Over the past two weeks, the renminbi has dropped 1.3 percent against the dollar. After eight or nine years of constant gains, this sudden drop has certainly shocked investors.
But why did the currency just change direction like that? The answer: the Chinese government. Why would the Chinese government do such a thing? A tougher answer.
The most apparent reason is to make these investors and speculators think twice before continuing to buy up Chinese assets. If any one lesson can be gleaned from recent crises, particularly the Euro crisis and the Asian financial crisis, it is that an excess of hot money in the form of foreign capital inflows can be deadly for an economy. Once these inflows stop, which they inevitably will, that nation is left holding buckets of debt that were funded by these inflows.
The primary problem is the mismatch in timing. Hot money is looking for short term investment that can easily make high returns, for example: speculating on the rise of China’s currency. These inflows are then fed into longer term investments. The crisis lies in the moment that investors begin to pull their short-term investments out, but the money is locked into the longer-term investments and can’t be accessed. This is the fundamental liquidity problem that we have seen time and time again, in the Asian financial crisis in the 1990s, in the US financial crisis in 2008, and most recently the Euro Crisis.
Another problem for China is that in addition to the hot money that has been encouraging investment, primarily in real estate and now in shadow banking, there is currently more of this hot money looking for a home. Investors are pulling out of Southeast Asian countries where investments relied on feeding China’s now slumping manufacturing sector. Lastly, as the US tapers its QE program, the last bastions of consumption bubbles will soon be disappearing, further causing capital to flee these export reliant Southeast Asian economies.
The economic dilemma that China faces is that it is trying to battle hot money and a rapidly inflating domestic credit bubble at the same time, and the cures are polar opposites. The answer to hot money is a depreciating RMB, which is what we are seeing now. The negative effects of which are more liquidity in the Chinese domestic economy.
This added liquidity gives more leeway to banks, real estate investors, and shadow bankers to place bets on riskier investments than they normally would. China’s government has been fighting this since June with a sequence of interbank loan interest rate spikes that have caused scares of potential bank bankruptcies. These bankruptcies would again be due to the short term hot money (this time from the government) being reeled in and leaving banks and shadow bankers with long term risky investments out to dry.
It seems that China has found itself between a rock and a hard place. It’ll be interesting to see how the leadership responds in the coming weeks and months.