The Great Decoupling
The Great Decoupling
With its economic model busted, China has to reinvent itself. They have chosen to do that by severing their symbiotic relationship with the West.
Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.
This article is entirely free to read.
TLDR Summary
Over many years, China reinvested the proceeds from their huge exports in FX reserves. It was an effort to conserve the financial benefits of those exports to use them at a later point. This point has come as China is hitting the limits of its export oriented economic model.
The second largest economy in the world cannot not rely on exports forever. It’s too challenging to find demand abroad at a sufficient scale to ensure the utilization of their production infrastructure. And it makes the country (and by that I mean the CCP) vulnerable and it introduces unwanted economic volatility.
And even if they could find enough growth markets overseas, serving them will likely not solve the CCP’s problems. To some extent, the Chinese economic model of using cheap labor to convert imported energy into exported goods is busted. The country has one of the worst demographic momentums out there and the government has raided its citizens’ savings to direct them into bad investments with low returns. They are in the middle of a vicious deflation spiral.
The CCP seems to have realized this and they have chosen to fundamentally change their international trade strategy. They are proactively decoupling from the West in an effort to become more self-sustaining. To achieve that, they need to increase domestic consumption.
Tapping into their FX reserves seems to be one way to do that. For several years already, they have been effectively converting them into loans to domestic banks. This loan book now accounts for most of the PBoC’s balance sheet growth in an effort to support private sector borrowing. The total balance of this Chinese version of a QE program has swollen to more than $2tn.
This trend will likely continue and it’s challenging to grasp all of its consequences for the global financial system. The pivot of Chinese international trade policy removes a significant buyer of Western financial assets. This may manifest itself in higher interest rates in the West, especially since the West may have additional capital requirements as they need to invest into their own manufacturing infrastructure to cope with declining trade with China.
But depending on how weak China turns out to be, this development may also become a boon for the West. If this strategic pivot will ultimately cause a devaluation of the Yuan, real valuations of Chinese assets may tank and investors may seek to reallocate their funds to the West.
The China Bear Case
In the article below, I argued that China is a no touch from an investor perspective. They have one of the worst demographic momentums of all countries out there. The government has raided its citizens’ savings and directed them into bad investments with low returns. And they need to import vast amounts of energy to run their economic model which makes them vulnerable in international trade. Their economic model based on central planning is failing in the wide open.
What follows does not necessarily build on the article above. But it may be helpful further reading for you to better understand my perspective on China.
China’s global economic integration gave rise to its FX reserves.
On December 11, 2001, China joined the World Trade Organization. Tariffs were reduced and property rights strengthened. This caused an influx of foreign investment and launched a huge export boom. Exports rose from 20% of GDP in 2001 to 36% of GDP in 2006. By that time, the country’s trade balance (i.e. net exports) surged to almost 9% of GDP.
Exporting means that citizens are working on products to be used by someone abroad, rather than themselves. Therefore, those citizens are not benefiting directly from economic output used for export. Benefits come indirectly.
Exports flush foreign currency into the country. If the exporters want to convert these into domestic currency, it will likely appreciate. Savers will then benefit from a positive wealth effect and consumers will benefit from deflationary pressure.
Exports also add to the savings of the domestic private sector. It’s therefore possible (if not likely or even inevitable) that proceeds from exports will be used domestically for consumption and investment. This may result in an unsustainable boom. Japan of the 1980s and 1990s is a prime example of that.
Policymakers can counter unwanted consequences of a surge in exports by buying foreign assets with freshly printed domestic currency. It counters the wealth effect and keeps potential excesses at bay. This sort of conserves the benefits of the trade surpluses to be used at a later stage when they might be needed more.
China has done exactly that. From 2006 to 2014, the FX reserves held by the People’s Bank of China (PBoC) climbed from less than $1tn to $4.5tn.
They invested a lot of that in US Treasuries (USTs). China’s UST holdings increased from $80bn at the time of the WTO admission to $1.3tn in July 2011.
