does this for a living. He will go to a business, check numbers, fire people, reduce their benefits. I also know a high ranking member of the Communist Party. No more additional houses, no more free meals paid by the local government. Officials are expected to pay, and present those receipts to inspectors. Why? Because China wanted to reduce corruption, and reduce public debt (The Tigers and Flies Campaign). Then entered Trump, the trade war, and China injecting capital into its economy to keep it running, hence this rise in debt (Lee, 2019). 

Currently, Chinese banks prefer to lend cash to large state-owned enterprises because they’re more reliable (Stevenson and Li, 2019). Chinese investors have become more wary, however, and like the banks, prefer to invest in safe S.O.E.’s; venture investment has dropped by 77% (Bloomberg, 2019b)

As such, private businesses and SME’s have begun to lend each other commercial acceptance bills in larger quantities than ever (over a third more than 2018). Unsurprisingly, we have seen a contraction in SME’s and private industries in China since the start of the trade war (Reuters, 2019a). This is something to be concerned about; a shortage of capital is the cause of many economic collapses. 281 smaller companies have declared bankruptcy in July 2019, an increase of over 40% (Stevenson and Li, 2019).

There is also concern about the debt incurred by One Belt One Road. China has exported more capital to developing countries through loans than the rest of the industrialised world put together (Grill et al., 2019). This debt is greater than the rest of the debt in China combined (Lee, 2019).

There is also a demographic issue; China is about to become overwhelmingly old. Chinese pension debt is 200 billion yuan now, and is about to become half a trillion yuan by 2022. Pension reforms have yet to be enacted, and the problem will only become worse in time. There are two issues blocking this:

1) There are going to be an awful lot of old people, and not as many young people to pay the taxes to support them.

2) Businesses are not paying their fair share by Chinese law. However, forcing companies to do so will drive more businesses into desperate circumstances during an already desperate time (Rothschild, 2019).

This upcoming elderly pension bomb is not unique to China, but China has a unique cultural issue; care of the elderly is important in China, and part of the government’s legitimacy is linked to the general welfare of the people, and should the elderly fall homeless or in poverty, it will hurt the legitimacy of the Chinese government. The problem is solved with money, but this is not a time where China is cash-flush.

Conclusion:

The depreciation of the Chinese yuan has advantages for China; despite the massive foreign reserves of China, I believe that the forced appreciation of the currency in general has led to difficulties for both the Chinese labour force, as well as inflating the price of their goods which has a general drag on the purchasing power of the planet. This is not a good thing for the rich in China (who I feel have advantages enough), but it makes the poor in China more competitive for labour, it makes investing into China more attractive, and it makes Chinese goods even cheaper without having to reduce quality.

It does make purchasing foreign goods less available for the Chinese, and will make exporting to China more difficult; however, China has an attitude of 一分钱,一份货; ‘you get what you pay for’. The more expensive a good, the more exclusive it is, and thus the more likely the Chinese will buy it. So luxury goods may find themselves still benefitting, as research so far shows. It also means that repayments to China through One Belt, One Road paid in USD will be cheaper to repay; the good side is that repayments are more likely when the cost is cheaper, but it means that China will receive less from these payments that originally agreed.

In terms of public debt, we’ve found that China’s is really not so high (50%), and that the massive number is due to biased counting of other factors that we do not count for other countries. Once we include these additional numbers, almost every country is above 200%, and many are above 250%. As long as consumption continues, this shouldn’t be a problem for China more than anyone else.

What issues do exist? I’ll lay them out again.

1) The growing elderly population

2) Chinese disposable income being reduced via inflation

3) China losing trade with, or being blocked from, wealthy countries

4) Foreign countries being unable to pay back their debts to China

5) An ever increasing focus on S.O.E.’s at the expense of SME’s

6) Food supply, prices, and inflation

Thankfully, I’ve written an article for each of these problems or their context if you’d like to read further; this is not an easy topic and requires large amounts of consideration.

I’m afraid to say that the Chinese economy is here to stay, and likely for a long-time. Even with the trade war, things will perhaps get difficult for the Chinese, as well as the domestic problems listed above eventually requiring attention, but the sheer economic size, population, spending power, One Belt One Road, and infrastructure both foreign and domestic of China cements its growing place as the Middle Kingdom of trade for a while yet.


If you’ve enjoyed reading this, please consider following me on Twitter @LeonDeclis or on Apple News on the Idea Meritocracy channel, or a Facebook page at @IdeaMeritocracyEcon. There is also an RSS feed option on this website for direct updates! Have a nice day!


Bibliography:

In all articles, I provide as much information for sources as possible, including links. I encourage everyone reading this article to read deeper, and make their own conclusions. For students, links are here so they can read the original source themselves. Most sources are linked the first or second time they appear in the article.


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