A couple of strange and terrible things are happening to the Chinese economy all at once

A few strange and terrible things are happening to the Chinese economy all at once.

  • The Chinese yuan is falling against the dollar — down a whopping 5% in the last 6 months.
  • Capital outflows are increasing as people pull their money out of the country. Outflows jumped to $206.7bn in 3Q from $98.5bn in 2Q.
  • And, despite the yuan’s weakness, Chinese exports are not getting a boost.

This is all bad news for Chinese policymakers. For months they have been trying to ease the yuan’s natural decline in value as market forces have guided it down. Capital outflows make this already “impossible mission” — as Societe Generale economist Wei Yao calls it — even more precarious.

The Chinese government is trying to move its economy from one based on manufacturing and foreign investment to one based on the services sector and domestic consumption. It’s the way the entire world is going, but for China to keep up, its people need to have purchasing power — their currency needs to be strong.

But that’s not what’s happening. The yuan has been reaching multi-year lows, and the dollar’s recent strength after Donald Trump won the U.S. presidential election isn’t helping either. What’s even more worrisome is that October export numbers show that a weak yuan isn’t helping the Chinese economy.

“Stripping out the impact of yuan depreciation, exports in dollar terms fell 7.3% year on year in October after a 10% drop in September,” wrote Bloomberg’s Tom Orlik in a recent note. “Imports slipped 1.4% after a 1.9% decline. China’s trade surplus in dollar terms was $49 billion, up from $42 billion. The surplus is in contrast to a larger-than-expected $45.7 billion decline in China’s foreign reserves in October, indicating quicker capital outflows in the month.”

So what do we do?

The government has responded to outflows by tightening capital controls, which has allowed it to avoid selling down foreign exchange reserves at the rate of $100 billion a month, according to Societe Generale’s analysis.

This doesn’t mean that controls are a cure-all, though.

From Societe Generale’s Yao:

…we do not believe that capital controls can have a lasting effectiveness for an economy of China’s size and complexity. Moreover, ongoing rapid money/credit growth on top of an already gigantic money/credit stock onshore as a result of policymakers’ preference for near-term growth stability is adding to the difficulties of capping outflow pressure…

Chinese policymakers can tighten capital controls further, but the scope is not exactly huge. While an imminent free floating is not our base case, we advise monitoring the situation very closely to gauge for any sign that the PBoC may be losing, or giving up, the battle.

Whenever the Chinese government temporarily loses this battle with outflows, markets convulse. It happened last year when the Chinese stock market crashed twice over the summer, and it happened at the beginning of 2016 well.

Keep your eyes on this one.

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