Everyone trying to amass renminbi holdings in expectation of its supposedly inevitable rise against the US dollar may be in for a surprise.
Jim Walker, managing director at economic research boutique Asianomics, says the RMB is more likely to depreciate against the greenback, at least in the short run.
Speaking last week at AsianInvestor's institutional investment forum in Hong Kong, Walker argues that the sudden decline of the euro is creating difficulties for China's exporters. The RMB has now appreciated by 18% against the euro, and the eurozone also represents China's biggest export market.
Within China, wage inflation is rampant, further squeezing the export sector.
Walker predicts that within the next few weeks, this pressure will prompt the People's Bank of China to change its currency regime. Instead of fixing the RMB to the dollar, as it has for nearly two years, it will revert to fixing it against a basket of currencies and allow the RMB to float within a band.
Although the PBoC will keep the basket mix a secret, the euro is sure to play a sizeable role. If the euro continues to depreciate against the dollar, therefore, it will cause the currency basket as a whole to also lose value, and thus the RMB will become cheaper.
Walker is also pessimistic about China's ability to prevent an economic crash. Its 2009 stimulus programme of having state-owned banks lend to local government special-investment vehicles is a "subprime nightmare".
He harks back to 1994-1995, when local governments borrowed huge amounts of capital and poured it into unproductive infrastructure and real estate, and predicts the PBoC will have no choice but to raise interest rates by 2% this year. Measures taken to date, such as raising banks' reserve requirements or putting restrictions on real-estate transactions, have merely tinkered around the edges of the problem, Walker says.
The biggest unknown in China is the extent of public debt. The official statistics seem reasonable but only account for central government borrowings, and exclude municipal and state-owned enterprise debt. Added together, Walker believes China's debt-to-GDP level is already at 100%.
This borrowing represents a massive distortion in capital allocation. Wages are up and labour is scarce, because resources have been directed to unproductive real-estate projects. Walker believes this is going to hurt China's economic growth.
Real-money supply has risen sharply within China, with the 2009 fiscal stimulus leading to an increase of credit growth of 31%, Walker reckons. Today China's money supply is 180% of GDP, and its credit is 120% of GDP.
His calculations suggest that 40% of 2009's GDP growth can be attributed to this stimulus plan via the expansion of credit. That's a stunning figure. By comparison, America's fiscal and monetary stimulus initiatives accounted for around 10% of its GDP growth last year.
This is why China is so desperate to maintain high levels of economic growth, but Walker describes this as a short-term gambit that is setting the stage for much-reduced growth rates over the next decade.
"For the last 10 years, real interest rates in China have ranged from -5% to -15%, which is why it now requires such a huge level of GDP growth to absorb the labour force," Walker says. "China used to need just 6% GDP growth to absorb new workers. Today it needs 9-10% GDP growth, and that's because of its mis-allocation of capital. This is a huge worry."
Walker says he can't see what can sustain China on this path. It has already poured money into capital expenditure, the export sector, infrastructure and real estate. Domestic consumption is one possible growth engine, but he's sceptical it has the ability to play this role for long, or across the nation.
By contrast, Walker believes India offers a more compelling investment proposition. The Reserve Bank of India has already raised interest rates several times.
"Real-money investors seek high returns," Walker says. "Those are found in places where interest rates signal that capital is scarce. Companies must build-in high IRRs to beat a government paper yield of 8.5% [as is the case in India]. Returns on equity in India average 23% per annum, versus 11% for China or 8% for Japan. Valuations are high, but so are the returns."
The AsianInvestor conference audience challenged Walker's view, arguing that China's deep pockets, its government's reputed understanding of its problems and its efforts to recapitalise banks suggest there is no cause for alarm.
However, Walker prefers to view the glass as half-empty. He argues that China's tightening measures so far are not proactive, but a reaction to a loss of control. And it is reacting everywhere, in all sectors, in the hope that something will work.
The $2.4 trillion of foreign currency reserves is a canard, Walker argues. China has been able to deploy its reserves to buy assets such as mines or farmland or energy companies abroad. But it cannot use FX reserves at home, because these represent IOUs, and for every dollar it holds, there is already an equivalent in renminbi that's been used.
China could increase its deficit and emulate the West by borrowing its way to economic growth. But China's public debt is already quite high, over 100% of GDP when including municipal and SOE borrowings.
Another possible solution is to allow the renminbi to appreciate against the dollar, which would dampen some of China's inflation. But this would harm its export manufacturing base. And now the euro's decline has led to the strange possibility that instead of revaluing the RMB against the US dollar, China may be forced to salvage its exports to Europe by effectively devaluing its currency further.