There is a growing possibility that China will be at the epicentre of President-elect Trump’s first crisis, triggered by concerns over the potential impact of protectionist measures on China’s trade surplus, which currently supports the increasingly fragile financing chains supporting corporate debt that the IMF estimates at around 155% of GDP.
Trump’s pledges to impose tariffs of up to 45% on Chinese manufactured goods threatens to drive a significant uptick in the amount of capital flight from the renminbi, while the prospect of measures to change the US tax system to encourage companies to repatriate cash to the are already pulling the dollar higher.
At this point the likelihood of Trump actually delivering on his protectionist rhetoric is secondary to the psychological impact on resident corporate and household savers of any potential threat to the current uneasy equilibrium within the Chinese economy.
The situation could quickly become much more acute than the one faced by the FOMC earlier this year, when the Fed appears to have backed off raising rates primarily due to concerns about China, so that President Trump will have to make a decision whether to clarify his intentions towards China and possibly repudiate his key campaign pledge at a relatively early stage of his presidency.
The consequences of his not doing so could be to precipitate an economic and financial crisis within China, that would obviously have major adverse consequences for the regional and global economies and also some potentially very serious implications for geopolitical stability.
In brief, our longstanding bearish view on China has rested on the governance factors at both a central and local government level that have led to massive cost factor subsidies driving overcapacity across a broad range of industries.
This has resulted in very high levels of debt which are being financed from an increasing range of institutions and instruments, most recently the city and county banks and shadow financing instruments, all of which are lack transparency even by Chinese standards.
No-one disputes any more that an increasing amount of financing is being used to service and roll over existing loans and that higher write-offs are not keeping pace with the flow of doubtful loans. The financing structures that surround the overcapacity industries are increasingly fragile especially on a regional level; Chinese enterprises are simply too interconnected to fail.
Over the course of 2016, there have been some indications of a visible improvement in both the macro-economic and corporate numbers, as well as some of the more physical and therefore reliable indications of activity such as power production and freight journeys.
This has, however, been a function of the massive monetary and fiscal stimulus beginning in the second half of 2015, to head off a potential crisis in response to the plunge in the onshore equity market.
Despite this apparent stabilisation, some of the more important underlying corporate indicators which we monitor, in particular the continuing rise in working capital ratios and debt relative to operating cashflow across a range of major industries (ex-capital goods), have not shown any real improvement, indicating a real vulnerability to further deterioration when the government and PBoC take their respective feet off the fiscal and monetary accelerators.
Moreover, even if the authorities do prove reluctant to ease for fear of the consequences, the psychological impact of the possibility of severe protectionist measures on the trade surplus will likely drive an increase in capital flight which will of itself have a tightening effect, especially as the PBoC will continue to intervene to keep what has so far been a relatively orderly renminbi depreciation from becoming a crisis inducing market riot.
The key point here is that all significant corporate and household savers will be well aware of the underlying fragility of much of the industrial base and accompanying financing structures.
The perception that the trade surplus could fall by a significant amount, together with a growing belief in a stronger dollar, is likely to be the catalyst for those Chinese who are in a position to export capital, to rush for the exits. Capital exports were relatively high in the latter part of 2015, running at an estimated $100bn plus in the fourth quarter. The level this year has been considerably smaller, but nevertheless appears to have been increasing to figures in excess of $50bn in both September and October.
Moreover, no-one really knows what constitutes an adequate level of reserves given the opaque nature of the PBoC balance sheet.
Some commentators aver that reserves can fall well below $2trn without imposing any undue pressure, while others suggest that $3bn is critical in practical as well as psychological terms.
In any event, I suspect that we are about to find out the sustainable level over the coming months and possibly sooner than that.
The relationship between the US and China is increasingly symbiotic in terms of monetary as well as trade policy.
We suggested at the end of 2015 that the somewhat parochial Fed watching community was greatly underestimating the extent to which the then dismal prospects for emerging economies and in particular China, would constrain the willingness of the Fed to raise rates. This scenario then played out over the first quarter, although I never anticipated the extent to which the ensuing dash for yield, together with China’s efforts, would drive up emerging markets. If there is a repeat of the situation in January, but in even more acute circumstances, then President Trump would quickly be faced with an immediate dilemma.
Should he effectively repudiate his major policy, namely to impose protectionist measures on China to save US jobs, or should he just let the market take its course which could have important geopolitical as well as financial consequences, as it is difficult to anticipate how an economically humiliated China under Xi Jinping might react?
So the defining moment of Trump’s entire presidency may well occur at a very early stage and in the absence of any meaningful political experience and to make matters worse the stakes could not be higher. I have no idea how he might react.
The very limited indications of his style of government so far suggest that he may take advice and row back on his rhetoric.
Most informed commentators rightly point out that the complexity of the global supply chain means that any shift towards substantive protectionist measures will inflict enormous damage on US companies and consumers. On the other hand few would deny that the massive cost factor subsidies for Chinese producers of a very broad range of industrial goods have completely transformed the economic of some key global industries.
Still, the mere fact of the Fed not raising rates will not be enough to assuage the markets as it was in the first quarter of this year.
Trump’s campaign rhetoric will have had the effect of putting him on the spot immediately in a situation where there are frankly no easy answers.