The Renminbi Ups Its Status

100 yuan notes

THE INTERNATIONAL MONETARY Fund added the renminbi to its basket of Special Drawing Rights (SDR) currencies at the start of this month, thus officially marking it as a member of the elite club of global reserve currencies. It is a membership of which China has long been desirous.

The IMF had decided last November that China could join at the next scheduled SDR review, and that it would constitute 11% of the basket. That gives it the third largest share, behind the dollar and the euro but ahead of the other member currencies, the yen and sterling.

Weightings are meant to reflect the use of a currency in trade and the financial system so China may have been treated generously in this regard. It share of global payments, for example, peaked at 2.8% last year and is below 2% now.

Joining the SDR basket is, at this point at least, as much symbolic as anything, an acknowledgement of the global weight of China’s economy, and encouragement to push ahead with the financial reforms that would make the renminbi the freely usable and widely adopted currency that IMF reserve currencies are meant to be.

That, in turn, would promote more foreign interest in yuan-denominated assets, particularly bonds. Central banks and sovereign wealth funds will, however, build up their renminbi-denominated holdings only gradually.

Looking back in a decades time, though, the change may look more momentous, both if China’s financial markets become deeper and more liquid or it turns out that the renminbi was just the first of several emerging market currencies (India’ rupee is another candidate) to find a place in the SDR basket.

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IMF Bangs On A Familiar But Necessary Refrain

THE INTERNATIONAL MONETARY Fund has left its growth forecasts for China this year and next unchanged at 6.6% and 6.2%. However, in the newly published edition of its World Economic Outlook, the IMF notes that “China’s growth stability owes much to macroeconomic stimulus measures that slow needed adjustments in both its real economy and financial sector”.

Policy support and opened credit taps stabilised growth in the first half of the year close to the middle of authorities’ target range of 6½% –7% for the full year.

The Fund bangs on a familiar drum when it calls for more decisive action in tackling corporate debt and governance issues in China’s state-owned enterprises (SOEs). Lack of progress on these, it says, raises the risk of a disruptive adjustment from reliance on investment, industry and exports to greater dependence on consumption and services. Rebalancing could become ‘bumpier than expected at times,” the Fund warns. The current short-term stimulus on which China is relying and a still-rising credit-to-GDP ratio exacerbate that concern.

Credit dependency is increasing “at a dangerous pace, intermediated through an increasingly opaque and complex financial sector”. A combination of factors are at work here: “the pursuit of unsustainably high growth targets, efforts to prop up unviable state-owned enterprises to preserve employment and defer loss recognition, and opportunistic lending by financial intermediaries in the belief that all debt is implicitly guaranteed by the government”.

The IMF’s policy prescriptions are similarly familiar:
• address the corporate debt problem by separating viable from unviable state-owned enterprises, harden budget constraints and improve governance in the former while shutting down the latter and absorbing the related welfare costs through targeted funds;
• apportion losses among creditors and recapitalise banks as needed;
• allow credit expansion to slow and accept the associated slower GDP growth;
• strengthen the financial system by closely monitoring credit quality and funding stability, including in the nonbank sector; continue to make progress toward an effectively floating exchange rate regime; and
• further improve data quality and transparency in communications.

The medium-term outlook for China remains clouded by the high stock of corporate debt—a large fraction of which is considered at risk. And vulnerabilities continue to accumulate with the economy’s rising dependence on credit, which complicates the difficult task of rebalancing the economy across multiple fronts:

The medium-term forecast assumes that the economy will continue to rebalance from investment to consumption and from industry to services, on the back of reforms to strengthen the social safety net and deregulation of the service sector. However, non-financial debt is expected to continue rising at an unsustainable pace, which—together with a growing misallocation of resources—casts a shadow over the outlook.

Spillovers from China’s rebalancing and gradual slowdown via global trade and increasingly financial channels continue to concern the Fund. These have been significant, and China’s growing global role, the Fund says,  makes it all the more important for it to address its internal imbalances.

