Zonder, I think Andy Xie's points (bolded) are likely to be the case, and if so, watch for signs of crumbling US financial markets.
morganstanley.com
To Be Sure, the Answer Was “No”
Andy Xie (Hong Kong)
China has said it will not change its currency policy for the foreseeable future. During US Treasury Secretary John Snow’s visit to Beijing, China’s leaders made this quite clear, in my view. However, in case anyone is still confused about who said what, the answer from China was again “no.”
I believe China must reform its financial system before it can open its capital account and change its currency policy. The reforms are not just about solving the stock of non-performing loans in the banking system, but more importantly, they are also about stopping the banking system from accumulating more bad loans.
The non-bank financial sector also presents a serious risk to China’s stability, in my view. In particular, our strategist believes the stock market is overvalued; I believe it is not a level playing field.
Further, the inefficient financial system reflects the contradiction between the need to narrow the gaps in regional incomes within China and the inability of the government to collect taxes. If China does not streamline its tax system to raise national tax revenue to more than 25% of GDP, the central government will likely have to continue to rely on banks to support investment programs in poor provinces to narrow the gaps in regional incomes.
There is a race between GDP and bad debt in China. If the latter grows faster, as it has been in the past, China may need to devalue the currency when its exports slow down because inflation is needed to reduce the burden from bad debt. Although productivity gains may support a renminbi appreciation at some point, the financial system is distinctly pointing at the other direction. If you are betting on the renminbi today, I say good luck.
China’s Gain in US Market Reflects Trade Redistribution
Some blame China’s market share gain in the US for the ballooning trade deficit in the US. I believe this is wrong. China’s gain largely reflects a redistribution of exports to the US from other East Asian economies to China. In the first half of 2003, overall imports in the US rose 10.3% from last year. However, its imports from East Asia increased only 7.4% even though its imports from China rose 25% in the same period.
Indeed, East Asia’s market share in the US declined to 32.5% in 1H03 from 33.4% in the same period last year. East Asia’s market share has declined steadily from a peak of 40.1% in 1994. This is because East Asian economies have been cutting prices in competition among themselves.
The US trade deficit with East Asia has been stable since 1999 even though its overall deficit has risen sharply. Its widening deficit with China reflects that the final stage of production for the US market has been shifting from Japan, Korea and Taiwan to China while these economies have been increasing exports of components and equipment to China. Even though China runs a large trade surplus against the US, it runs a deficit against every other East Asian economy. This is why China’s overall trade is now in balance and is probably headed to a deficit position.
Trade Sanctions Do Not Frighten China
For each US$1 in value for a product that China exports to the US, a product sells for US$4–5 at the retail level in the US. Therefore, American brand owners and distributors benefit far more from China’s output than the Chinese themselves. Moreover, for each US$1 in value for a product that China exports to the US, businesses in Hong Kong or Taiwan take 20 cents. More than US$1 trillion of market capitalization in the US stock market depends on inexpensive Chinese imports, by my estimates. If the US were to impose sanctions on China, it would likely cause the US stock market to weaken, which could prompt a recession.
Moreover, as we have argued before, China would not be able to purchase US bonds if it could not export to the US. That would likely increase bond yields in the US that in turn could deflate the US housing market, which would be an even more likely reason for the US to go into a recession, in my view.
I believe it is incorrect to compare China today with Japan in the 1980s. Japan made products on its own, built its own brands and even created its own distribution channels in the US. Sanctions on Japanese products mainly hurt Japanese producers. In contrast, sanctions on China’s products would directly hurt American businesses, in my opinion.
US consumers have paid US$100 billion less a year for goods since 1997 because of the drop in prices for products from East Asian economies. Anyone who is blaming China today should think hard about what China means for American consumers whose spending has kept the US economy afloat. Without the low prices because of imports from China, would American consumers continue spending like they have been?
Financial Reforms Must Precede Capital Account Liberalization or Currency Regime Changes
The China’s currency peg to the US dollar is first and foremost about confidence, in my opinion. The high level of non-performing assets in the banking system casts doubt on the value of the renminbi, but the peg creates the illusion that its value is the same as the dollar. Without the peg, China’s depositors may not be so easily convinced. If China were to change its currency regime without fundamentally reforming its financial system, it could lead to a financial meltdown.
Financial reform is hard in general, but I believe it is much harder in China. State ownership has always led to banks being poorly run. However, full privatization of banks in China is still not possible at present, in my view, because China is still relying on its state-owned banks to fund investment in poor provinces to narrow the income gap between the different regions of China. Of course, this process is creating bad debts in itself. Indeed, state ownership opens the door for creating bad debts in every direction. Without a profit motive, is it possible for a bank stop creating bad debts?
I calculate that China must increase its tax revenue to 25% of GDP from 17% at present to make income redistribution transparent through fiscal redistribution. However, China is giving tax breaks to investors to encourage investment, eroding the tax base. The high value added tax (VAT) and land sales have become the most important sources for government revenue. The transition from the current tax system to one with a broader base — a necessary condition for raising revenue to 25% of GDP — will likely be long. In the meantime, the government will likely continue to rely on banks to redistribute income. Therefore, we believe it is unlikely that China can easily solve its financial problem in the foreseeable future.
Eventually, China’s current system could lead to a devaluation. Indeed, inflation brought about by a devaluation — as was the case with Korea in 1998 — may be necessary to pay for the current income redistribution. |
