Outside of Super Tuesday and a boatload of U.S. data being released this week, the big news was that Moody’s Investor Services cut its outlook for China’s government credit rating to negative from stable. We have been constructive for a long time on China, but the litany of critics and questions is starting to add up. Outside of a similar move by Fitch Ratings three years ago, there has not been a downgrade of China’s sovereign debt since 1999. And as we have discussed before, there are a lot of significant bets placed by hedge funds for a sharp depreciation in the value of China’s currency this year.
Moody’s rationale is based on a weakening fiscal position, a fall in foreign currency reserve buffers and uncertainty about the government’s ability to handle the reforms it has promised. But for markets, the exchange rate seems to be a safety valve that will signal trouble in China when it comes.
The big picture revolves around what are considered to be outstanding debts in China and whether or not the banking system will buckle under the weight of those debts. A more medium-term conundrum comes in the form of FX policy management. Since the beginning of the year, when the renminbi started looking frail, there have been a steady stream of capital outflows from the private sector. A lot of these are to pay U.S. dollar-denominated debts or outbound direct investments, but they are forcing the People’s Bank of China to back up its promised defense of the currency by using U.S. dollar FX reserves to buy renminbi.
The problem is that as money leaves the country, it has the effect of tightening liquidity – the same as if interest rates go up. To combat that, the People’s Bank of China would need to ease liquidity conditions. But that weakens the currency again, which requires more drawdown of FX reserves, and so on. This feedback loop would tend to collapse the currency unless the Chinese government can stop it.
So what can the Chinese government do?
There is a market expectation forming that the Chinese government will basically tread water for two to three months while it allows Chinese companies to hedge currency exposure against a rising U.S. dollar and hopes to keep the economy from collapsing until the global economic dynamics change. Outside of that, there are smaller measures the government can take, such as lowering the reserve requirement ratio and opening its debt markets, a move that was announced earlier this week.
My View: These measures will buy a few months, but I still do not see a way for China to get out of this conundrum without a significant depreciation of its currency.
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