As Chinese Trend Growth Slows To 6-7%, Is the RMB Now Overvalued?

Well, it’s certainly getting to harder to argue that it’s cheap. The Bank for International Settlements produces a real exchange rate calculation (adjusting for relative inflation rates) which shows that the RMB since 2010 on a trade weighted basis has risen faster than any other major currency. Using unit labour costs rather than CPI would show an even more dramatic loss of competitiveness, and every manufacturing SME owner I met on a recent trip to Zhejiang province was feeling the pain. The latest surge in the nominal RMB exchange rate is odd as it comes at a time of soft growth, falling inflation (only 2.1% y/y to May) and flagging exports (which grew by only 1% over the same period), and largely reflects a surge in hot money inflows until last month, when a regulatory clampdown on fake invoicing began. The RMB appreciated by an annualised rate of 5.5% in May, after rising at a 9.2% annualised pace in April but that is likely to slow dramatically and even go negative in coming months.

Slower capital inflows due to the crackdown on over-invoicing of trade, and the wider retreat from riskier assets by investors in global markets have reduced net capital inflows, exacerbating liquidity tightness inside the banking system are tight in China, reflected in interbank rates. Beijing is committed to increasingly the volume of buyers and sellers of the currency, thereby boosting liquidity and forcing financial institutions to adapt gradually to FX risks. While recent interbank tightness and endless growth downgrades have raised hopes of a rate cut, raising interest rates to slow investment growth and credit expansion is key to promote financial liberalisation, exchange rate reform, and capital account convertibility.

However, the financial constraints to raising interest rates are large because of the existing debt burden of Chinese local governments and SOEs, which, in the absence of alternative revenue streams, requires cheap and abundant credit from the banking sector. Interbank rates will come down over the next month as the central bank injects more cash through its open-market operations; funding can’t be sustained at such a high level because it will disrupt the whole lending market. If liquidity is so tight that it is even difficult for government to raise funds, it will be even more difficult for highly leveraged companies, many of which have short duration debt. Ultimately, it’s inevitable that we will see local equivalents to the current financial chaos surrounding Brazil’s EBX group, and indeed that process is crucial to establishing lending discipline.

On my recent trip around China, rising graduate unemployment and unsustainable levels of pollution were identified by many well-placed sources as key political threats which only a wholesale reform push can help solve. There is no going back to investment led stimulus to goose growth, and the diminishing marginal return in GDP terms makes it pointless anyway. Credit growth accelerated in Q1 to around USD1trn and in April and May and total social financing increased by RMB1.6trn in April and RMB1.19trn in May. New credit is generating ever weaker returns in the real economy, suggesting that there has been a breakdown in the credit transmission channel, such that credit is being directed into sustaining debt servicing burdens and loan roll-overs. Once interest payments consistently grow faster than income at a national as much as household or corporate level, debt becomes unsustainable and that ‘tipping point’ is the crucial one for China, with aggregate interest payments already amounting to about 10% of GDP.

For the past few months, as noted above trade data has been inflated by over-invoicing as speculators sought to bring in capital, largely through higher export receipts for tech goods via HK. The weak exports and imports data suggest consensus GDP growth forecast downside, although limited ‘hard landing’ risk at this stage. As the RMB has floated up within its daily band, the central bank has largely accommodated its movements, raising its morning reference rate by a similar amount, perhaps guided by larger reform plans.

Last month PM Li Keqiang said that an operational plan for easing capital controls would be put forward later this year; if the RMB was significantly below its market value, relaxing capital controls could attract destabilizing speculative inflows so the stronger RMB might be seen as a necessary precondition for looser controls. In the past few weeks, regulators have clamped down on hot-money inflows disguised as export earnings and the RMB appreciation has leveled out – a widened trading band should see downside volatility reemerge.

Investment in real estate is slowing and fell from 24.4% in April to just 23.6% in May. Meanwhile, investment growth in manufacturing has slowed from an average of 43% each month in 2011 to 25% in 2012, and to just 17.8% in May. The combined reading of the official and HSBC/Markit PMI for manufacturing has now slipped from an average of 51.4 in March to 50 in May. In addition, the employment sub-index for the PMI for manufacturing has now had 12 consecutive months of sub-50 readings. New exports orders remained in contraction for the fourth month this year so far in May. In fact, with the exception of a run of 10 consecutive months of sub-50 readings from July 2008 through April 2009, China’s new export sub-index of the PMI hasn’t had a worse year-long stretch since data started being collected in 2005. Given that 58% of exports now go to other emerging economies, few of which are in good shape, that’s not surprising.

The virtuous trade circle around the emerging economies which insulated them from the worst effects of the 2008/9 crisis and which saw intra GEM trade soaring is now a drag as they simultaneously slow. China is better placed to adapt to the new reality (and its markets better discounting the impact) than many of the countries which profited from entering its economic orbit in recent years. The World Bank has forecast that real interest rates are likely to jump by up to 270 points in the more heavily indebted emerging markets as the Fed unwinds quantitative easing, and the tightening cycle starts in earnest. Coming on top of the terms of trade shock from weaker commodity prices as China shifts its growth focus that will create sustained volatility and a polarisation in valuations across GEM between the relative macro winners and losers (the former net commodity importers, particularly those which haven’t seen excessive real estate/lending booms) in this on-going paradigm shift. Once the dust settles on the current Fed tapering volatility, that structural shift will be the key GEM investment theme through mid-decade.