Writing about the Chinese economy can be daunting, not only because it’s so big. China is just plain extraordinary. Things in China work differently from elsewhere, sometimes astonishingly so. Predicting how such an unusual place will change is close to impossible.
But change is certainly in the air. The news of the moment is capital flight, which is believed to be accelerating. Not long ago China was a very difficult place from which to export capital. Lately all sorts of formal and informal holes have been opening up in the old system of capital controls. Chinese money brokers boast they can turn your yuan in China into dollars in a foreign bank account in about an hour.
Nomura’s chief China economist, Yang Zhao, estimates that $100b was sent or pulled out of China in the first three weeks of August, on top of $90b in July. That’s according to the Daily Telegraph’s summary of his private research. Much if not most of the departing money represents Chinese investors paying off dollar financing and liquidating long positions in the yuan or commodities.
The trigger for this exodus was a mere 3% drop in the value of the yuan, a scale of devaluation that anywhere else would have been taken in stride. But the Chinese currency market is so carefully managed that a 3% move wasn’t just shocking. It was understood to represent the tip of an iceberg of market pressure.
And indeed the yuan has been under growing pressure for about a year. The central bank’s decision to hold the yuan stable against the strengthening dollar resulted in a costly appreciation against most of China’s trade partners. With export growth slowing, that has been difficult to defend. As of the end of June, the central bank’s foreign exchange reserves had shrunk by about $340b over the past 12 months. Probably about half of that was devaluation of non-dollar assets, and the rest was spent intervening in currency markets to prop up the yuan.
Now the central bank is believed to be spending FX reserves much more rapidly, as it struggles to prevent further depreciation. The pace and scale of its intervention is likely more than $10b a week.
That’s the background in which I present the next three charts. I don’t mean them to provoke alarm or to spread a sense of doom. Remember, China is different.
One way China is especially different is its very large volume of bank deposits. As of the end of June, China’s M2 money supply, which includes circulating currency and bank deposits, came to $21.5 trillion. M2 is defined somewhat differently in different places, so international comparisons aren’t exact. But if taken at face value, China has about 75% more M2 than the United States, although the US economy is still about two-thirds bigger than China’s.
What this chart shows is a sizable portion of the world’s wealth moving into Chinese bank deposits. That has happened partly thanks to the considerable wealth-generating power of China’s export-oriented industry, and partly because in China other kinds of financial assets are less developed. Bank deposits in China substitute for any kinds of public and private savings, insurance and safety nets one finds in advanced economies.
Those $21.5 trillion worth of Chinese deposits and currency also represent the opposite side to commercial bank and central bank assets. The largest and most important part of those are commercial bank loans, which in China are largely state controlled and often used as a kind of quasi-fiscal stimulus. China had $15.2 trillion worth of bank loans outstanding at the end of June, compared to $12.9 trillion at Euro Area banks and just $8.3 trillion of bank loans in the US, where bonds are favored over loans in corporate finance.
In other words, the value of deposits in Chinese banks is backed mainly by the loans those banks made to finance China’s urbanization and industrialization.
The next chart puts the difference between China and major advanced economies in starker terms. Instead of comparing the outstanding stocks of M2 across economies, this chart compares the flows of new M2 being created, relative to GDP.
And here you can clearly see how different China is.
Remember all the talk about the vast sizes of advanced-economy quantitative easing programs? You might be able to see those here, barely. Major advanced economies have been adding M2 at paces that usually hover around 5% or less of GDP, broken mainly by a surge of M2 creation in the Euro Area before the 2008-2009 crisis. But even that didn’t come close to the pace of 15%-40% of GDP at which China has been adding M2. Remember, most of that M2 creation in China is through commercial bank lending.
The good news is: the loans tied to this M2 growth have by and large worked, despite some that haven’t. Chinese exports grew from about $320 billion in 1999 to $2.2 trillion in 2014. That’s according to the import data of China’s trade partners, so there’s no question of fudging. Even after accounting for dollar inflation, that still represents an almost quintupling of exports over 15 years, or an average growth pace of about 11% a year. That couldn’t have happened if loans were rampantly misspent.
The other good news is that Chinese people and companies seem to mostly trust that their deposits will be made good. One of the main distinguishing features of an undeveloped country is lack of popular trust in bank deposits. The least developed countries of the world typically have M2 to GDP ratios of less than 25%, and if they attempt to grow M2 too rapidly, most of it turns quickly into circulating banknotes and drives inflation.
The Chinese people’s willingness to hold bank deposits is evident in the fact that M2 reached 204% of GDP at the end of June. That compares to 184% in Japan, 98% in the Euro Area, and 68% in the United States. When people are willing to hold increasing volumes of bank deposits as savings, that sterilizes liquidity and allows banks to boost lending without driving a lot of inflation.
The bad news is: the supply of bank deposits in China is nonetheless probably too high. There appears to be a large pent-up demand in China for alternative financial assets in which to save. The high-flying, short-lived equity bubble of last November to June can be seen as one symptom of that pent-up demand. The same can be said of the over-investment in residential apartments that prevailed until last year, leaving a glut of unoccupied flats held for investment.
The current wave of capital flight could be another symptom of pent-up dissatisfaction with deposits. After all, even one-year time deposits earn only about 1%-1.5% in real terms. A 3% devaluation and a perceived threat of more are serious reasons to reconsider trying to save that way. However unusual China is, it can’t get around that it’s still a developing country without the rule of law and other liberal traditions that underlie popular trust in bank deposits in advanced economies.
The other bad news is: China’s bullish lend-and-grow strategy might not be working anymore. Many people have tried to call its expiry date before and been proved wrong, so I wouldn’t be too certain. But it does appear that large sectors of China’s industry are hitting a wall of overcapacity.
That’s most clearly reflected in the fact that nominal GDP growth, especially in US dollar terms, has slowed much more rapidly than real GDP growth. Nominal GDP growth in the first half of 2015 was just 6.5%, less than real GDP growth. That means output volume gains are driving down prices.
One of the biggest problems for China is that most of its fastest-growing export markets were its suppliers of raw materials. They have been hard hit by big drops in prices for those materials, and many are devaluing their currencies and sharply reducing imports.
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