China Fights Overcapacity and Currency Threats – 1/31/16

The Chinese government is currently trying to have its cake and eat it too, when it comes to the country’s finances. In spite of large reserves and open threats by officials to punish offenders, China is finding itself threatened by a run on its currency.

China is attempting to maintain control of a fixed exchange rate, keep monetary policy independent, and have open international capital flows; a trinity that no control before it has managed to keep. Low interest rates are needed to stimulate the economy during a painful slowdown but capital is fleeing the country because the same slowdown makes China look like a bad investment. In turn, the capital flight threatens to devalue the currency which the government wants to keep pegged to the dollar. China holds large foreign exchange reserves to prop up its currency but if the country can’t find a way to whip the domestic economy back into shape, even tossing a few trillion dollars at the problem won’t be enough, especially when it’s burning through ~$100 billion per month.

For years, investors assumed that Chinese officials could guide the nation through its economic troubles while keeping volatility low and, for the most part, the state was able to deliver stable growth.

Until now. Overcapacity resulting from cheap credit has become a burden on Chinese growth and the struggle to shift to more sustainable growth areas is set cause a sharp slowdown in the countries growth. Irrational exuberance in markets has led to many bubbles in asset markets but the belief that the Chinese government could prop up growth forever is an especially interesting case. For reason, despite a widespread lack of faith in the US government’s ability to do just about anything, American investors praised Chinese officials for their policies that extended cheap credit to state-owned businesses. Inefficient, unprofitable firms expanding using debt was never sustainable though, as we now see plans to cut output and lose millions of jobs in China’s primary industries. Debt practices favoring more “stable” state supported sectors over more nimble, innovative ones ultimately held back creative albeit volatile small businesses.

Unfortunately for the current leaders in China, the time to come clean about the many problems hidden by capital controls and questionable state data has fallen into their laps leaving them nowhere left to hide it.

China’s “Ghost Cities”:¬†

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