The writer is an independent investment strategist and founder of the online research marketplace ERIC
For the first time foreigners have a large enough position in renminbi-denominated securities to influence Chinese monetary policy.
Foreign investment in China has historically focused on direct investment, and investment in portfolio assets was largely confined to foreign currency denominated debt.
Things have changed dramatically in the past 10 years. In 2011, foreigners’ holdings of China’s liquid portfolio assets were just 14 per cent the size of China’s reserve assets. In June, they were almost two-thirds the size at $2.1tn.
This surge, when combined with the country’s managed exchange rate policy, confers a new power upon foreigners, as evidenced when one considers the size of foreign holdings of China’s portfolio assets in relation to the size of the country’s foreign reserves.
In 2011, foreigners’ holdings of China’s liquid portfolio assets of $458bn was 14 per cent the size of China’s reserve assets. Today, that percentage is about 5 per cent, but holdings are much greater in absolute terms at $2.1tn. What happens if these assets are liquidated?
Downward pressure on the renminbi exchange rate forces intervention from the People’s Bank of China. And as foreign reserve assets decline, liabilities in the form of renminbi-denominated bank reserves also decline. The action of foreign investors would dictate, through this process, a tighter monetary policy, just as China is struggling with falling residential property prices and growing distress in the private credit system.
The consensus among professional investors is that foreign ownership of Chinese portfolio assets can only continue to rise. The reasoning goes that Chinese bonds can provide the uncorrelated returns that boost their value to any diversified portfolio and they will be in large demand.
This faith in future inflows to portfolio assets is bolstered by the belief that those who construct benchmark indices of global portfolio assets, those conductors of blind capital, will only raise the weightings of China’s portfolio assets within those indices.
However, there is a growing list of reasons why foreign portfolio inflows to China can stop or even reverse. The increased risk of a cold war means it is not clear that foreigners will be permitted to fund, even partially, the Chinese government’s military build-up through their purchase of Chinese government bonds.
Growing focus on environmental, social and governance concerns will probably impinge upon foreign investors’ ability to add to their Chinese positions. These key external factors are exacerbated by China’s growing internal problems.
The overbuild in China’s residential property market is hardly a new story but prices in it have recently declined amid signs of credit distress among developers.
This distress is exacerbated as Xi Jinping, China’s president, seeks to draw a line between what is a public risk, that can be financed by the state-controlled banking system, and what is a private risk that should have no credit from this source. Investors who assumed that companies receiving loans from state-controlled banks were a public risk are in the process of re-pricing such risks.
All this is particularly bad news for the informal credit system which has often financed what state-controlled banks are no longer allowed to.
The operation of the managed exchange rate is keeping Chinese monetary policy tight, with broad money growth near a postwar low. While foreigners invested in Chinese government bonds may welcome tighter monetary policy, more likely it will frighten foreign capital out of the Chinese equity market.
Xi’s aim to create greater ‘common prosperity’ in China does not necessarily reduce private property rights, but is likely to.
Monetary history is the history of how politicians have needed to control the price and quantity of money to pursue their political goals. Xi is currently constrained in his common prosperity goal by the tightness of monetary policy dictated by the operation of China’s managed exchange rate.
Sometimes political leaders must choose between a deflationary adjustment or a move to the exchange rate flexibility that allows control over the price and quantity of money and inflating away debts.
China’s debt-to-GDP ratio has soared since 2009 and it is now as overleveraged as the developed world.
Xi’s political goals are no longer compatible with a stable Chinese exchange rate. Xi has to choose between a flexible exchange rate and monetary independence or a deflationary economic adjustment with its attendant financial and political risks.