For about a week now, everyone on Wall Street has been saying the same ridiculous thing about the Chinese economy — that with a little communication, the volatility that the country is experiencing (and spreading around the world) will end.
It sounds great, and it’s true that a lot of things that can happen in the market are about expectations that actors have or have not set up beforehand.
China’s volatility isn’t one of them.
It’s a systemic condition resulting from the shift in China’s economy from one based on investment, to one based on consumer consumption. The only thing that will stop it is the completion of that shift. That shift can only be completed — roughly or smoothly — through action. Not through talk.
I’ll explain why, but first let’s figure out where this “communication” issue was first brought up.
Davos, the most serious place in the world
I’m going to go ahead and blame this new “communication” meme on the head of the International Monetary Fund, Christine Lagarde. She’s the one who started this whole thing at the World Economic Forum in Davos, Switzerland, last week.
“There is a communication issue,” Lagarde said on a Bloomberg panel on China. On the same panel, Gary Cohn, president of Goldman Sachs, echoed that sentiment, saying “the communication is really what’s important here.”
Luckily, a Chinese official was there to acknowledge that, yes, his country could do better communicating with the west.
“You’re right we should do a better job, and we are learning,” Fang Xinhua, vice chairman of the China Securities Regulatory Commission, said.
“I’m here today to communicate,” he said, spurring chuckles from the audience. “Our system isn’t structured in a way that’s able to communicate seamlessly with the market.”
But by golly they will try, seems to be Fang’s point. In the meantime, analysts all over Wall Street are picking up on Lagarde’s language. Take Societe Generale, for example, which on Tuesday published a note saying:
There is a credibility issue on China’s policies, especially the FX policy. The uncertainty and lack of clarification from the authorities regarding these policies is a key concern for the markets, which consider the policy response to the economic slowdown and market turmoil as insufficient.
The Chinese government has been talking about policy responses for months now. They have talked about sending capacity out of the country through the “One Belt, One Road” regional infrastructure program; they have talked about creating measures for organised bankruptcies of indebted state-owned enterprises; they have talked about keeping the yuan as stable as possible.
None of that talk is settling anyone, though, because now it’s time to do.
I hate to say this, but ‘confidence game’
And here’s how we know it’s time to do.
On Tuesday, we learned that in 2015, $1 trillion left China. That was before anyone on Wall Street was talking about “communication issues.” It was before the volatility we’re experiencing now.
It happened during a period in which the structural issues with China’s economy started to really hurt growth. It’s when the government cut interest rates and bank-reserve requirements, and made it easier for Chinese people to buy a car. It was when everyone started to get worried.
It’s also when, in response to bad economic data and resulting from a natural slowdown in growth, China devalued the yuan in August. Directly after that China had its worst outflows of 2015 — $194 billion in September.
The yuan and Chinese outflows stabilised in October and November while the currency was seeking entrance into the Special Drawing Rights club — a special group of reserve currencies designated by the IMF. After the yuan was accepted at the end of November, the yuan started to slide.
In December, the Chinese government burned $108 billion of its reserves to keep the yuan from falling so fast. Not to keep it from falling, but to keep it from falling too fast. That month, China experienced $134.4 billion in outflows.
The government has been wrestling with the yuan ever since, and it’s a costly, reserve-depleting effort. China needs those reserves to get through this reform period, so some officials think that the government should just do one big devaluation and then end it. That way, investors have a set value for the yuan and know that it’s not going to depreciate further. The opposite of uncertainty is a guarantee. Wall Street loves guarantees.
The government, though, doesn’t seem keen on that. That is likely because, as long as the Chinese economy is slowing, the value of the yuan will naturally erode.
No one knows how long this slow down will continue, so no one knows where the floor should be. They don’t know where to put the guarantee.
And how can a government communicate what it simply doesn’t know?
What you’re not going to do
What we do know is that China is tightening capital controls, and telling any trader who will listen that if they have the gall to short the yuan there will be consequences.
Here’s what the government said about it in an editorial published in state media outlet Xinhua. It was signed by an alias known to be used by the government (emphasis added):
As for those who want to bet on the “ultimate failure” of the Chinese economy, they should look back at the past four decades, which witnessed China’s growth from an underdeveloped economy into a global economic powerhouse through continuous reform and opening up.
They should also take into consideration the fact that the Chinese government has been constantly improving the country’s market regulatory system and legal system. As a result, reckless speculations and vicious shorting will face higher trading costs and possibly severe legal consequences.
China even took a shot at legendary investor George Soros, who said at Davos that China would most likely have a hard (but survivable) landing. Soros once shorted the British pound in a legendary squeeze, so I imagine the Chinese were just concerned that the yuan’s position might entice him to get out of retirement.
This messaging has been backed up by action. Earlier this month the Chinese government went after yuan shorts in Hong Kong, buying the currency and squeezing them to death in the process.
The question is, how long can China keep going to war like this? Businesses can find ways around capital controls, and traders aren’t scared every minute of the day. The country needs to show yuan holders that their currency is not going to keep depreciating in value.
And that can only happen when the economy — the real economy — shows signs that promised reforms are taking hold. That may involve some super-indebted SOEs defaulting, so that investors know that there’s moral hazard, and that China is starting to pick its way through the debt deluge that is its corporate sector.
In short: China’s problems aren’t going to be solved by more communication. They’re going to be solved by the same things that were going to solve them a year ago — a restructuring of the country’s over-indebted, under-productive corporate sector, and a reduction in overall overcapacity.
Action, not talk, is what will calm the volatility in China’s markets. And that action is incredibly difficult to undertake.