First published: 5th August, 2015
It never rains but it pours.
China’s angling to have the RMB included in the IMF’s SDR basket when the IMF’s five-yearly review takes place later this year, may have hit a roadblock. The IMF has just announced (5th August) that while the review would still take place, any changes to the SDR would not come into effect until September 2016.
Until the announcement, China has struggled to stabilise its equity market and made its stability dependent on extraordinary intervention and regulatory support measures.
And behind the world of finance, the structural downturn in economic growth is unrelenting. For the fourth year running, infrastructure and liquidity support initiatives have been wheeled out to stabilise economic activity. They seem to be working in the middle of the year but are likely to lose their edge before too long. The downturn in the economy has to be viewed in the context of President Xi’s strategy of political centralisation and his more assertive stamp of Party control over the government, which is turning out to be a double-edged sword.
China’s financial diplomacy – the SDR link
I have referred before to China’s new financial diplomacy here, specifically to the One Belt One Road, AIIB, NDB and capital account liberalisation initiatives. China’s wish to have the RMB added to the SDR basket is part of this broad policy narrative. The SDR is, of course, the IMF’s accounting unit. No one has deposits or makes transactions in SDRs, but in China’s eyes, inclusion would corroborate a new found and desired status. It is probable that the RMB is going to be included in the SDR – Christine Lagarde has said it’s a question of when, rather than if – but the phased timetable is most likely to give China the opportunity to make further progress on financial reform and openness.
Whether the inclusion of the RMB in the SDR enhances or accelerates the Chinese currency’s prospects of becoming a significant reserve currency is a moot point. For reasons that many including your scribe have explained before, the RMB can’t really become one until China either runs a permanent current account deficit or has a fully convertible capital account in which trillions of RMB can flow freely into and out of China. Since neither of these are likely any time soon, or are even compatible with the Party’s political philosophy, reserve currency status on a scale bigger than that of the Canadian and Australian dollars, Sterling or even the Japanese Yen can be safely be put to one side.
Nevertheless, the RMB is going to become more usable and used in the global economy, as is evident from its growing significance in direct currency trading, trade invoicing and settlement, the denomination of capital market transactions, and its representation (still on a small scale from a low base) in central bank reserves. China believes the strategy to ‘internationalise’ the RMB will be helped in the wake of its admission to the SDR. To this end the People’s Bank of China has kept a firm grip on the currency even as the US dollar has soared against most emerging market currencies, and China’s regulatory authorities have continued to liberalise capital account regulations.
There is no problem on the IMF Board – which much approve SDR basket changes by at least 70% – with the export criterion for the RMB to be included. There is though still some contention about the ‘freely usable’ criterion, which is essentially about regulations and controls on capital account items and on the flexibility of the exchange rate. Even if the US with 16.7% of the voting rights, and Japan with 6.2% were to vote against China, there would still be enough votes among European countries and BRIC economies to offset them. After the AIIB saga, it seems unlikely that the US would want to make an issue here, but you never know…..
In any event, most types of capital transactions in China are now permitted, but few are free of government controls, quotas and so on. The IMF has noted that China has now introduced full or partial convertibility for 35 of 40 capital account transaction types. Foreign direct investment is mostly open but subject to approvals, and restrictions in some sectors. Trade credit and offshore borrowing are subject to prudential controls. Foreign exchange regulations are widespread but have been eased, while RMB is subject to a managed float with daily fluctuation margins that may now be +/-3%.
The biggest obstacles outstanding relate to transactions by individual citizens, portfolio inflows and especially outflows where a structured quota system persists under the Qualified Domestic and Foreign Institutional Investor programmes. China is taking its foot away very slowly by allowing greater access to domestic equity, bond and interbank markets, and sanctioning modest private portfolio capital outflows. It seems, most likely though that China will persist in welcoming inflows more than it is prepared to allow outflows, and that controls, restrictions and quotas will persist, much as we would expect of a political party that insists on its primacy and control over the state and citizens.
Stock market messages are about debt…
Those who have followed Chinese equity markets since the Shanghai and Shenzhen markets were opened in 1990 and 1991, respectively, may be blase about what happened in June and July. If a bear market is a fall in value of 20% or more, this year’s bear is the 27th in less than 25 years, and only six have been bigger. But as I wrote in the Financial Times on 5th July, Calling Time on China’s credit and stock market party here, China’s stock market isn’t really a market in the way we understand. Rather, it functions objectively as a state-directed channel for asset appreciation and determining capital structure for SOE’s. Clearly, on both grounds, things didn’t quite work out as planned.