After selling some of these FX reserves, they are left with $3tn of total reserves, $800bn of which are held in USTs. Framed the way I have done above, these holdings represent the economic value of its many years of trade surpluses. Value that has not yet been consumed.
Now, this integration is being walked back to some extent.
As the economic integration of the US and China progressed, tensions increased and experts as well as politicians raised concerns. In the US, Donald Trump’s rise to power was an important catalyst. Many industries and citizens had been net losers from the trade with China as a lot of manufacturing jobs had been lost. This frustration was part of what carried him into the White House in 2016. He then started a fully fledged trade war that lasted from 2018 to 2020.
But contrary to what we may be perceiving in our Western media, frustration did not just occur in the US. Chinese officials were also dissatisfied. They didn’t feel like the winners as they were presented by Trump. As early as 2011, the PBoC’s governor, Zhou Xiaochuan argued that China’s FX reserves were too large to be managed properly, they exposed China excessively to US Dollar volatility and they were the result of imbalances in China’s economic model, particularly its trade surplus. He recommended for China to seek a more balanced economy with more domestic consumption and ultimately with a floating exchange rate regime. Such comments were echoed by other prominent Chinese economists and officials in later years.
It is important to view the recent economic decoupling between China and the US in this context. As of Jul'24, the LTM net imports from China into the US are $282bn, 6% lower than the pandemic low of $301bn in Oct'20 and 33% lower than the ATH of $418bn in Dec'18.
The US is China’s most important trading partner, but this trend is visible elsewhere as well as evidenced in Germany’s trade balance with China below.
Falling trade integration reduces the need for FX reserves, at least in their historical size. And with a struggling domestic economy, China may have better ways to allocate central bank resources.
Which is why China is liquidating some of their FX reserves.
There is however a problem that comes with declining FX reserves. Building them is an inflationary move. Liquidating them is a deflationary move.
But (more) deflation is the last thing China needs right now. They have already more than enough of it. Over the last four years, inflation has just averaged 0.5% annually and over the last two years, consumer prices have been flat.
They are in the middle of a vicious deflation spiral caused by a toxic demographic setup coupled with too much private sector debt, especially in real estate. Both of these forces are a burden on the demand for goods, services and assets.
Credit enables time travelling of consumption and investment. Leveraging up pulls it forward from the future to the present. Deleveraging pushes it back to the future. There is a lot of ‘Back to the Future’ in China right now.
China’s bond market is painting a gloomy picture for the Chinese economy. The 10Y yield is close to 2%. As I have occasionally mentioned, nominal government bond yields represent the market’s expectation for future nominal GDP growth, i.e. real growth plus inflation.
This is why the PBoC can’t just sell FX reserves and retract the associated Yuan similar to a share buyback. They need to deploy them in a different way, ideally in the domestic economy to bolster demand.
The path they have chosen - potentially out of necessity to keep their financial system going - is to lend huge amounts of Yuan to domestic banks. Between 2014 and today, the PBoC’s loans to depository institutions and other financial corporations has risen from ¥3tn ($340bn) to ¥17tn ($2.3tn). These now represents 40% of the entire PBoC balance sheet of ¥44tn ($6tn). FX reserves are now 50% of the balance sheet, down from 80% in 2014.
For reference, the Fed’s $7tn balance sheet consists almost entirely of their securities portfolio, which mostly contains Treasury securities and mortgage backed securities.
I view the PBoC loan portfolio sort of as a Chinese-style QE program. It’s their attempt to stimulate the domestic economy similar to what the Fed attempted in the early 2010s when they were dealing with excessive private sector debt.
Forming a view on the eventual outcome of this development is extremely challenging and I don’t feel like I am in a position to provide you with a qualified opinion. I do however believe it is important to spend time on this topic because China’s path forward seems central to the path forward of the entire global financial system.
Sincerely,
Your Fallacy Alarm