World Economy

China's economy doesn't look so wonderful when you look at the really big numbers

China's falling FX reserves are a key challenge: StanChart
China's falling FX reserves are a key challenge: StanChart

The supposed stability being portrayed in China's recent economic reports doesn't look so rosy in the scope of the big picture.

For example, less money appears to be fleeing the country than only a month or two ago — but looking back 12 months, the trend is still worrying.

China bought U.S. government bonds in December for the first time since May, the Treasury reported Wednesday. However, overall holdings fell by a record $188 billion last year, according to news service StreetAccount.

Similarly, official foreign exchange reserves fell at a slower pace in January, but they have dipped below the psychologically important $3 trillion level. That marks a $1 trillion drop in just two-and-a-half years.

"The faster we get to $2.5 trillion [in total reserves], the quicker the sense of eventual disarray will be," Junheng Li, founder of China-focused equity research firm JL Warren Capital, said in an email. She estimates that about $65 billion to $70 billion leaves the country every month, including more than $80 billion in January alone.

"Additional tightening of [capital] controls is likely," Li said. "However, we are starting to see restrictions imposed on areas with increasing marginal cost. Therefore, one needs to wonder if they will be able to slow down much further the pace of outflows."

Beijing tightened restrictions on individuals taking money out of the country in the last several months. From a purely financial perspective, Chinese also have seem to be showing less urgency to buy assets denominated in U.S. dollars since the yuan pulled out of the 7 percent dive it made last year, gaining 1 percent so far in 2017.

But the yuan could come under pressure again. The U.S. dollar will likely stay strong or move higher, since the U.S. Federal Reserve looks on track to raise interest rates at least twice this year. Higher interest rates typically push currencies higher.

"As long as the U.S. is in a tightening environment, we'll likely see capital outflows" from China, said Francis Cheung, head of China-Hong Kong strategy at CLSA, a brokerage and investment firm based in Hong Kong.

Capital trapped in China

Money sloshing around inside China's closed markets creates investment bubbles — the country has seen everything from real estate to stocks to bonds to soybeans swell in price, and then pop. When those bubbles burst, authorities rush to patch up the situation, putting U.S. investors on edge.

The problem with China is "every single asset class has been inflated" or "deflated," Cheung said. "It's a fundamental issue."

A 40 percent plunge in the Shanghai composite in 2015 and a failed attempt to implement circuit breakers half a year later contributed to market shocks that reverberated globally. When Beijing limited investors' ability to borrow and invest in stocks, Chinese turned to speculating on Chinese commodities exchanges, which then drove prices for global assets such as iron ore.

The eventual deflating of China's property market is a constant concern for those worried about a sharp slowdown in the world's second-largest economy.

One major factor behind the worries is the sheer amount of money China has put into its system, economists explained to CNBC.

"You have this huge amount, nowhere to go. We're just going to get this happening over and over again," said Derek Scissors, chief economist at the China Beige Book. "You can't handle that size of money stock other than bubble, bubble, bubble."

He pointed out that China now has about $9 trillion more in "M2" money supply — a measure including cash, savings, checking accounts and mutual funds — than the United States does. In 2011, China had only $2 trillion more.

Debt rising, off the books in shadow banks

Total social financing, a closely followed broad measure of credit in China's economy, continued to show stable levels of growth in January.

The volatile data showed year-over-year growth of 16.4 percent when adjusted for financial transactions such as debt swaps, according to Larry Hu, chief China economist at Macquarie.
That's roughly in line with the last six months, he said.

However, the headline figure of 3.74 trillion yuan ($545.3 billion) in new loans was the highest level on record "due to strong off-balance sheet lending," Hu said in a Tuesday note.

That means more loans were issued by unregulated financial institutions, or the shadow banking system — a growing and largely inscrutable area of China's financial system.

There are signals indicating that many businesses favor shadow banks, because of volatility in China's bond market in December. Hu noted it was a second-straight month of contraction in corporate bond financing.

Besides going increasingly off the books, new loans appear to be less effective at delivering growth.

Analysis from China financial data firm Wind Information showed that as of December, every yuan of GDP growth required more than three yuan in total social financing loans, close to levels not seen since the financial crisis.

China reported growth of 6.7 percent in 2016, the slowest in 26 years. Most economists outside China doubt the credibility of its growth announcements.

That said, China watchers are generally confident in Beijing's ability to prevent a sharp economic slowdown, and say authorities' communication in implementing policy has improved.

In fact, Macquarie's Hu expects credit growth to slow down going forward, "given top leaders have set the tone for monetary policy as 'neutral.'"