Did China sink the yuan, or did it sink by itself?

Q: First up, how should we understand the Chinese devaluation? Just a repegging of the currency away from the dollar to a basket or a currency war to grab markets?

Prasad: I think it is first helpful to shift away from the term devaluation which suggests that the People’s Bank of China (PBoC) is actively managing the value of the currency to this notion that in fact, it may be markets that are pushing down the value of the currency relative to the dollar. As you have correctly pointed out, the PBoC has indicated that it is going to manage the currency’s value against a basket. They have not explicitly said this, but the statement put out on the PBoC website on December 11, certainly contains that strong suggestion. And if that is so, given the strength of the dollar over the last year and indeed ongoing strength, it certainly makes sense for the renminbi to depreciate marginally, relative to the dollar.  And of course, this is being fuelled by a market that is very concerned about capital outflows from china, about the underlying state of the Chinese economy and about the willingness of the PBoC to accommodate such significant moves. Now, the big question is whether this is going to help China in terms of its growth. And there, the message is really very mixed. Because if you think about a falling currency, that is certainly going to help exports somewhat, but more of China’s major export markets are very weak. So, the bang for the buck in terms of exports is going to be limited. On the other hand, it could fuel further capital outflows and reduce capital inflows if it looks like the Chinese currency is depreciating. And that could put some pressure on investment and in fact, make it harder to manage the currency’s value and to promote the currency’s international role. So, I do not see what is happening as the PBoC actively pushing down the value of the currency in order to support the economy. It is what markets seem to want right now. And if anything, as you pointed out, the PBoC seems to be intervening to prevent the currency from falling too fast, rather than rising.

Q: What is your sense? Is China's economy slowing more than what the markets had discounted, would that be an interpretation of recent events?

Pradhan: We have thought that the Chinese economic growth had a pretty strong growth shock in the first part of last year and they have recovered from that or at least stabilised just enough probably around the second half of this year. The strategy from their side has always been at least as far as we could tell from the summer, our view has been that they have adopted a nominal effective exchange rate targeting work. So the dollar by itself was less relevant.

What we are seeing over here possibly is a move that is moving into that region of managing the nominal effect of exchange rate rather than looking at the dollar but what that means is whenever the dollar stronger or weaker, the bilateral exchange rate moves a little bit more, the risk obviously is that are they moving beyond that nominal effective exchange rate regime, one of the things that we have flagged as a risk was the nominal effective exchange rate or the trade rate at exchange rate itself might move around. We don’t think that is necessarily the strategy. We still think that what they have in mind is to keep the nominal effective exchange rate steady and that is what they have delivered in 2015 as well. Q: How do you interpret the statement put out by the PBOC, after trading hours on Friday? It spoke about the yuan itself and said that its effort would be to make the yuan more international, keep the currency basically stable, further improve currency formation mechanism, deepen reforms of currency foreign exchange management systems. What does this complex of phrases mean? Prasad: That is boilerplate language they have been using for a long time in fact, even going to the period before 2005, when the yuan was pegged to the dollar, they were using exactly the same language of saying that they were going to improve the stable formation of the exchange rate mechanism and try to promote the use of market forces in order to determine the value of the yuan. So I would not read too much into it except to say that at this juncture, it has particular resonance in the sense that the PBOC is trying to send a signal that it is going to start reducing the level of intervention in the currency markets in either direction and that is going to lead to some more volatility in the currency's value, relative to the dollar, which is what we tend to focus on but they sent a signal last month, which we should take fairly seriously that markets should be focusing not on the value of the yuan relative to the dollar but the value of the yuan relative to a much broader set of currencies. Q: Would you say that the fundamental problem of the PBOC is that of communication that it is not constantly communicating and that it is not able to win credibility? Prasad: There are two problems to PBOC, the first is of its own making. I think more effective communications and having a strategy to communicate to the public both inside China and to investors outside China would be very helpful. It is not obvious that the PBOC has a well articulated strategy about what they want to do other than to liberalise markets. The second problem that the PBOC faces is out of its control because in order to stabilise expectations and to reduce market turmoil what China needs is a broad set of policy measures including monetary and fiscal policy in order to support the economy and some confidence building measures in terms of economic reforms, there is a lot to be done on the supply side of the economy in terms of moving forward with state enterprise reform, liberalising the services sector. We have heard a lot of words about these issues in the last two years but very little has happened other than some steps on financial market reform. So I think we are going to need this set of measures and policy reform statements in order to generate some confidence or at least stop the drop in confidence in the direction of the Chinese economy but that unfortunately is out of the PBOC's hands and in the absence of those measures, we are going to see continued turmoil in both currency and equity markets because so far all the markets are seeing are not good macroeconomic measures or policy reforms but directed and somewhat heavy handed intervention in the equity markets in particular, which has got markets even more concerned and on edge. Q: What would your advice be to market professionals around the world that the stock market moves are not at all reflective of the economy? Prasad: Certainly what has been happening on the stock market is not necessarily a good reflection of what is happening in the economy. The stock market accounts for a much smaller share of the overall economy than in advanced economies like US and Japan. In addition, the stock market largely represents a shares or firms that are in the manufacturing of construction industries, which are certainly hitting a rough patch. However, the services sector, household income, household consumption all paint a picture of an economy that is not doing as badly as the stock market has been doing. What has happened to the stock market since June of 2015 is basically that it has come down in value relative to where it was about a year before last summer. So in fact the value of the Shanghai composite index is off only about 2 percent right now, relative to where it was exactly one year ago in January of 2015. My view is that there is still some froth in the stock market if one looks at price earnings ratios, they are still not in territory that can be supported by corporate profits in the manufacturing sector and macroeconomic fundamentals more broadly. However, the problem that has made things a lot worse in the stock market is the government's moves towards intervention. They have sent these very haphazard signals that they will prevent the market from falling too sharply and then at other times have withdrawn that support, what China needs is more fundamental reforms. The stock market acts like a casino mostly because even retail traders undertake momentum trading because there isn’t good corporate governance, there aren’t good accounting and auditing standards, there isn’t corporate transparency, so investors don’t have very much to go on in terms of company's fundamentals. So I think a much broader set of institutional reforms is going to be needed to have these financial markets work very well.

