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China and why “Winter is Coming”

January 22, 2016

China and why “Winter is Coming”

by Lushfun

There are several problems in establishing a currency regime that can be stable. It has to be able to establish an environment that can sustain long term capital deployment without fear of rapid devaluations to solve government problems. It has to be convertible into other currencies rather freely to facilitate external trade. Furthermore there has to be stability in the internal financial system that can provide clearing for goods, services, and other aspects.

China and the problem it created for itself. In order to develop rapidly and create an environment of trust vis a vis business and external partners China established a peg to the dollar. It was a very rational policy and provided a static margin that ensured the business community of profitability. The problem today is that as the dollar gained relative strength so the margin versus global currencies became lower and eventually negative since purchasing power became more and more vested in the currency pair of Dollar=Yuan since they are linked. Ergo products that would cost 5 Yuan in currency X, Y, or Z, went to 10 Yuan and it became unprofitable to import them.

Longer term financing that was used to establish production capabilities and the ideology of how those businesses were set up put forth an environment where dollarized financing was used via various methods. One of the major problems when creating something like this and using a major market like the U.S. as a springboard is that your dependence hampers your profitability and you need very large volumes. Companies in China, not all but quiet many are financed to the brink to establish those high volumes, however any variability in demand hampers profitability severely. Notice the possibility of weakness in variability of exchange rate was moved to variability in demand. Problem for the financial system as a whole is that it is strained to meet a certain threashold of capacity to satisfy that demand irrespective of its’ existence. Basically variability of demand has direct impact on financial system in the form of company solvency. Which we are now monitoring.

 

The solution thus far that is approaching is devalution of the peg that was done slowly, foretold in advance and gave the ability for businesses to adapt. It does not however unwind the financial links established by companies to operate, transition their capital structure function into Yuan, or defray the cost of capital re-deployment to make it possible to technologically upgrade and meet the challenge of variable demand.

 

When a country tries to springboard itself from a different country’s currency without establishing adequate attractiveness for participants to maintain their working capital and operating budgets in home currency it gets a capital shortage and the trade flows re-orient elsewhere.

Imagine you have a business, which makes something. You have deployed 10 million dollars into plant, salaries, commodities, shipping contracts, capital goods, and so on. The most liquid part of that money is deployed constantly, as soon as, you notice that going through the production chain is becoming a negative sum game, you may stop. Working capital deployed in inventory sold abroad, commodities bought abroad, deposits for shipping and insurance partly abroad, and some savings held abroad for upgrades to capital equipment will not transition back. At this point the most valuable thing this business has are the contracts to satisfy demand in the exporting market. Granted it may have some demand internally as well but you could split the internal from external businesses or evaluate if it that part could be sold or remain autonomous.

The hardest problem from a financial system perspective is to have enough trust from the people whom operate these companies that you will not transfer/re-distribute/steal purchasing power from them to others in that system. Think loosing purchasing power and someone getting loans below the rate of inflation to expand firms that are oriented internally in the country. Essentially at that point you would be forfeited for someone else and since you cannot be profitable in this new environment you may lose everything.

Urgency arises at the point of declining marginal demand. Right now as global demand for goods of all sorts declines and factory utilization drops while profit margins decline or go negative, the need to re-orient for internal demand would require massive funds that shift the structure of the economy and production in general. These funds cannot be created out of thin air. They can be financed into existence based on possible demand in the future but for that you need markets, and participants. The “New Silk Route” is attempting to bring both onboard.

New questions but old problems arise. How does one separate the peg while keeping the flow of capital in the system constant if those that export can see the paint on the wall? If liquidity is low due to working capital escaping and insolvent enterprise loans maturing essentially destroying Yuan capital while shifting into Dollar capital, how does one keep the monetary system robust for the transition?

Imagine a world where China succeeds, the rate of Yuan to the dollar is 7 or 8 it is moderately free floating and you could buy contracts to get it on an exchange or pay for goods in Yuan to export them elsewhere. Where would those exports go if market share is lost to higher margin producers that are located locally and can sustain more variable demand and competition?

Belief in Yuan being tied to the Dollar is bolstered by the trillions in dollar reserves by China. However, if everyone knows and trusts that it has to go down in value, everyone will short or sell the Yuan or Yuan denominated assets to capture the gain by participating in the decline. This is some of the reason why China equities went down since capital controls in a way prevent direct shorting of the Yuan. But again to reiterate the point I made above, the biggest and most dire danger is the exit of capital and re-orientation of trade flows. Something like that would render a large segment of the economy without ability to survive and have fairly dire social consequences. Attempts to create demand for the Yuan by going global to attempt to compensate the exiting capital with foreign holdings that would allow the monetary system to re-finance the structure may succeed in certain areas. But on the whole it will probably fail due to access of financing being limited to those connected, subsidy of companies for social reasons, aggregate impediments of ability to deploy that capital into ownership that can be defended by external actors, and government interference at various levels. On a different level one can say that the problem is not China but the system it is trying to compete within and spring forth from. It simply cannot escape the gravity of global demand contraction by attempting to expand market share into markets that have no or low purchasing power, unless how profit comes into existence changes. Perhaps manifesting monetary currency out of thin air can create demand that is sorely lacking, but fitting a finite world into an infinite monetary universe will end very badly.

Some food for thought

Money – Pink Floyd HD

https://www.youtube.com/watch?v=cpbbuaIA3Ds

 

1) http://www.scmp.com/business/markets/article/1857714/chinas-yuan-devaluation-part-wider-transition

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