China dominates the discussion as we begin a new year. Sharp drops in Chinese stock markets forced closure of mainland exchanges last week. Indications are increasing that China is seeking to further devalue its currency in the face of weak export demand and declines in manufacturing. We think such a move represents a step backward on the path toward rebalancing and internationalization, which ultimately leads to a healthier outcome for China and the world. Devaluation perpetuates dependency on a broken model of export-driven growth and delays a necessary shift toward a greater role of the private sector and domestic consumer in their overall economic mix. Instead of preserving the status quo and propping up short-term growth, China should be looking to deepen and open capital markets, significantly raise transparency, emphasize the rule of law and property rights, and reduce exposure to state mandated restrictions. All of this would promote more balanced and sustainable growth and encourage more efficient allocation of Chinese and global capital. This process of rebalancing and internationalization would provide for a deeper pool of available capital to the Chinese economy for funding future investment and furthering growth. It would provide for greater financial stability in the long run. These lofty goals, however, appear to be taking back seat to the more immediate concern of controlling financial markets through direct government intervention.
China stands at an important crossroads. From the early 1980s through the mid-2000s, China relied almost exclusively on an export-driven growth model underwritten by its foreign sector and heavily depreciated currency. That model cannot be relied on for fueling China’s future growth. By devaluing the currency by more than 80%, China produced a large current account surplus with its trading partners, notably the United States. By also running a fiscal deficit, it forced the private sector to run large surpluses and accumulate significant financial assets. The flipside of that process was the unsustainable buildup of debts here in the United States and elsewhere. That debt bubble burst in the 2007-2008 financial crisis and highlights why China’s trade surplus driven model, financed on foreign borrowings, is broken and can no longer be relied on by China as the way forward. Instead, China must find a new model centered around internal consumption and domestic demand. This process is bound to involve some pain and will take time, but the process will ultimately be made easier by further integration with the rest of the global economy. The short-run haircut to growth represents part of the cost of building a more sustainable path for future Chinese and world growth.
We are realists about China, however, and do not expect China to abandon its command-and-control, centralized economic model overnight. This is a process that will take years, if not decades, and it is unlikely the Chinese form of economic organization will ever fully conform with the western world. The reforms required of China to fully integrate financially are too great and the political will for aggressive reform seems absent. There are many areas involving currency reform that are especially important if China is to move toward greater integration and a new model for growth. Increasing the ability of China’s currency, the renminbi, to float more freely and allowing for greater convertibility of the currency are key areas to watch for signs of progress.
Convertibility of the renminbi, for example, would involve allowing for the free trade of the currency on the foreign exchange market. China is reluctant to allow this because it relies on capital controls to maintain the currency’s advantage in international trade. If it allowed free capital flows it would be forced to maintain its foreign exchange rate via monetary policy. Given the potential size of capital flows, that would potentially move into and out of the country under full convertibility, adoption of a new paradigm would mark a dramatic and major shift for the world economy. In this model, foreign investors gain access to investment opportunity inside China, China receives a source of capital not previously available, and Chinese investors would be free to diversify their renminbi holdings abroad, producing greater stability in private balance sheets. However, the gulf between the practical reality and this vision remains far apart, especially since it is a direct threat to the status quo. Ultimately, however, currency convertibility will need to be addressed for China to move beyond their current export-driven economic model.
By most accounts, the Chinese currency appears undervalued relative to the U.S. dollar, and a floating of the currency would likely lead to an upward adjustment. A stronger renminbi would, however, further weaken exports and undercut some of China’s competitive advantage, something the Chinese appear unwilling to accept. On the contrary, China moved in the opposite direction this summer when it intentionally weakened its currency, and we think it is likely they will do so again in a bid to shore up their manufacturing and export sectors. Such a devaluation is shortsighted and inconsistent with the longer goal of “rebalancing.” Not only does a weaker renminbi run contrary to the long-run goals of rebalancing and internationalization, but it negates whatever near-term benefits might come with a stronger currency. A stronger renminbi, for example, would convey benefits to the Chinese consumer by making foreign goods more affordable, thus raising real wages and consumption, for example.
We recognize change comes slowly and sometimes not at all. However, we believe China’s export-led growth model is outmoded and fundamentally flawed, and further currency debasement will do little to alter this fact. China’s “forced” rebalancing now stems from an external source, an exhausted foreign sector now being manifest as weak export demand. In our view, the Chinese government will eventually give in to pressure to reform if they are to advance toward a new and better growth model based on rebalancing and internationalization. In the short-run, China is likely to resist change and will seek to preserve calm in financial markets through whatever means necessary (prohibitions on shorts, liquidity injections by the central bank, direct purchases of public equities by the government, etc.)
As a next step, the Chinese government may seek to enact fiscal measures designed to soften the impact of a contracting current account balance. They are very likely to pursue at least a temporary currency devaluation, even though this runs contrary to the longer run process of rebalancing and internationalization. Lastly, China should continue to resist calls for currency reform including further limiting convertibility. In the long run, however, China and the world will be better off if China continues to evolve toward a more open, market-oriented, and transparent model less dependent on export-driven growth.
Slower global growth now, in exchange for a better and more stable global growth profile later, is an attractive tradeoff.
Kevin Caron, Portfolio Manager
Chad Morganlander, Portfolio Manager
Matthew Battipaglia, Analyst
Suzanne Ashley, Junior Analyst
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