China's global importance

Despite seemingly a multitude of worries over the potential for a slowdown in US growth, the growing signs of weakness in Japan, the arrival of an industrial recession in Europe and the uncertainty over BREXIT, financial markets have arguably performed remarkably well over recent months. We would argue that the primary positive driver of financial markets over the last few months has been events within China.

Although China’s economy is clearly weak in growth terms – as commodity producers, German car and capital goods producers, Japanese exporters and of course the New Zealand dairy sector can each testify – the fact remains that the desire on the part of Chinese private sector to diversify into non-RMB denominated assets such as property in North America, Australasia and increasingly Europe, bank deposits (chiefly in the US), hoarding commodities, and even direct investments into companies abroad has resulted in what we estimate to be perhaps as much as a US$200 billion per month flow of capital into financial markets.

This rate of outflow, while clearly causing China’s authorities a degree of angst, is probably more powerful than any Western QE type flow. In reality, much of the money that is supposedly being created by the BoJ and ECB QE programmes is not making it ‘out’ of the domestic banking systems – many of the bonds purchases by these central banks are acquired from commercial banks who are then simply sitting on the money by holding them as excess reserves – but China’s outflows constitute ‘real money’ in the hands of ‘real people’ who are spending that money on assets around the world. Moreover, inasmuch as many of these outflows are themselves being funded and encouraged by China’s still very strong state-sponsored domestic credit boom, we have taken to calling China’s outflows as representing “QE on speed”.

However, it is far from clear that China can continue along this track for too much longer.  By our calculations, the capital outflows from China are exceeding the country’s trade surplus by two to three times with the result that we believe that China’s underlying Foreign Exchange Reserves position is deteriorating by over a US$100 billion per month. It is estimated by some that if this rate of decline in the FX reserves continues unabated, China will in effect run out of liquid reserves that it can draw upon in the middle of 2017. We would, however, argue that it would make little sense for China to exhaust all of its reserves and to then be obliged to act from a ‘position of weakness’ as much of Asia was ultimately obliged to do in 1997-98. Instead, it would be much more rational for China to seek to act from perhaps a stronger position sooner rather than later.