However, it also notes the other side of the coin:

The outlook for emerging market and developing economies will continue to be shaped to a significant extent by market perceptions of China’s prospects for successfully restructuring and rebalancing its economy.

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A Scorecard Of China’s Economic Rebalancing

A NEWLY PUBLISHED IMF Working Paper takes the measure of Beijing’s progress in rebalancing the economy away from investment and export-driven growth to high-value-add innovation-led industry and domestic consumption.

In summary, the paper says:

External rebalancing has advanced well, while progress on internal rebalancing has been mixed, with substantial progress on the supply side, moderate progress on the demand side, and limited progress on the credit side. Rebalancing on income equality and environment has also been mixed, with the energy intensity of growth falling and labor’s share of income rising, but income inequality and local air pollution remaining very high.

The author of the paper has also created a visual traffic-lights type scorecard, with data going back to 2010 and forecast out to 2021.

We have taken the liberty of taking a snapshot of where we are now based on 2015 or most recent available data (see Table 1, left).

The IMF has long been cheerily upbeat about the prospects for China’s economic development — no dramatic headlines generated by dire warnings of the rising risks of a banking crisis, as came from the Bank for International Settlements in its latest quarterly review published this week.

While the paper does acknowledge in this regard that the risk of “a disruptive adjustment” will increase significantly in the medium term, it also says that buffers such as foreign-exchange reserves are still large and able to help absorb potential financial shocks, although they will likely diminish over time, especially if reforms lag.

The paper also notes that demographic and structural changes will provide tailwinds to China’s rebalancing. It is certainly true that the rapid ageing China will experience over the next 15 years will turn the demographic dividend that has helped power growth for the past three decades into a demographic deficit.

The paper underlines that “successful rebalancing requires coordinated progress on various fronts. Going too fast on one area, while too slow on others, may derail the whole process.”

That is also not to say that significant policy efforts are not needed to get there.

Specific recommendations include:

  • continuing to move to an effectively floating exchange rate regime to prevent future foreign-exchange misalignments;
  • raising government health care spending to encourage a lowering of the savings rate (always a treat to see the austere IMF urging a communist country to increase state spending);
  • deregulating services to drive service sector productivity to offset the impact of labour being re-allocated away from the high-productivity industrial sector. This also comes with a warning of the dangers of deindustralising too early and too fast;
  • pushing ahead with the glacial pace of reform of state-owned enterprises to improve the efficiency of credit allocation.  Currently, 40% of industrial assets are managed by SOEs, with asset returns some 7 percentage points lower than their private counterparts, the paper notes; and
  • improving the redistributive role of fiscal policy through a more progressive tax structure, increased transfers and strengthened social safety net.

No surprises in that list. All the prescriptions are out of the IMF’s policy toolkit for China that the Fund has been using to cajole for reform.


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China’s R&D Gets Ever Bigger Bucks

TARIFF CUTS ON imports of some 200 IT products ranging from touch screens to semiconductors took effect on Thursday. The goal is to eliminate them within seven years.

China is one of 50 countries that signed up to a World Trade Organisation Information Technology Agreement last year to promote trade liberalisation of technology goods. China imports an estimated $325 billion worth a year of the components covered by the agreement. Reducing the duty on them will cost an estimated $2.25 billion a year, rising to a potential $8 billion a year with complete elimination.

However, the benefits of cheaper imports for the IT sector are seeing as outweighing these costs. Beijing is undertaking a drive to promote the development of technology-based industries. To this end, it is also raising research and development spending to 2.5% of GDP by 2020 from 2015’s 2.1%, a change that eventually will fatten China’s R&D pot by $50 billion a year.

Intensification of investment into R&D facilities outside China parallels this. So far this year, Chinese companies have announced nine new overseas R&D centres for a total capital expenditure estimated at $224m, according to fDi Markets, a Financial Times division, with pharma and biotech investments particularly prominent. Only Germany and the United States have spent more.

