Newsletter Reviews

Keeping the Economy Afloat

SOURCE: [Floating the yuan and protecting forex reserves will allow China to avoid a repeat of the Asian Financial Crisis

Emerging economies face capital outflows. Between 2009 and 2011, low interest rates in developed economies sparked massive flows of hot money into emerging economies. The hot money fueled asset inflation and spiced up economic growth too. The latter gave the perception of emerging economies decoupling from developed ones and incited even more inflow. The asset inflation eventually sparked general inflation, which slowed economic growth and diverted money from asset markets. The resulting asset deflation further decreases economic growth. Hot money is now leaving because it sees the unsustainability of the growth dynamic in emerging economies.

The Indian rupee and Brazilian real have declined by one-fifth from their recent highs, reflecting pressure from capital outflows. Because China has a controlled exchange rate, the outflow has come later, as investors believed in the safety of a government-supported exchange rate. The weakening economy this year appears to have sparked expectations of yuan depreciation. The government support of the exchange rate has become an accelerator for capital outflow, as it is increasingly viewed as a subsidy for early leavers.

China's banking system is supporting the property market through rolling over loans for delinquent property developers. It distorts the price in a market with sales of 13 percent of GDP last year. This force is another subsidy for capital outflow, as developers cut sales to slow price declines. Because a large share of hot money has landed in the property market, the banks are effectively subsidizing its liquidation value. This subsidy is encouraging capital outflow too.

The sum of trade surplus, foreign direct investment and the decline of forex reserves totaled US$ 164 billion in the second quarter. It is a crude approximation of capital outflow. It doesn't include the interest accrual on the stock of forex reserves, which could add another US$ 30 billion to the sum.

The macro data are consistent with anecdotes on the ground. The difficult operating environment and uncertain outlook are prompting businessmen to emigrate en masse. Gray income appears to be looking for safety offshore.

Full Article