China’s Rebalancing Timetable by Michael Pettis Global Source Partners

Special points to highlight in this issue:

  • Last week’s announcement by the IMF – that the RMB would join the four currencies that comprise the SDR – set off yet a new round of speculation about the future value of the RMB. On balance and over the medium term there are stronger economic reasons to keep the RMB steady than to devalue the currency by enough to affect the trade account, but it is important to remember that any change in currency policy is also form of distribution of resources within China. For this reason any decision is more likely to be the outcome of political give and take than of a carefully reasoned economic strategy.
  • The PBoC announced one of the biggest ever monthly declines in central bank reserves: Reserves dropped by $87 billion in November, of which over $30 billion may represent valuation changes in non-dollar reserves. This highlights the need for the PBoC to address net outflows on the country’s capital account.
  • One of the key questions facing China is the amount of time Beijing has to get its rising debt burden under control. This is the timeframe within which rebalancing must occur, and while there has been very little discussion about this timeframe among most analysts, this is mostly because few economists understand China’s debt dynamics, or indeed the dynamics of sovereign debt more generally. What is more, there is nothing in the literature that shows how to evaluate a country’s debt vulnerability. But investors and policymakers still need a way to frame the issue of timing. Once China reaches its debt capacity limits, or once debt levels are high enough that financial distress costs become highly self-reinforcing, China will be forced into a disruptive adjustment.

I don’t usually do this but a recent piece I wrote for my blog – about the timing limits that that China’s debt capacity imposed on the Xi administration – seemed to get a lot of attention and generated many questions. It occurred to me that it might be useful to write an issue of this newsletter around that piece, and provide graphs, additional tables, and a more complete explanation of the model I used. Next week I will send out the newsletter I was planning for December, with this current issue mainly for the purpose of expanding the explanation of how I think about debt constraints.

Before I go into it, I thought I would preface it with a note about last week’s IMF announcement that the SDR basket would now include the RMB. The announcement caused the inevitable surge in speculation about the future direction of the exchange rate. I spoke to some of my former students who are now in Hong Kong trading currencies. They’ve become cynical, as traders do, and suggested that now that the IMF has approved the new SDR arrangement, they may have lost any ability to influence PBoC behavior, an argument that I have heard repeated elsewhere among investors.

It was perhaps mainly because of an implicit threat that the IMF would withhold approval, they suggested, that Beijing has devalued the RMB sharply over recent years. With that threat gone, after an appropriately respectful pause to allow everyone to save face, the may decide to force down the value of the currency so that China can grab a larger share of weak global demand as it wrestles with its domestic demand imbalances.

They didn’t necessarily believe that this would happen, only that the IMF announcement eliminates a constraint, and whether or not this constraint actually interfered in Beijing’s devaluation plans, its elimination must introduce a jump in expected volatility. I try to teach my students who are planning to become traders that, unlike investors, traders shouldn’t have strong opinions one way or the other about the fundamental direction of prices. Aside, of course, from always looking for convexity, mis-pricings, and structures that embed reflexivity, they would probably do best if they treated the decision-making process largely as a black box, subject to a whole set of incentives that range from those emerging out of the obvious economic fundamentals to political, institutional and structural incentives. The more clearly they grasped the incentive structure, the better. A good trader won’t necessarily know what will happen next, but he should never be surprised by what does happen.

So it does make sense to think carefully about what the external pressures for and against devaluation before the IMF decision were, and how the IMF decision might have changed those incentives. Including the RMB in the SDR basket certainly does eliminate a potential reason not to devalue, so that unless the decision also eliminates or lessens a balancing pressure, it must increase the probability of devaluation, by however small an amount.

But is a weaker renminbi more generally in China’s best economic interest? It probably isn’t, at least not over the medium term, for at least three reasons. First of all, devaluing the currency would reverse the painfully limited rebalancing of domestic demand China has managed over the past four years. I discuss the extent of rebalancing a little later in the newsletter when I introduce the model I use for thinking about the time constraints China faces. The important point is that a weaker RMB represents a transfer of resources from those who are long the RMB and short the dollar (or short foreign currencies more generally) to those who are long the dollar and short the RMB.

The PBoC would be the biggest winner, of course, with its huge, mismatched balance sheet. Exporters would benefit too, as would Chinese businesses and wealthy individuals who own assets abroad. The losers, on the other hand, would be businesses who have borrowed abroad to fund domestic operations, and net importers, which includes the entire household sector (except subsistence farmers).

What is more, if China’s low urban unemployment causes the tradable goods sector to bid up wages as exports expand, the labor-intensive sector, which is dominated by the services sector, would lose twice – once because wages were bid up and once because transfers from the household sector would reduce consumption, and the main source of demand for the services sector is household consumption. A weaker RMB, then, strengthens exporters, the central bank, and entities with foreign assets at the expense of households, the services sector, and companies that have borrowed abroad. Except for the last, this reverses the direction of flows that Beijing actually wants for China, and this is probably one of the main reasons the PBoC is said to oppose devaluation.