China’s Big Hidden Problems

As China’s President Xi Jinping visits the White House this week, he must be losing sleep over his country’s economic problems, those both visible and hidden. The country’s Caixin/Markit Purchasing Managers’ Index, the numbers for which were announced this week, fell to 47, a six-year low (anything below 50 means China’s manufacturing sector is close to contraction). The government claims growth is practically 7%, but it’s really much lower. In one month, China lost around $100 billion in reserves for supporting the country, and the bad debts in the banking system from brokerage loans and real estate are becoming ever more apparent. Yet China’s economic management is becoming more sensible, and long-term, the economy has more strengths than weaknesses.

Over the past few decades, China built up foreign exchange reserves of some $3.5 trillion, by far the largest of any country. That gives it plenty of ammunition to fight a drain of reserves, which its trade balance doesn’t seem to indicate it has; that balance showed a massive $60 billion surplus in August. The problem is that by gradually relaxing restrictions on yuan usage the Chinese authorities are allowing domestic residents to change money into foreign currencies (still technically illegal), and with the economy wobbling this is causing a massive drain of foreign exchange.

The solution would have been to free up exchange controls a couple of years ago, when China’s economy was roaring ahead and domestic liquidity was excessive. China’s restriction against its citizens owning foreign currency violates their freedoms just like the other repressive aspects of the country’s regime; with over $3 trillion in foreign exchange reserves, it is also entirely unnecessary. The best solution is for Chinese authorities to free their citizens fully to own foreign currency and take the short-term hit to the reserves, but the government probably won’t do this just yet.

China’s foreign exchange problem is artificial. Its stock market is less important than its $4 trillion market capitalization would indicate, because retail investment represents less than 10% of China’s savings. However, China’s real estate market is a much bigger problem, overinflated by the government through funny money and overbuilt by regional governments, which led to empty office buildings. So Chinese banks have a lot of bad debts.

Still, the government owns the majority shareholdings in most of the banks, has $3 trillion in foreign reserves and is not over-borrowed. Hence China’s problem can be worked through, provided the government takes a sensible approach. China’s government shows every sign of doing so by managing its exchange rate, accepting lower growth and not supporting the stock market directly.

In the long term, China’s growth will slow from the rates of past years, just as Japan’s did. But China is in an economic state similar to Japan in 1960, not Japan of 1990; China has a lot further to go before it hits Western wage costs and its products become uncompetitive. So for the next decade, China and its market remain a solid investment for a portion of your money.