Suspensions – at one time affecting half the listed names – significant liquidity creation, buying by pension funds, and state investors including especially the hitherto little known China Securities Finance Corporation, short selling and IPO restrictions, and investigations and punishments finally look as though they have stopped the rot that set in after the Shanghai Composite high of 5166 on 12th June. But through all the volatility, it was barely higher on 5th August (3694) than the lows to which it has periodically slumped between support announcements.
Behind the headline making news and volatility though, two main strands of thought emerge.
First, boom and bust in the stock market are one more reflection of China’s date with debt addiction, over-investment, and slowing economic growth. In the equity market, the specific villain was margin debt which had been allowed to escalate sharply along with stock pledge lending, under which executives of listed companies pledged shares as collateral for loans. The latter is thought to have surged in the last few months before the bust and while the numbers are imprecise, each scheme may have outstandings of about RMB 2.5 trillion, even though margin debt outstanding has probably come down a bit since July. Debt-financed equity price appreciation echoes debt-financed capital spending and capacity expansion, as is now widely understood.
Frustrated by the failure to sow the seeds of more equity financing by nurturing thr equity markets, and undeterred by the current state of play regarding corporate and national debt levels, China has just authorised its development banks, which were heavily recapitalised earlier this year, to issue RMB 300 billion – a down payment on an eventual RMB 1 trillion – to fund new infrastructure projects. This takes the spotlight away from local and provincial governments that had been centre-stage in debt financing. The government had also banned, and then relaxed restrictions on, local government financing vehicles from borrowing more. It had also announced a debt swap plan under which local government bank debt was earmarked for replacement by new and cheaper bond issuance. Briefly, a series of announcements and initiatives designed to put a lid on SOE and general government debt financing don’t seem yet to have planted roots.
… and politics
The heavy-handed and at times, clumsy, intervention to stop the fall in the equity market revealed not only that state has many tools (of questionable effectiveness), but also that it does not trust the very market mechanisms that it vowed in 2013 to introduce to help promote efficiency and new sources of economic growth.
To be fair, though, we have to acknowledge that under new leadership and emphasis on Party management, the state has succeeded in doing a number of things. These include overcoming resistance to financial reforms and local government debt controls, capital account liberalisation, more forceful environmental regulations, the freeing up of some utility prices, establishing discipline among senior Party, SOE and PLA cadres (as far as we can see), and advancing China’s new financial diplomacy.
And these accomplishments can be attributed directly to President Xi’s initiatives to forcefully put blue water between the Party and the apparatus of government. I have addressed the implications of Xi’s emphasis on Party purity here, but we can now see my earlier concerns were, if anything, an understatement. Convinced that his predecessors’ neglect of the Party had lead to political gridlock, deteriorating economic performance, and widespread corruption, Xi has been determined and ruthless in centralising power around himself and Party bodies, especially the so-called 39 ‘small leading groups’, which are anything but small, and which have effectively usurped the number, power and authority of government ministries and agencies. For the record, Xi himself manages 7 of 18 of the most important groups, while Premier Li Keqiang manages 5 of 21 others.
So while, decision-making and overcoming resistance in government circles have been enhanced by these political changes, they have at the same time created new problems that have stifled the economy and the ambitious programme of reforms in other ways. They have blunted the effectiveness and risk-taking capacity of government, as opposed to the Party, exacerbated the economic slowdown, and forced the People’s Bank of China and the other agencies of the state to introduce liquidity and fiscal support measures, blurring the Party’s principal dictum that economic stimulus should play second fiddle or less to structural reforms. Since the Party has also clamped down further on human rights advocates, NGO’s, the media and the legal system, the machismo of centralisation could ricochet quite easily, resulting deteriorating economic performance, and little progress in overcoming the economy’s addiction to debt, and resultant deflation and overcapacity. Worst of all, we can already see signs that it is interfering with a much need recasting of the role of the state and of state institutions, and the shift towards private and market-based economic initiatives to boost flagging productivity. These hold the key, after all, to China’s medium-term economic prospects, and to its cherished goal of avoiding the so-called middle income trap, and commanding the world’s respect for a soft power it hasn’t yet acquired.