The impossible trinity is the trade-off between three diverse objectives of macro-economic management: a fixed-exchange rate vs a market-determined exchange rate; an independent monetary policy vs a dependent one, i.e., one that reacts to external capital flows rather than manages them; and free capital flows vs capital controls.
All three - a fixed-exchange (or managed-exchange) rate, an independent monetary policy and a free capital-flow regime - are not possible. Most countries make do with a compromise with one or the other of these objectives, mostly in the exchange-rate regime that they follow.
The breakdown of the exchange-rate mechanism (ERM) in 1992, when currency speculators led by George Soros 'broke the back of the Bank of England', is a good example of how the impossible trinity is now a part of economic gospel. The Bank of England (BoE) tried to keep the pound inside a band, but its inflation levels were running at three times the German inflation rate and it was facing the aftermath of the Lawson Boom, the collapse of a real-estate bubble caused by the (monetary) expansionist policies of Nigel Lawson.
China, today, is going through the same situation. Multiple bubbles have burst: first, commodity investments in steel/aluminium, etc., then real estate and now the stock market, and it needs to follow expansionary (monetary) policies to hold up the economy in the aftermath. These policies are impossible if you want to keep the yuan's fixed peg to the dollar, and, therefore, China must devalue its currency. The question is when and how. While there is no George Soros on the other side, given its huge foreign-exchange reserves, China needs to shift its yuan peg to a basket of weaker currencies like the euro and yen.
In place of George Soros, China is facing an army of investors, mostly from within, directly or indirectly. The name being used right now is 'capital flight', and it has already resulted in about $1 trillion reduction in its forex reserves. Mind you, this is an economy that is running a trade surplus of over $500 billion over the same period, although even that should reduce substantially. Nothing to worry so far, but there is a Lehman moment round the corner. And that will happen when either China clamps capital controls or goes into a huge devaluation. The former will internalise the pain, while the latter will try and export the pain to the outside world, leading to a huge global (market) instability.
I personally think that we will see a bit of both, some form of capital controls and some devaluation, as China tries to bring its half-engine economy down into a soft landing. Lower interest rates are needed to get its consumer economy moving, to fill in the gap created by the implosion of the commodity/investment-demand economy. It will not be a soft landing - neither for China nor for the global markets.
With all these moving parts, it is very difficult to say anything with certainty, but one thing is for sure: China will not follow a dependent (on external flows) monetary policy. That is one thing we can assume for sure. Thereafter, how will it control the aftermath of its actions, especially capital flight, as it drops interest rates? Either through direct, brutal capital controls, which would destroy its credibility as an aspiring reserve currency or by a sharp, vicious devaluation, which might trigger a currency war.
My bet is that even if it chooses the first option, it will only be for a while. China is a nationalist country, more than most. Nothing in their past suggests that they will hold back on their direct interests. The implication for world currency markets is then a wave of volatility, as we adjust to the new China.
For somewhat overvalued currencies like the Indian rupee, there is just a one-way ticket to ₹75, maybe. Yes, I am trying to shock you, just to prepare you for a number that you cannot imagine just now.
Are there any mitigating factors just now? Yes, there are, and only China can do it. In sectors where there is no hope of any (economic) revival, China is not taking the 'Japan option' of keeping zombie companies held by zombie banks. This was what caused deflation-depression that led to the 'lost decade' of Japan. China is doing some serious restructuring of its coal, steel and aluminium sectors, for example. In steel, it has announced the closure of a whopping 150 million ton of capacity, shortly after acknowledging that 90 million ton of capacity has already been closed. That means that a combined 240 million ton of capacity will go offstream, and (hopefully) the related debt will be written off. No new capacity is being allowed, a relief for the rest of the sector. If we estimate a surplus of, say, 360 million ton, then this should have a salubrious impact on global steel prices; the timing of this restructuring has not been spelt out, but it should have an impact on sentiment.
China is responsible for the global commodity blowout, and since almost 40-60 per cent of global capacity is within its borders, it has a vested interest in reviving the fortunes of its producers. It will be nudged into doing this further if it triggers global protectionism, as it tries predatory pricing to enter foreign markets by dumping its produce. Enough countries have not pushed back. In our own specific case, despite a clearly articulated Make in India policy, we have failed to protect ourselves against Chinese dumping, leading to huge non-performing assets with our banks in the steel-and-metal sector.
It makes sense for China to follow a calibrated policy that is a mix of tactics, rather than take a dogmatic stance in favour of some hubristic fixed-exchange-rate policy, for example. At one level, it takes the write-offs from its devastated commodity sector, recapitalises the banks for losses and prints the needed yuan. This will loosen its monetary policy, but it is a one-time shock rather than a continuous 'zombie' policy that is simply averse to taking the pain and the resultant job losses. This is what democracies are prone to do, as we saw in the case of Japan.
In the short run, when this form of quantitative easing takes interest rates down, it will probably impose capital controls, either explicitly or in some implied form. Plain administrative controls are possible in a totalitarian economy, something that one cannot think of in a democracy. Hence, only China can do it. This is what got them into this soup in the first place, and this is what will get them out of it.
Meanwhile, keep letting out the steam by small doses of devaluation that do not trigger a currency war like the bullies who push you on the school playground but not enough that you go get your elder brother. A full-fledged currency war will degenerate into a race to the bottom, especially in South-East Asia and Japan/Korea.
In a world full of uncertainty, one thing is for certain: China is at the heart of the global recession, and until its consuming economy can replace and make up for the hole created by its manufacturing economy, there is no alternate engine that will take up the slack in the interim. Yes, India is an aspirant, but it is coming off a very low (relative) base; the developed world is simply too exhausted. While it is not the end of the real economy, it does mean markets are almost universally overvalued and need to correct further if they want to price in a long U-style downturn. Surprisingly, the upside will come from the given-up-for-dead commodity sectors, while the downside will come from the 'profitable growth' sectors where valuations have got simply too high. This is, therefore, a market-valuation problem, not a real economic problem.
The author teaches, trades and writes at spandiya.blogspot.com.
This column appeared in the March 2016 Issue of Wealth Insight.
This article was originally published on April 08, 2016.
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