Victor Shih is an associate professor of political economy and has published widely on the politics of Chinese banking policies, fiscal policies and exchange rates. He was the first analyst to identify the risk of massive local government debt, and is the author of “Factions and Finance in China: Elite Conflict and Inflation.” Prior to joining UC San Diego’s School of Global Policy and Strategy, Shih was a professor of political science at Northwestern University and former principal for The Carlyle Group. Shih is currently engaged in a study of how the coalition-formation strategies of founding leaders had a profound impact on the evolution of the Chinese Communist Party. He is also constructing a large database on biographical information of elites in China. He holds a Ph.D. in Government from Harvard University and a B.A. in East Asian Studies from George Washington University. He was interviewed by Anna Balderston CMC '18 on Jan. 29, 2016.
In your talk at the CMC Athenaeum in February last year, you warned that China would experience a possible financial crisis in the near future, in part due to high levels of debt. Is there any linkage between China’s high financial leverage and the growing depreciation pressure on the yuan?
Yes, there is a connection because China was making many wasteful investments for a long time. I would say it started in 2005, but really got much worse in 2008. Of course, because the government controls the banking system, they could just keep doing it, but that lead to a lot of wasteful investments. Then, at the end of the day, there was very low return on the investments. That means entities that were borrowing money to invest made wasteful investments.
They couldn’t pay high interest rates because the return is so low; so the profit was not enough to pay the interest on the loans. Even if the banks never make them repay the principal, they still have to make the interest payment, and firms in China were increasingly unable to do that.
When the dollar interest rate is near zero, which has been the case since 2008 because of Fed reaction, that means even if the interest rate in China is relatively low, money will flow into China because the global interest rate otherwise is basically zero. Any country that has an interest rate higher than zero will attract a lot of money. Of course, China still being a relatively fast-growing economy, the interest rate in China, at around 6 percent, was actually high by global standards but low by Chinese standards. Therefore, money flooded into China, allowing the Chinese government to continue this very wasteful pattern of investment.
Everything would be fine, except now the Federal Reserve is starting to raise interest rates. Then, at the same time, heavily indebted firms in China are increasingly unable to pay high interest rates – they can’t even pay 6 percent interest. So their government has cut interest down from 3 percent to 2 percent at the same time the long-term dollar interest rate is rising to 1 and a half percent. This is converging with Chinese interest rates, which means that international speculators no longer have any incentive to move money into China, because there’s no longer any carry interest rates.
Carry interest rates basically imply free money one can make simply by moving money from one place to another; it used to be you could borrow money at virtually nothing in Hong Kong, move it into China and earn six percent. For instance, one can borrow at one percent somewhere, put it in a Chinese bank account, and then earn six percent. One could do that all day long and earn three to five percent interest every year.
Now, almost the exact opposite is happening. You are borrowing money in Hong Kong for a year and you pay 2 to 3 percent, and when you deposit it in a bank account in China you’re earning 2 percent, so there’s no more free money to be made. Therefore, nobody has the incentive to move money into China.
On top of that, anybody who wants to guard against political risk, economic risk or any other kind of risk in China would want to move money out of China. The opportunity cost of moving money out of China has also fallen to zero. People used to think that even though there was a little bit of political risk, they would have higher return if they kept their money in China. And they didn’t want to move their money out unnecessarily.
Now, however, the onshore interest rate is about 2 percent, so people may opt to put their money in, for instance, a CD in the U.S. or Canada to earn 1.5 percent. On top of that, the dollar is very strong. There’s no longer any opportunity cost, so this is what’s causing a lot of money to leave china.
So, the money is no longer coming into China, and a lot of money is leaving China -- right now it’s not an all-out panic. Even if people just want to diversify their risk, which all smart investors want to do, they still want to move money out of China.
The final piece is that wealthy people in China have a lot of money. Even if they’re moving 20% of their portfolio from Chinese assets to non-Chinese assets, that amount is equivalent to the entire foreign exchange reserve, which is $33 trillion at this point. A lot of people have moved some of their money offshore, but I would guess that wealthy people in China could continue to diversify until the entire amount of China’s foreign exchange reserve has left China.
There are now calls for China to tighten capital controls to restore the stability of its currency? This is against Chinese efforts to liberalize its financial markets and capital account. What’s your take on this?
Well, they will do it. They tried to internationalize the renminbi because the renminbi was very strong just two years ago. At the time, the Chinese authorities thought that their currency was very strong, so they wanted the whole world to buy in it. They started pushing their agenda for renminbi internationalization, and part of that was to open up the capital account. Very soon after that, the whole situation turned around. The renminbi became weak and there was much expectation for depreciation.
