Thursday, August 27, 2015

How to Create a Chinese Economic Crisis in Three Easy Steps

First, peg the yuan to another currency that has been rapidly appreciating over the past year...

...this will choke the tradeable sector...

...and really put a damper on nominal spending growth.

Second, respond to the above economic weakening by easing domestic monetary conditions. Over the past year, the People's Bank of China has done so with five cuts to its prime lending rate and several large reductions in the required reserve ratio for banks

Third, allow nervous investors to pull their capital out of China. Investors have come to expect a large yuan devaluation given the above developments. For the easing of domestic monetary conditions has put downward pressure on the yuan while the dollar peg has pushed it up inordinately high, creating an imbalance. The only way China can maintain this imbalance is to defend its dollar peg by burning through its foreign exchange reserves...

...a response that becomes more expensive the the tighter Fed policy becomes...

...but there is a limit to burning through these assets since China still needs some foreign reserves buffer. Ambrose-Evans Pritchard reports some observers are already wondering if China is getting close to its buffer limit. If so, China will be forced to devalue. This is what investors are now expecting and therefore are eager to get out. This puts further pressure on China's stock of foreign reserves.

Note that devaluing the yuan will be costly too. Many Chinese firms, previously expecting the dollar peg to hold, have taken out lots of dollar denominated debt. So either China burns through its reserves or it increases the private sector's real debt burdens. There are no easy choices here.

China, in short, has backed itself into a corner because it has attempted to do all three goals of the impossible trinity...

...something the emerging market crisis of 1997-1998 taught us does not end well. But China is trying anyways and the recent stock market roller coaster ride is just one of many adverse outcomes likely to come out of these efforts. Fortunately, most emerging countries are not making this mistake as noted by Greg Ip. That is good news. The bad news is that it will not be easy for China to undo the three steps it has taken toward doing the impossible trinity.

P.S. For a broader perspective that makes the same point see this post by Lars Christensen.


  1. David, I am confused about one thing. Why does China try to keep the yuan from falling? It seems downright nutty to simultaneously expand the domestic money supply and also buy up yuan with foreign currency. Are you trying to loosen or tighten? If you have an NGDP shortfall, then why not just let the yuan drop (stop using dollars to buy yuan), leading to foreign demand for domestic goods, leading to increased domestic production.

    I suppose if for some reason they want to expand NGDP and simultaneously expand real domestic consumption even more, then I guess there'd be some reason to expand the yuan locally (increasing local demand) while buying yuan with dollars (reducing foreign demand), but it seems odd at best.



    1. Ken, great question. There are smart folks at the PBoC and they have to know this stuff. I suspect there are a number of reasons for not devaluing. First, as mentioned above, it will raise the real debt burden for the private sector given Chinese firms have lots of dollar-denominated debt. Second, China is probably worried about the international backlash it would get if it devalued too much. Third, there may be some that view the overvalued yuan as useful in the country's transition from an export-driven economy to domestic consumption-driven economy. Finally, the fear of the unknown might be holding them back.

    2. And what about a falling Yuan as a sign of political weakness? China is meant to be on the way to Asian if not global domination. A falling currency is a sign of political failure and top Communist leaders cannot fail. Never underestimate macho-pride.

      And a falling currency will justify all those who have engaged in capital flight, and encourage others.

  2. Off topic, but David: Can you tell me what the scale factor is between M4 as plotted in this post and the M4 index as it is published by CFS? I would greatly appreciate it if you could tell me.

    1. Anonymous,

      The M4 used in that post is the 'simple sum' measure of M4. That is, it is the total dollar amount of all the assets that make M4. The CFS releases the 'Divisia' M4 measure. It is a weighted measure that accounts for the fact that not all the M4 assets are perfect substitutes. The Divisia measure is a much better way to go. I used the simple sum measure in the post to make easier comparison to the dollar amounts of the monetary base and M2.

  3. Excellent blogging. From here the People's Bank of China should print a lot of money and let the yuan devalue. They can help those companies that have dollar denominated debts, even just print money and give it to debtors.

    The PBOC can do this as China is still below its inflation targets.

    The bulk of their problems is as described: they had a tight money policy, pegged to the dollar.

  4. Is the capital account as open as you suppose?

    1. Uhm, yes.