China’s fundamental problem is its excessive savings rate and warped financial system which have skewed its development towards unproductive investment at the expense of consumer spending. China accumulated huge foreign exchange reserves but at the expense of private household wealth, which almost certainly would have been rising at a much faster rate than the paltry return foreign reserves invested in low yielding dollar assets have achieved. China’s undervalued currency allowed it to grab export market share at a fast pace, fuelling strong export income growth that allowed the state to throw money at unproductive investment without debt building up fast. During that period the argument was that the yuan should have been allowed to increase much faster to help the economy decrease its reliance on exports and investment and foster consumer spending.
But the situation now differs because the currency has become overvalued since 2011. The rebalancing from investment towards consumption given the overvalued yuan would be made easier if the currency is allowed to depreciate as capital flows are liberalised fully. This may not be the government’s intention, which for now seems keen on fostering their domestic fixed income market and allowing more capital inflows than outflows. But the higher the yuan, the more difficult it will be for the decimated corporate sector to abstain from cutting jobs and pay. It would then become a race to the bottom between investment and consumption amid weak external demand.
Investors have become aware that China’s growth story has changed over the past couple of years. It’s time to reconsider that the solution to China’s problems could well be different this time around too.