CHINESE New Year has come and will soon go. The eurozone debt crisis is well past two years. Yet uncertainty persists. The World Banks January 2012 Global Economic Prospects reports:
World economy has entered a very difficult phase characterised by significant downside risks and fragility and as a result, forecasts have been significantly downgraded. However, even achieving these much weaker outturns is very uncertain Overall, global economic conditions are fragile.
This weeks IMF World Economic Outlook says more of the same: The global recovery is threatened by intensifying strains in the euro area and fragilities elsewhere. China, India, South Africa and Brazil have entered a slowing phase.
No country and no region can escape the consequences of a serious downturn. Nevertheless, growth in the East Asia and Pacific region (excluding Japan) is expected to slowdown to about 7.8% in 2012 (8.4% in 2011) and stabilise in 2013.
This reflects continuing strong domestic demand (evident in third quarter or 3Q 2011 GDP) while exports will slow to about 2% due to Europe heading towards recession and sluggish rich Organisation For Economic Coercion And Direction (OECD) demand.
The middle-income nations are, I think, in a good position to weather the global slowdown, with significant space available for fiscal relaxation, adequate room for interest rate easing, ample high reserves and rather strong underpinning for domestic demand to rise.
I see the modest easing in Chinas growth being counterbalanced by a pick-up in GDP gains in 2013 over the rest of the region. Outside China, growth has slackened sharply to 4.8% in 2011 (6.9% in 2010), but is expected to strengthen in 2012, reaching 5.8% in 2013.
GDP growth in China, which accounts for 80% of the region, had eased to about 9.1% in 2011 (10.4% in 2010) and is expected to slacken further to a still robust 8.2%-8.4% in 2012.
The World Bank projections point to growth moderating at 8.3% in 2013, in line with its longer-term potential GDP. Expansion is expected to emanate from domestic demand, with private spending and fixed capital outlays contributing most of the growth in 2012.
For China, the health of the global economy and high-income Europe in particular, represents the key risk at this time. Domestic risks include property overheating, local government indebtedness, and bloating bank balance sheets.
The 4Q 2011 growth of 8.9% annoy investors who are looking for indications either weak enough to justify further policy easing or strong enough to allay fears of a hard landing. Bear in mind the forecast growth for 2012 will be the weakest in a decade, and may cool further as exports slump.
The Chinese economy is buffeted by two very different forces: (i) slow global growth will hurt Chinese exports (especially to its largest trading partner, European Union) which rose by 7% in December, and exporters foresee more trouble ahead; however, (ii) analysts point to strong retail sales (up 18% in December) reflecting rising wages and domestic spending which represented about 52% of GDP in the first quarter, higher than in 2009-11.
China is counting on its massive effort to build low-income social housing to provide enough demand to keep the real-estate market from collapsing.
It is unclear whether China can accelerate this program to build 36 million subsidised housing by 2015enough to house all of Germanys households. But financial markets are anticipating worse news ahead. After all, the Shanghai Composite Index fell 21% in 2011. As the adage goes, stock analysts did forecast 10 of the past 3 recessions!
Appreciation of the yuan (renmimbiRMB) against the US dollar in 2012 is expected to slow to about 3%, from +4.7% in 2011. The yuan closed at 6.3190 at end 2011, up about 8% compared with June 10 (when China effectively ended its 2-year long peg to the US dollar and has gained 30% since mid-2005 when it was last revalued.
The slowdown reflects growing demand for the US dollar amid uncertainty, lower growth, diminishing trade surplus, and growing US military presence in Asia, according to Chinas Centre for Forecasting Science (of the Chinese Academy of Sciences) which reports directly to the State Council, Chinas Cabinet.
Much of it will be in the latter year as China is likely to keep the yuan relatively stable in the first half to allow time to assess the impact of goings-on in the euro-zone. Dollars are pumped in via state banks, providing markets with a clear signal it will not allow the yuan to depreciate, while not in a hurry to let it appreciate either. The yuan has since moved sideways.
To make the yuan a true reserve currency, China begun to liberalise currency controls and encourage an offshore yuan market in Hong Kong, creating an outlet for moving the currency across borders. However, foreign investors in China have been slow in using the yuan.
In practice, it is still difficult to buy sell yuan because of paperwork bureaucracy. It is still easier to settle in US dollar as it is the universal practice. Its convenience outweighs the potential costs of any unfavourable move in the US dollar-yuan rate. Nonetheless, China is encouraging more businesses to use the yuan and more US banks to step-up their yuan-settlement business.
This market will grow as China diligently moves to internationalise its currency. Encouraged by the authorities, a vibrant offshore yuan market has blossomed in Hong Kong. Beijing still controls the currency and how the yuan bought in Hong Kong can be brought back to China.
Yuan deposits in Hong Kong rose more than 4 times to 622.2b yuan (nearly US$100bil) at end September 2011 from a year earlier according to the Hong Kong Monetary Authority, and now account for 10.4% of bank deposits.
Growth in offshore yuan stalled in late 2011 as China slowed its currency appreciation against the dollar. Given Beijings gradualist approach to reform, the market will soon revive.
An audience poll at the recent 2012 Asian Financial Forum in London indicated 63% believes full yuan convertibility is more than 5-years away.
The very fact that London wants to be a yuan-trading centre now says a lot. Only 10% of Chinas international trade is settled in yuan, rising to 15% in 2012. Its still a small market in the global context.