That will support the transformation of the manufacturing economy from low-end exports to self-sustaining indigenous technological innovation, an essential prop for the rebalancing of the economy overall towards being consumption-led.

Winning domestic market share is the aim for now of Chinese firms’ R&D efforts.  The success some are having is creating an indigenous innovation culture built around rapid, incremental product development that can take advantage of the economies of scale of the domestic market.

However, Chinese firms are closer than ever to competing with developed-economy companies in R&D. Products they are now selling in Africa and Asia, as well as at home, are starting to show the results of that, a harbinger of what will eventually come to developed markets, too.

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China Gets Its UK Nuclear Prize, Probably

THE UNITED KINGDOM’S decision to go-ahead with three nuclear power plants, the first at Hinkley Point, has had a somewhat surprisingly gruff welcome from state media.

Shortly after taking office in July, UK Prime Minister Theresa May ordered a second look at the projects, which were approved by the previous administration. This was to include cost and environmental concerns but also a security review of China’s involvement, which includes part-financing new reactors at Hinkley Point and Sizewell, both to be built and operated by France’s EDF, but also leading the construction and operation of a reactor at Bradwell to indigenous Chinese designs.

“However, in spite of the approval, China-phobia sentiments continue to hover and could possibly introduce more troubles as construction of the project gets underway, a Xinhua commentary thundered. “It is reported that while announcing the go-ahead, Theresa May has also promised ‘significant new safeguards’ to make sure that investment from China does not threaten national security. Of course, the British leader’s misgivings make little sense.”

The new safeguards give the British government a veto over sales of full or partial ownership of the reactors both while they are being built and then operated, and institutes national security reviews for future critical infrastructure projects, a practice that is common in most large economies, including China.

There had been dire warnings from the Chinese side when May announced her review that abandoning the projects would end the ‘golden era’ of Sino-British relations championed by her predecessor David Cameron and his finance minister, George Osborne.

“Let us hope that London quits its China-phobia and works with Beijing to ensure the project’s smooth development, Xinhua’s commentary continued.

Its testiness underlines the uncertainties that still surround the projects. China is desperate that Bradwell goes ahead to give it a key early sale to a developed nation of its still untried Hualong One reactor. Beijing hopes that will lead the way to a global export market for what a senior official at China General Nuclear Power estimates will be some 200 nuclear power plants.

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China Can Now Rattle Global Markets With The Best Of Them

Shanghai Stock Exchange seen in 2009. Photo credit: Aaron Goodman. Licenced under Creative Commons.

BOTH LAST YEAR and early this, global stock markets were fazed by a sharp fall in prices on the Shanghai and Shenzhen exchanges. Chinese equity and currency movements are having an increasing impact on investors everywhere. A new working paper published by the Bank for International Settlements, ‘the central bankers’ central bank’, suggests that China’s influence in this regards is rising to the level of that of the United States in some circumstances.

Market moves in China no longer reverberate just in Asia, the authors argue. However, the growth of financial and economic linkages within Asia raise questions about the pace and extent of financial market spillovers in the region and whether there are substantive differences in those flowing out of China to those from the United States.

Empirical study is only starting in this area, though the anecdotal evidence of the effects of financial market shocks is growing steadily. Chang Shu and her colleagues in the bank’s Monetary and Economic Department conclude that China’s influence in this regard has been growing significantly in recent years. This is especially true of equity and currency movements, as increasing financial linkages supplement extensive trade ones established by China’s central position in Asian supply chains.

A working paper from the IMF published last month came to a similar conclusion.

However, that has not diminished the importance of the United States, which also has impact across all asset classes including bonds, and particularly at times of market stress. China’s global financial linkages, though growing, remain modest compared to the United States’ not least because China’s capital account is not fully liberalised. Chinese monetary policy is nowhere near as potent a driver of global liquidity as the US Federal Reserve’s.

