Constraints, Capitalism, and China

The Chinese credit bubble is big.

It’s nearly impossible to find a clear, definitive estimate. Bloomberg will say $34 trillion between public and private borrowing. McKinsey estimates that number has quadrupled since 2013.

Regardless, it’s a lot.  

The Chinese Communist Party uses debt to keep the masses employed, extend power externally, and enrich party members with frauds like Luckin Coffee.

Existing industries need double-digit credit growth in order to maintain the status quo.

80% of all credit is issued by state-owned banks, so the CCP effectively decides which businesses get access to credit, and how much.

Picking winners and losers from their domestic economy is an essential pillar of how a single political party has remained in control of a nation of 1.4 billion people.

Companies can fail as long as the percentage of bad debt on Chinese banks’ book remains less than 2%.

If you have a closed economy, like North Korea, you can perpetuate this system for a very long time.

However, when you conduct business globally, the risk of an expanding debt bubble inevitably creates severe downward pressure on your currency.

This creates an impossible trinity of policies for Chinese financial policymakers.

Let’s run through some quick definitions.

Domestic Monetary Policy is the collection of levers that a state’s monetary authorities pull to accomplish goals like stable growth in gross domestic product (GDP), maintaining low rates of unemployment, and keeping foreign exchange and inflation rates in a predictable range.

Its primary lever is cutting or raising interest rates to, respectively, either expand or contract the economy.

Lately, central banks around the world have been cutting rates to make it easier for businesses to access credit. This increases the liquidity of financial institutions charged with managing the debt.

A Capital Account is the measure of how much capital is flowing in to, or out of, a country. Most nations that are thoroughly connected to the global economy allows capital to flow freely and have an open capital account.

Liberal, open capital accounts reward economic policymakers that adopt and maintain sound policies. Why? A perceived deterioration in its policy environment could be punished by domestic and foreign investors, who could suddenly take capital out of the country.

Open capital accounts also facilitate capital from capital-rich industrial countries to capital-poor developing economies. Poorer countries get funds to develop and industrial countries get greater returns on their savings.

North Korea does not have an open capital account.

A currency exchange rate is the value of a nation's currency versus the currency of another nation or economic zone.

Like an open capital account, most globally connected nations have a free-floating exchange rate that rises and falls with changes in the foreign exchange market.

Exchange rates influence international trade as buyers decide where they can get the best deal on goods and services.

Source: Poverty&Equity Databank and PovcalNet

China has a tightly controlled exchange rate that the People’s Bank of China (PBOC) is committed to constraining into a narrow range.

Central planners fear a collapse in the yuan, which would eviscerate China’s ability to import the food and energy it needs to support its population. Funding basic necessities is Governing 101.

To avoid this, the PBOC collects USD in its reserves to use in foreign exchange markets against excessive selling of yuan (which deflates the price).

The PBOC cannot keep enough USD in its reserves if domestic Chinese firms & individuals are racing into international markets to spend their hard-earned yuan.

So, their State Administration of Foreign Exchange (SAFE) strictly oversees the $4 trillion in annual international gross trade flows.

It restricts outflows of USD by calling the nation’s exporters and demanding every dollar that they receive in compensation for their goods be repatriated back into China.

Even before the recent extension of CCP law into Hong Kong, SAFE would regularly call on Chinese firms with accounts holding USD in HK banks demanding the money return.

It’s not airtight, but it’s hard to maneuver through. The imminent roll-out of a digital yuan will make controlling capital flight (and censoring buying power of dissidents) even easier for the central government. Imagine a future with more conditional currency where an authoritarian regime insists that digital yuan can only be spent locally and not traded abroad.

The issue is that as the PBOC extends more and more credit to local companies, it applies more and more pressure onto the system.

The only release valves are a deflation of the currency or a flight of capital. Policymakers realize the center cannot hold.

Before the 2020 Pandemic, financial commentators were already sounding the alarms that the country’s GDP growth was slowing and debt expanding on balance sheets.

With these circumstances, there are only three end game scenarios that are easily conceivable.

1. Keep Fixed Exchange Rate and Open Capital Account. Give up Domestic Monetary stimulus.

This is the least politically tenable. A tightening of domestic credit would lead to sweeping bankruptcies across the country. Real estate prices would collapse dramatically.

Unemployment would explode. Unlike the two-party system of the US, there is no alternative party to replace leadership in a period of significant political unrest.

The CCP leadership and President Xi Jinping will not potentially risk the overthrow of their political order.

2.  Keep Domestic Monetary Policy and Open Capital Account. Give up Fixed Exchange Rate.

This is the most economically sensible path forward.

The yuan would likely lose ~50% of its value. China would remain capable of playing a role in global trade as a low-cost exporter.

The country would struggle to import enough to maintain its current living standard for workers.

If the CCP can de-escalate the trade war with the US, they could potentially settle into this position.

3. Keep Domestic Monetary and Fixed Exchange Rate. Give up Open Capital Account.

China starts to look more like North Korea. They decouple from the US and the rest of the world.

They force more and more of Chinese consumers to buy Chinese-made products to reduce the demand for imports.

Media outlets like the WSJ and NYT have recently been expelled from the country.

I fear things are trending in this direction.

The only thing that could delay or avoid these scenarios is the USD weakening against yuan. Given the US is the world’s largest economy and the USD is still the world’s reserve currency, the likelihood of this is low.

At this point, many Americans will want to take a victory lap. We’ll ‘win’.

Don’t miss the human story behind all this. When the game gets unwound, people will suffer. For three decades, a staggering percentage of China’s population has been lifted out of poverty.

Whatever choices are made by the authoritarian regime will result in consequences on the ground.

We’re talking about millions of people, just like you and me, who want to make enough to support themselves and their families.

Just like you and me.

Maybe the bureaucrats will get removed from office, but that’s no guarantee.

As this plays out over the course of the 2020s, I won’t spend one second celebrating.

You shouldn’t either.