Because wealth is so concentrated in China, all of a sudden approximately one trillion dollars left China. That’s the largest capital flight by scale in the history of the world. Very few countries have had over one trillion dollars in reserves, and no country has seen one trillion dollars leave in one year.
Thus, the only response to prevent the acceleration of capital flight is to impose capital control, which means the agenda for internationalizing the renminbi is put on the back burner. It is going to be delayed for the indefinite future for now.
Chinese officials and some leading Western investors claim that the market reacted poorly to the People’s Bank of China’s decision to change the exchange regime because of its poor communication to the market. Do you think this is a good explanation for the substantial fall of the yuan?
No, I think that of course People’s Bank of China made a mistake because they didn’t communicate adequately with the market, but I think the underlying structural factor was there already. This factor was the convergence of interest rates between the dollar and the renminbi, and, given this convergence, money was already flooding out of China – even prior to August 11. What they did probably accelerated the process, but the process would have continued anyway given this convergence of interest rates.
Do you think the yuan’s inclusion as an IMF Special Drawing Rights currency had anything to do with the downward pressure on the Chinese currency?
Not the downward pressure; however, I think the Chinese authorities, especially the central bank, was so focused on getting SDR status that they neglected the potential risk of opening up the capital accounts. It just kind of blew up in their face, so to speak.
I think the IMF is left in a difficult position. Being a global reserve currency means that the currency needs to be immediately tradeable. However, capital control measures make offshore renminbi increasingly illiquid, and make it increasingly hard for both financial market participants and people in the real economy to hedge against their currency risk. This is because China is trying to limit the availability of hedging instruments for the renminbi. That goes against the spirit of the SDR, and, if this situation were to continue, I think the IMF would have to withdraw China’s SDR status, which it can do.
In retrospect, do you think China made the wrong call trying to get into the SDR before it is really ready? Did the IMF make a serious mistake as well by admitting China?
Of course, it was a huge mistake on everyone’s part. The central bank of China really pushed for the agenda, and people at the IMF were asleep at the switch. Who knows what happened there.
What are the realistic options China has in stabilizing its currency?
The most realistic option is to try to float the currency, which means to de-peg it or let it float. I think the capital control will intensify quite a bit. One interesting dynamic that affects all the universities in America is regarding foreign students’ ability to pay tuition. You have many classmates coming from China—and CMC is not cheap. Therein lies the problem.
Right now, the individual can only legally convert $50,000 from renminbi to dollars every year. Before this it was very easy to pay tuition – the parents each could each convert $50,000 for a total of $100,000, and then the son or daughter could convert $50,000, so there would be $150,000 per family. Recently they made a rule that stated people converting $50,000 and sending it to the same overseas bank account, even if it’s within the same family, is illegal. Therefore, many students cannot pay tuition. What if the authorities decide to decrease the convertible amount to $20,000 a year? Then even a family of three with each family member converting $20,000 cannot pay tuition, and certainly not tuition and board.
This could be a real problem. Already, there are limits on ATM cash withdrawals for Chinese ATM cards. Right now there’s no limitation if on Chinese visa cards or debit cards, but the authorities could well impose a limit on that soon. People would likely still have enough quota to buy groceries and necessities, but would they be able to charge luxury vacations to the Caribbean on their credit cards? Perhaps not so much in that case.
Do you see a risk of contagion in this period of depreciation? i.e. competitive devaluation?
Yes. We saw it already: Bank of Japan just reduced their interest rates to negative, which is going to put a lot of pressure on China. As the yen weakens, and Japan becomes more competitive, Chinese consumers are more likely to buy stuff from Japan or to travel to Japan. That is posed to intensify the pressure on China to devalue their currency also; everybody knows that, so that increases the expectations for renminbi devaluation.
China’s growth is slowing down. Will the pressure on the yuan make things worse in China?
Yes. The outflow of currency creates a huge dilemma for the policymakers. A very obvious way to stabilize the currency is to increase interest rates. If the Chinese interest rate was increased back to six percent, then people would still choose to make money by borrowing money in Hong Kong or in the U.S. and moving the money to China. Money would thus flow back to China.
However, because there are so many heavily indebted firms, if they raise interest rates from 2.5 percent to six percent, a lot of companies will go under. Other companies will be under a lot of pressure. Growth will slow down quite a bit. They cannot raise interest rates if they want to meet the six to seven percent growth targets. When they do not raise interest rates, the money flows out of China, and when money flows out of China it actually decreases the money supply in China, which also slows down growth. This means that corporations can’t borrow as much money, and interest rates will automatically increase. So, this creates a big problem for the authorities in China.