For investors, the implication of the work is that diversification of portfolios through Asia investment is becoming less effective at mitigating risk because Asian market movements are now driven by external factors to a greater degree than before.

For regional policymakers, the findings pose the challenge that yield-seeking capital flows to their country (and their exit) will be driven by developments in both Chinese and US financial markets, often in a mutually reinforcing way that could undermine macroeconomic and financial stability in vulnerable economies. It will likely take the emergence of intraregional institutional investors to weaken that linkage.

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Beijing Struggles To Rein In Pyongyang

NORTH KOREA’S LATEST nuclear test further undermines the argument that only Beijing can rein in Pyongyang but won’t do so. China’s ability to direct Kim Jong Un is diminishing as quickly as it is losing patience with his regime.

It is not alone in that. Kim has shown himself to be undeterred by international sanctions against his rapidly progressing nuclear programme — to which the latest and harshest Beijing has signed up.

China wants stability in the region and a buffer it can rely on between it and U.S.-aligned South Korea. Kim’s hell-for-leather pursuit of nuclear arms makes the region less not more stable, and Kim feels that he can disregard China’s national security interests with impunity for as long as U.S.-China relations are tense. 

He felt sufficiently secure of his position to test fire three ballistic missiles during the G20 summit that China was hosting in Hangzhou at the start of this month, much to the fury of Beijing which was otherwise basking in playing the role of world leader and was notified of the test through back channels only a few hours in advance.

For a long time, Pyongyang’s unpredictability has been supported by Beijing as a way to keep Washington on the back foot in the region. Now that is outweighed by the risk to Beijing that a nuclear-armed North Korea would lead to a nuclear-armed South Korea and Japan, and that being the sole ally to an archaic remnant of the Cold War only undercuts China’s international standing as a modern world power.

So Beijing’s calculus is changing. Its endorsement of the tough UN sanctions passed in March following Pyongyang’s previous nuclear test was a sign of that. Beijing had been lukewarm to previous sanctions rounds, and uneven in their enforcement. Even though that was a stance to which it seemed to be returning after South Korea decided in July to deploy the United States’ THAAD anti-missile system that China sees directed more at it than North Korea, Beijing’s condemnation of the latest nuclear test was harsh. 

However, if, as seems the case, Kim is using his pursuit of making North Korea a nuclear state central to cement his dynastic legitimacy, then halting nuclearisation can only come from regime change. Sticks and carrots from China, or the international community more broadly, will not induce a change of course on Kim’s part. They have certainly not shown any sign to date that they will.

Regime change in North Korea will most likely come from economic collapse that causes elites to contest diminishing economic resources. That shows no sign of happening soon of its own accord.

China could precipitate it. North Korea is dependent on imports from China of energy and food, so Beijing has the means to act.

But engineering economic collapse is the ‘nuclear option’, so to speak. It would bring a large-scale influx of refugees into northeastern China. Beijing has contingency plans for dealing with that eventuality (they were leaked to Japanese media in 2014), just as South Korea does.

What is not known is what preparations China is making to take control of an imploded North in what would be a scramble to beat the United States and South Korea in the rush to provide humanitarian aid and security for the peninsula as a whole in the name of reunification.

South Korea does have contingency plans to move troops into the North fast. If they were to run into the Peoples’ Liberation Army forces coming in the opposite direction, North Korea could become as chaotic as the Middle East, especially if remnants of Kim’s regime undertake guerrilla warfare, or China was to afford political protection to them.

In the meantime, Beijing is becoming as stymied as Washington in dealing with Pyongyang, and left scratching its head for a way to remove the Kim dynasty that throws the North into neither chaos nor the hands of the South. That it is saying publicly that it is the responsibility of the United States not itself to solve the problem, is a sign of how far from a Plan B it is.

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