Q: Now, onto the real economy which you study so closely. How slow is the Chinese economic growth? The world fears, as George Soros put it, that probably it is slowing much more than the world is estimating. What is your own guess? Prasad: I think there is considerable concern about the actual state of Chinese economy given the opacity and a lot of Chinese data and certainly, one should not take too seriously, the quarter-on-quarter (Q-o-Q) movements in the gross domestic product (GDP) growth rate which looks suspiciously smooth. But, over longer periods of a year or a few years, I do not think the GDP growth data are a significant misrepresentation of what is happening in the economy. And given the opacity in Chinese data, market analysts and investors tend to focus a lot on high frequency indicators that are available on a month-on-month (M-o-M) basis. These are seen as much more reliable than GDP data. So, these include things like bank lending, freight volumes, electricity consumption, all of which are seen as somewhat more reliable. But the problem is that all of these indicators which certainly have not been doing very well recently, are largely about the manufacturing sector of the economy. And this is something that the Chinese government itself has acknowledged that the manufacturing sector certainly has hit a very rough patch in the economy. But, it is important to remember that the manufacturing sector is not as big a component of GDP as it used to be a decade ago or even five years ago. The services sector has become much more important.  So, available data which unfortunately are not available on a M-o-M basis, they are available only at a lower frequency, say quarterly, those data about the services sector, about what is happening in the labour market, what is happening to household incomes and consumption, all suggests an economy that is by no means stalled as the manufacturing sector data would suggest. And it is quite plausible in my view that the economy could be growing somewhere in the 6-7 percent range. It is hard to be much more precise than that. And there are legitimate questions out there about whether the services sector is growing fast enough to account for the apparent weakness in the manufacturing sector.  But whatever the growth rate, it is also very important to keep in mind that if the economy were in fact, stalling very sharply, the Chinese government does have a significant amount of room with both monetary and fiscal policy to be able to boost growth in the short-run. I think they are holding some of their powder dry in the short-run largely because they do not see the landscape quite as foreign investors seem to be seeing it an in addition, they want to move forward with a somewhat more balanced mix of policy rather than just relying on monetary policy which would mean a credit financed investment boom that would not be good for the economy in the long-run and they are thinking of trying to use fiscal policy somewhat more aggressively to put money directly in the hands of corporations and consumers so they go out and consume more and perhaps, have the private sector invest more. But, that has not happened yet and I hope there will be more action on that, so I am less concerned about short-term growth than about how they accomplish it. Q: What is your take? What is the next scenario that one might expect out of China? Much more instability in their markets, much more slowing economy or do you think that the worst has been seen and things will smooth out now? Pradhan: What has happened in China over the last 12 months is that the manufacturing sector has really slowed down significantly. And over the summer, there was a concern that it could get even worse and at that point, what we have seen is some more of a stabilisation. Our proprietary index that our China economics team puts out, Morgan Stanley China Economic Index (MS-CHEX) suggests that we have had some very modest stabilisation, and as China has stabilised, the economic story, at least, if not the market story, has allowed some semblance of normalcy to return to the data into sales. Now, at this point in time, what we believe should happen is that the consumption story should start slowing down. This is typically what we have seen in Japan, what we have seen in Korea, but also from an economic point of view, if you are no creating capital formation at a very rapid pace, then sustaining wage growth, sustaining income growth and therefore sustaining consumption becomes harder.So, consumption will slowdown, but keep in mind that with investment growth falling further and remaining very low, for every year that consumption growth is higher than investment growth, you will see consumption as a share of GDP pick up. And so, there will be something for the bulls, there will be something for the bears. The bulls will say that look, China is becoming consumption oriented because the share of consumption is rising. And the bears will say, look, China’s consumption itself is slowing down which is not what was anticipated. Most people had anticipated a pickup in consumption growth which I think will be very hard for them to generate.

