This is going to be a pivotal year for China. We will see if it can levitate another year or whether it falls back to Earth in 2017. My base case is that they continue the levitation act, but we are going to see an increase in volatility.

China is manipulating the yuan but with a twist

 

An Estimated $1.5 Trillion In Corruption Proceeds Escaped China Between 1995 And 2013
Source: Pixabay

I’m not sure how many people are aware that the overnight rate for offshore yuan reached an incredible 105% at one point last week.

The natural direction for the yuan, if it were allowed to float, would be significantly lower against the US dollar than it is today. The Chinese are manipulating their currency, but they are manipulating it to maintain its current value and allow it to slowly fall to its natural rate.

Any precipitous move in the yuan can unsettle markets quickly.

Further, some $2 trillion worth of Chinese currency has been converted into dollars and moved offshore in the last few years. Think about that in the context of quantitative easing and realize that individual Chinese sloshing money around the developed world impact the global economony to the same extent central banks do.

Keeping the masses happy could have devastating results for China

The Chinese Communist Party will hold its 19th party congress in the fall and will almost certainly give Xi Jinping another five years at the helm. He has become China’s most powerful leader since Deng Xiaoping and could well surpass even Mao before he departs.

Xi may need to exercise all his power if he is to maintain both economic growth and domestic order. Sagging exports and rising labor costs are causing manufacturers to turn to automation, but that shift creates unemployment. Xi’s government is doing all it can to keep the masses happy, mostly by handing out generous benefits and subsidies to the usual suspects—including state-owned enterprises. This help makes it very hard to tell which of China’s many state-owned enterprises are actually turning a profit vs. operating at a loss because officials have ordered them to.

A major side effect is that all the stimulus sloshing through an economy with few international exits has nowhere to go. The Chinese have fairly serious limits on the amount of money that individuals can take offshore in a given year. That means there is a lot of money in China looking for a home.

The Chinese could pull a rabbit out of the hat as they’ve been doing for decades

The results are predictable: asset bubbles rolling through regions and asset classes whose valuations follow no discernible logic. These imbalances can’t continue indefinitely, but I don’t know how the Chinese will arrest them. The direct route would be a currency revaluation. That seems to be what they are attempting, albeit very slowly.

Xi’s hands are tied: Propping up the value of the yuan is going to force him to use his dollar reserves or to raise interest rates in an already volatile market. The Chinese are getting to a place where manipulation will be a lot more difficult than it has been in the past.

The US is the world’s largest economy because we create most of our own supply and demand. It took us many decades to reach that point; China is trying to do it in about two decades. Their export-heavy model can’t work much longer, but they don’t yet have a way to create sustainable internal demand.

Maybe Xi will balance his massive economy perfectly and skip right over the painful adjustments that developing nations typically go through. The Chinese have been doing things that nobody thought they could do for quite a few decades now. But I won’t bet on it either, especially this year.

China’s problem could become everyone’s problem

I saw a report last week estimating that $1.5 trillion—yes trillion—in corruption proceeds escaped China between 1995 and 2013. That is in addition to the legal money coming out of the country.

Most of it landed in the US, Australia, Canada, and the Netherlands, where it has helped to inflate some of our own asset bubbles. In my travels, I constantly run into people who tell me they manage Chinese money. Not trillions, just $50 million or $100 million here and there. It adds up.