The yuan is used for just 0.29% of all global payments in November 2011 according to financial messaging network Swift. By comparison, the euros share is about 40%.
A booming business in dim-sum bonds (offshore yuan denominated bonds) followed, with companies including Caterpillar and McDonalds issuing such bonds. In September 2011, a spurt of capital flight towards safe haven assets in the US tied to the worsening debt crisis in Europe caused currencies of emerging nations to depreciate against the US dollar.
In East Asia, modest declines were recorded compared with South Africa (the rand fell 22%) and Brazil (the real dropped 18%). Only the Indonesia rupiah (down 5.8%) and the Malaysia ringgit (fell 5.4%) come under some pressure.
This event slowed the appreciation of the yuan and with it, trading in dim-sum bonds eased as investors were no longer in a hurry to invest. Over the medium-term, most analysts expect this yuan market to grow in the face of its massive US$3.18 trillion in reserves, as China moves to build its international status.
When dim-sum bonds started to hit the market in 2010, investors were enthusiastic, bidding up prices and driving down yields. But in the second half of 2011, the average price of investment grade dim-sum bonds fell 3.3%, amid a broad flight towards quality spooked by euro-zone turmoil and Chinese accounting scandals.
Bankers hope new entrants (private banks, commercial banks, mutual funds life insurers) will give the market more stability this year. They would add depth breath to the market, which tripled to 185b yuan (US$30bil) in dim-sum bonds issued in 2011. Expectations are for such bond issuance to reach 240 billion yuan this year, as new issuers (including more foreign companies) join early adopters such as government entities state run banks.
This offshore bond market has developed well over the past year. Investor diversification in both types geographics is still evolving, which is key to the healthy growth of the market. Equally important, investors look to the continuing appreciation of the yuan.
In addition, its average yield has risen to 3.8% (from 2.35% since mid 2011) and most now trade at higher yields than comparable US dollar bonds.
This rise in yields reflects expectation for (i) slower yuan appreciation; (ii) increase in supply; and (iii) investors desire for a higher liquidity premium during market downturns. Overall, the dim-sum market is turning into a buyers market.
China is forging ahead in laying the groundwork to internationalise the yuan via bilateral arrangements with foreign companies, nations financial centers, particularly Hong Kong (mainly because it can fully control the terms of the market). More mainland-based financial institutions will be able to issue yuan denominated bonds in Hong Kong.
This is part of a broader effort, first started in July 2009 when it encouraged enterprises in Shanghai Guangzhou province to use the yuan when settling trade with Hong Kong, Macau and some foreign companies (see my column China: RMB Flexibility Not Enough of July 3, 2010).
The post-Xmas direct yuan-yen trade deal forms part of a wide-ranging currency arrangement between China Japan to give the use of the yuan a big boost. After all, China is Japans largest trading partner with 26.5 trillion yen in 2-way transactions last year. Encouraging direct settlement in bypassing the US dollar would reduce currency risks and trading costs. Also, Japan will buy up to US$10bil in yuan bonds for its reserves even though it represents no more than 1% of Japans US$1.3 trillion reserves. And, it is now easier for companies to convert Chinese and Japanese funds directly into each other without an intermediate conversion to US dollar. About 60% of China-Japan trade is settled in US dollar, a well-established practice.
The package allows Japan backed institutions to sell yuan bonds in the mainland (instead of Hong Kong) helping to open Chinas capital market.
In recent weeks, China has taken new steps to promote the use of yuan overseas, including allowing foreign firms to invest yuan accumulated overseas in mainland China; widening the Peoples Bank of China (its central bank) network of currency swaps with other central banks to enable their banks to supply yuan to their customers, including with Thailand, South Korea and New Zealand totalling 1.2 trillion yuan.
It already has completed arrangements with the big Asean counterparts. Berry Eichengreen (University of California at Berkeley) observed: Japan appears to be acknowledging implicitly that there will be a single dominant Asian currency in the future and it wont be the yen.
But Harvards Jeffrey Frankel is more down to earth: This hastens a multicurrency world, but this is just one of 100 steps along the way.
China still has a way to go in: (i) getting the yuan fully convertible (ii) reducing exchange rate interventions (iii) liberalising interest rates, and (iv) reforming the banking system. In all, so the yuan can really trade freely.
What to do?
The China-Japan deal points the way, nudging the yuan towards the inevitable becoming a reserve currency alongside now discredited US dollar and the euro. This is to be welcomed by all.
China must realise a fully internationalised yuan should be free to float (and to appreciate) part of its overall reform. Over the longer term, though, avoiding huge imbalances is good for everyone, not least China. While it is understandable for its Prime Minister to label China today as unstable, unbalanced, uncoordinated and ultimately unsustainable, opportunities to take advantage of new openings dont come often.
Alexander Gerschenkron, my professor at Harvard (in my view, the best economic historian of his time) points to economies like China as having advantages in backwardness, including Chinas ability to weather shocks: high reserves, robust fiscal situation and comfortable external position.
Shakespeares Hamlet sums it up best: If it be not now, yet it will come – the readiness is all. A grown-up yuan is good for Chinas welfare.
It also means a more stable world economy which benefits the United States. For China, there will never be enough cushion. Politicians need to seize the moment and act boldly.
#9679; Former banker, Dr Lin is a Harvard educated economist and a British Chartered Scientist who now spends time writing, teaching promoting the public interest. Feedback is most welcome; email: firstname.lastname@example.org