China’s Growth and the Yuan Continue to Make Headlines

China’s Growth and the Yuan Continue to Make Headlines

China recently made news for two items, one surprising and one not-so-surprising. Last week China let the yuan’s value rise .56%, more than it has risen since 2005. Considering a weaker currency helps exports, which is a major source of China’s economy, and the fact that Japan and the ECB continue to push policies aimed at weakening their currencies, this came as a surprise. However, the Fed’s move to hold off on raising rates has led to a weakening of the dollar against the yen and euro. Letting the yuan rise enables the People’s Bank of China to align its currency with the world’s major currencies.

On the not-surprising front, China announced economic growth of 6.7% for the first quarter of 2016–down from the 4th quarter’s growth of 6.8%, but right at the top of their targeted range of 6.5-6.7%. The growth came in large part because of the recent stimulus. Unfortunately, the result is that the economy continues to rely on its old method of growth–investment, or more accurately, over-investment spending. As we discussed in our recent video (click here to view) China must transform from an economy driven by investment spending to one driven by consumer spending. China, it seems, fears any disruption this transition would cause.

So to drive growth, total debt (which includes corporate, private, and government debt) went from 150% of GDP in 2008, to 237% now. For a developed country, this level of debt is not out of line; however, for a developing country, it is high. The amount of debt is not the main concern, the rate of growth is. Debt is growing at over twice that rate of the economy. Last year, bad debt jumped 50%. To make matters worse, most of the new debt is coming from state-owned enterprises, which have seen their profits plunge. Historically, nations that have gone through binges of debt subsequently suffer prolonged slowdowns or financial crises.

Much of what is happening in China reminds me of what happened in Japan in the 1980s and 1990s. For a time growth boomed, then the Plaza Accord was signed, causing the Yen to appreciate, hurting exports and growth. Instead of transitioning the economy, the Japanese ramped up debt and for a while no one noticed. Thoughts that the US had won the war but Japan had won the peace were common. The feeling was that the Japanese business model was superior to ours. The West’s pursuit of quarterly profits was short sighted and going to be our ruin. Unfortunately, Japan’s economy shares a number of characteristics with China’s today: a reliance on “over” investment, high debt, an aging population, and low profitability.

Needless to say, there are many differences as well. China still has a long way to go before it meets the prosperity of the West. However, as we have learned from Japan, profitability is important for viable long-term growth and job creation. My fear is not that China will hit a hard landing anytime soon but they may end up like Japan, taking years to work off asset bubbles. China has had time to accumulate large foreign reserves so they can keep spending for quite some time with little regard to profits; however, that day of reckoning will come, and if debt continues to soar, it may come sooner than expected.

Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.

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