Q: I want to zoom out to the world economy just to end this conversation. Would you say that in 2016, the global economy given what you know about the Chinese economy and the US and other parts of the world that the global economy will grow more slowly in 2016 at least in the first half than it did in 2015? Prasad: China is certainly not going to be a huge contributor to an increase in world growth. If anything we are going to see a slight moderation in growth but Chinese economy is now the second largest in the world and amounts to about USD 11.5 trillion compared to the US economy, which is about USD 17 trillion. It is still a very big economy and if it grows at 6 percent, that adds even more to global gross domestic product (GDP) than the US economy growing at somewhere in the range of 2.5-3 percent. So I don’t want to minimise what is happening in China but certainly, if we see continued depreciation of the Chinese yuan driven by market forces as could well be the case and if he see, there is very little domestic demand pick up in the eurozone and Japan that does put in for a difficult year ahead and ther oter big concern is that the deflationary pressures could intensify around the world. In China, consumer price index (CPI) inflation is quite low around 1.5 percent and purchasing deflation in the producer price index (PPI) is now entrenched, it is now at about 6 percent and it has been negative for a very long period. Japan and the eurozone are still tethering on the edge of deflation and this could all mean that the world looks to the US to pull it along, which could mean a stronger dollar, which might end up hurting the US economic recovery although that doesn’t seem to have happened as yet. So I think we still face a lot of fragility in the world economy in 2016. Q: Would you say that 2016 -- the global economic growth is going to be slower than what it was in 2015? Pradhan: It is certainly starting off in a more worrisome fashion. We had a very difficult time for China if you go back to 2015, China had a very difficult growth period. We don’t think that the growth data this year in the recent past has been as worrisome in fact most of the numbers from sales and property markets and everything still look reasonably stable but the issue has been about investor expectations and the issue has been about the currency expectations and that has moved on in a more dramatic fashion in the early part of the year. There is no doubt about that. The risk is clearly that where oil has gone suggest that the economy could be showing more signs of weakness than strength. I think it is probably too early to make that as a stable call for this year. It still looks like something that will kind of push through a very slog oriented growth strategy but I don’t think this is something that many are discounting at this point. It is a worry that most people are taking on board.

Q: Would you say therefore that 2016 also is likely to see global commodity markets in a bear hug? Prasad: Commodity markets are going to have a very rough period in 2016 because world domestic demand growth is going to be quite weak and the driver of commodity demand for a couple of years has been China which had a voracious appetite for commodities during its massive investment surge. That is certainly not going to happen even if China’s growth does not slow. As I mentioned, more of the growth is going to be coming from services and from consumption. Although the Chinese manufacturing sector will still continue growing, the growth in world demand for commodities is going to remain very weak from China and I do not see many other parts of the world where there is going to be much increase in demand.  Increase in demand from the US is going to be offset of course, but I think supply of certain commodities like oil including from the US. So, if one looks at the overall landscape, it is hard to see anything that could substantially trigger an increase in commodity prices.