Nearly a quarter-century ago, former president Bill Clinton began the American tilt away from Japan. With the inauguration of President Donald Trump, the reset of US-China relations has begun. Along with the eradication of radical Islamic terrorism and deregulation of the US economy, the China reset is likely to be one of the important policy agendas of the new administration. My friend Prosenjit Basu told me that the very reason Laura D’Andrea Tyson was appointed chief economic adviser to the president by Bill Clinton was her “Japan-bashing". Others might take a more nuanced view but she was not averse to selective intervention against trade distortions practised by other countries, Japan included. Her famous book was Who’s Bashing Whom?—Trade Conflict In High Technology Industries.

Not only that, not a single day passed without Lloyd Bentsen, Clinton’s first treasury secretary, complaining loudly against a weak Japanese yen. Wall Street took the cue. By April 1995, the Japanese yen had strengthened to 79 against the US dollar. For perspective, readers should note that when the floating exchange rate era began in 1973, the exchange rate was 360 yen to a dollar. Japan was battling a recession, an enfeebled banking system stuck with a mountain of bad debt from the collapsed real-estate and stock-market bubbles and several other economic woes. To offset the domestic economic stress, the country needed a weak currency. The US worked hard to ensure a different outcome for Japan. I do not recall “Liberal" commentators despairing at the American treatment of a democratic Japan. Now, several commentators are prophesying the end of the world at the trade retaliation measures that President Trump has promised against an autocratic China. Now, suddenly, China is the champion of global integration, President Xi Jinping is the only adult in the room and he is the darling of the Davos crowd. Stranger things have happened in the world, of course, but this has had its own amazement value too, for me.

According to research by Fathom Consulting in the UK, China’s economy is growing at around 3% in reality while the government has rather accurately estimated that the economy grew 6.7% in inflation-adjusted terms in 2016, exactly as it had targeted. One province had admitted that it had fudged economic growth data for at least three years. The South China Morning Post dutifully explained that it could not have influenced the economic growth estimate for the country as both are computed independently. Who says that humour has no place in economic journalism?

China’s economic problems are well known and even many mainstream economists working for investment banks have begun to acknowledge the inherently contradictory nature of the country’s stated economic goals such as stable growth, rebalancing of the economy towards services and consumption, deleveraging, a stable exchange rate and internationalization of the currency. In the end, only one goal is pursued and that is growth with releveraging as the only policy constant.

In their annual outlook for China for 2017, economists from Goldman Sachs noted that, adjusted for all data quirks, China’s overall credit growth in 2016 was 20%. It added that if the same approach were adopted for calculating China’s overall fiscal deficit, the effective fiscal deficit would be 6% and that an “augmented" fiscal deficit would be well into double digits. Bank of America-Merrill Lynch economists chip in independently. According to their calculations, China’s government debt ratio was close to 70% and the fiscal deficit ratio was 10% of GDP. At this rate, they reckon, “Chinese government debt to GDP could be over 100%, an astonishingly high level for an emerging market and higher than the equivalent level in the US." China has an AA- credit rating and Standard & Poor’s has not warned of credibility erosion for its central bank.

In the last couple of weeks, there have been four independent news stories on China, with all of them having one common thread. First was the news that Japan had once again become the largest creditor to the US government, a mantle that it had ceded to China in the new millennium. There was a story that the Chinese president was travelling to Davos for his first-ever visit to the annual gathering there. Then, we heard that China’s foreign exchange reserves had declined to within a whisker of $3 trillion. According to official data, that is. Finally, the bond investment firm Pacific Investment Management Co. (Pimco) wrote that China’s next market shock could be a freely traded yuan. The common thread in all the four stories is China’s rising external vulnerability and the eventual inevitability of a substantially weaker currency. It could be after the National Party Congress in October.

It is an important lesson for policymakers. External vulnerability is not just a question of having foreign currency denominated debt. High and rising domestic debt will persuade residents to flee the domestic currency. If the government reads the riot act on capital outflows, then the capital account would turn porous. The currency will become uncompetitive in real terms and the black market will tell us the true value the market attaches to the currency.

A devaluation is the smoking gun that Trump would need to declare China a currency manipulator and unleash trade sanctions. What happens next? Well, let us watch the movie. It has just begun.

V. Anantha Nageswaran is an independent financial markets consultant based in Singapore. Read Anantha’s previous Mint columns at www.livemint.com/baretalk

Comments are welcome at baretalk@livemint.com

Close