China Is Under Pressure…and So Is the Yuan

Wednesday, 13 May 2020
Melbourne, Australia
By Greg Canavan

For the past few years, Australia has been a neutral bystander in the US–China trade wars.

Now we’re in the middle of our own spat with China, and the stock market doesn’t like it.

Because we had the temerity to call for an investigation into the origins of the coronavirus, China is now threatening us on the trade front.

It’s being a bully, but we should not be intimidated.

China is under pressure here. It’s going to be the big loser in a post-COVID world.

Unfortunately, that is going to be an issue for Australia too. We have hitched our economic wagon to a communist dictatorship. As the saying goes, you reap what you sow.

Of course, those who have most to lose are not happy about the government’s call for an investigation. As The Australian reports:

Australian China Business Council CEO Helen Sawczak has accused the Morrison government of damaging the nation’s relationship with China and says hardline advice from security agencies is threatening the nation’s economic wellbeing.

In strident comments during a web discussion with Huawei’s Jeremy Mitchell, Ms Sawczak said national security concerns were undermining Australia’s dealings with its biggest trading partner. “There has been a lot of talk about national security concerns and that they should override our economic interests,” she said. “Well if the spook’s were managing our economic interests this country would go down the gurgler.”

And if we endlessly kowtow to Beijing, we will find ourselves subjects of a police state.

Look, our economic relationship with China is crucial. I get that. But to act with such deference that we want to protect the dictatorship’s feelings at all costs is ridiculous.

As I said, China is under pressure. That’s why it’s reacting strongly against calls for an investigation into the origins of the virus.

While the virus itself may be relatively short-lived (or not, it’s still too early to tell), it’s almost certain there will be longer-term ramifications for China. Even before the virus hit, Trump’s America First policy started the trend to move manufacturing away from China.

The virus induced slowdown will only accelerate this trend, as nations all around the world realise they cannot outsource everything to China.

As evidence of this emerging pressure on China, have a look at its monetary response to the crisis. The following chart shows the cumulative value of new loans and aggregate financing over recent years.

As you can see, new loan growth in March and April this year has surged, despite the sharp economic slowdown. Clearly, China is compensating for the collapse in consumer demand domestically and internationally by turning on the credit taps…again.

The Insider

Source: The Daily Shot

But it will come at the cost of another sharp increase in its debt ratios.

As China watcher, Professor Michael Pettis tweeted on Monday:

Total social financing (the broadest official measure of Chinese debt) for April came in about a fifth above market expectations. It rose by CNY 3.1 trillion (equal to roughly 35 percentage points of GDP), for an increase of 12.0% over…

…April 2019, compared to an already-high 11.5% increase in March. At this rate China’s debt to GDP ratio will rise by at least 14-19 percentage points this year, compared to 6 percentage points last year, which was bad enough.

According to the Institute of International Finance (IIF), at the end of September 2019, China’s total debt-to-GDP ratio stood at a massive 310%. If Pettis is right, it could end this around 330%.

For now, that’s not a problem. In fact, it’s been good for Australia, as it’s kept up the price and demand for our iron ore. It’s why Fortescue Metals Group Ltd’s [ASX:FMG] share price is back up around all-time highs (see chart below).

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Source: Optuma

Given the revenue that iron ore brings into the country, China’s 2020 debt binge has also no doubt helped the Aussie dollar. Without it, we may be sitting in the 50s right now.

Back to China’s debt though…how long can it keep piling it up? And if economic growth is slow to recover, the debt ratios will blow out even more (the economy contracted in the first quarter).

I don’t know the answer to that. What I do know though is that there MUST be pressure building on the US dollar–yuan exchange rate.

The yuan is no longer pegged to the dollar. But it is a managed exchange rate. As you can see in the chart below, after relaxing the hard peg after the global credit crisis, the exchange rate peaked (in favour of the yuan) in early 2014. It’s been falling ever since.

My guess is that this is when China’s economy started running faster on the debt treadmill. It needed more and more debt to produce the same amount of economic growth. One of the few ways of relieving the build up of pressure this causes is via currency devaluation. 

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Source: Optuma

If China is indeed susceptible in a post-COVID world (and you would think it is, given its aggressive response to Australia’s call for an investigation), then a devaluation of the yuan may be on the cards.

That would be bearish for the global economy…and for stock markets.

It would be particularly bearish for Australia, given our reliance on China for export income. 

Our overall market has been hit hard thanks to a big fall in the banks. But the resource sector has outperformed the banks on the back of China’s ‘resilience’.

Just how much longer we can rely on China is shaping up as one of the key questions for 2020.

It’s a topic I’ll be sure to keep revisiting in the weeks and months ahead.