With Donald Trump’s historic tax reform on the verge of passage, and with the Fed continuing its rate hiking cycle so far undeterred, and according to the Fed’s own dot plot still having another 7-8 rate hikes to go, China is getting nervous because, as the WSJ reports, it fears “a double whammy sapping money out of China by making the U.S. a more attractive place to invest.” In other words, those capital outflows which China was confident it had finally bottled up, are about to return. And that’s even as the U.S. is taking China to task over trade imbalances, recently rejecting China’s bid for “market economy” status with the WTO.
In response, the WSJ reports that Chinese leadership is preparing a contingency plan to counter consequences for China of U.S. tax changes and the Fed’s expected interest rate increases.
Under the plan, the PBOC will deploy a combination of tools including “higher interest rates, tighter capital controls and more-frequent currency intervention to keep money at home and support the yuan.” Just like the unstable market which can careen, and crash at any one moment without central bank supervision, and which earned the stock market the title of a “Gray Rhino”, which China defined as “highly probable, high-impact threat that people should see coming, but often don’t” the WSJ notes that an official involved in Beijing’s deliberations has also called Washington’s tax plan a “gray rhino,” an obvious danger in China’s economy that shouldn’t be ignored.
“We’ll likely have some tough battles in the first quarter,” the official told the WSJ.
The sense of urgency illustrates Beijing’s challenge in battling policies rolled out under Mr. Trump’s “America First” banner.
At the center of China’s dears is the yuan, which has just regained its footing after enormous government efforts to prop it up for the past two years. Should the yuan start to lose steam again, the thinking goes, “it could further exacerbate capital outflows in a vicious cycle.”
It would also mean that bitcoin is set to soar even higher as some more of the $35 trillion in Chinese deposits seek quick and easy ways to circumvent China’s capital account “firewall”, and where despite Beijing’s posturing, cryptocurrencies remain the most effective mechanism of evading China’s capital controls. Some more details from the WSJ:
Tighter restrictions on money leaving China helped stem outflows and stabilize the yuan, which so far this year has recovered most of the ground it lost against the dollar in 2016. Improved faith in Chinese growth, now on track to handily meet Beijing’s target of around 6.5%, has also helped keep money from fleeing. But the outlook appears hazier in light of an expected slowdown in both property and infrastructure investments. Meanwhile, debt continues to pile up in the economy, leaving it vulnerable to a prolonged downturn unless the government takes more forceful measures, economists and analysts say. Official data released Monday show that while total credit growth dropped in November, as regulators forced banks to bring off-balance-sheet credit onto their books, bank lending jumped.
With these unresolved issues in mind, Beijing is sensitive to any threats that could cause a repeat of market turbulence seen in 2015 and 2016, Chinese officials say. President Xi Jinping has publicly urged authorities to limit the potential “spillover effects” from policy actions overseas. It’s a topic likely to be discussed at a high-level meeting early next week to map out Beijing’s economic agenda for 2018.
So what is China’s planned response specifically? Not unexpectedly, it is doing the same as the US: tightening and hiking rates to prevent capital outflows:
Under the contingency plan now being prepared, one course of action China’s central bank could take involves gradually guiding up costs for bank-to-bank borrowing, which has significantly added to financial risks in recent years, while leaving unchanged benchmark interest rates so as not to make it too difficult for companies to borrow or pay back debt, both of which could hurt growth.
If true, kiss further easing measures goodbye: “The PBOC likely will be biased toward a tighter monetary stance in the first quarter,” said Zhu Chaoping, a Shanghai-based global market strategist at JPMorgan Asset Management.”
That said, China is hoping that none of these measures would be needed: “The officials involved in the discussion underlined that the planned measures may not be needed if the U.S. tax plan or interest-rate moves have limited impact on Chinese outflows.”
Meanwhile, some economists and analysts are also calling on China to take advantage of its still relatively strong growth to renew its efforts to foster freer cross-border fund flows and have a more flexible exchange rate.
“The government may act opportunistically to loosen capital controls subject to the strength of inflows and vice versa,” said Gene Frieda, a London-based global strategist at the Pacific Investment Management Co. Using a phrase from the movie “The Karate Kid,” he called it “a version of wax on, wax off.”
That, however, will not happen as the moment Beijing leaves a door crack wide enough for a few trillion Yuan to be laundered around the world, China will see a dramatic surge in capital flight, sending the local economy into economic tailspin, and eventually shock if not worse.
Finally for those wondering how China’s tax system differs from the US, here is a snapshot:
While U.S. companies pay a higher national income-tax rate—35% versus 25% in China—Chinese companies face a welter of other taxes and fees their U.S. counterparts don’t, including a 17% value-added tax. And while Chinese firms don’t pay state taxes, as U.S. companies do, Chinese employers pay far-higher payroll taxes. Welfare and social insurance taxes cost between 40% and 100% of a paycheck in China.
World Bank figures for 2016 show that total tax burden on Chinese businesses are among the highest of major economies: 68% of profits, compared with 44% in the U.S. and 40.6% on average world-wide. The figures include national and local income taxes, value-added or sales taxes and any mandatory employer contributions for welfare and social security.
The irony in all this is that not only is the jury still out on whether Trump’s tax reform (and alleged $1 trillion infrastructure spending project coming next year) won’t overheat the economy, sending the market tumbling as the Fed rushes to catch up to inflation, but now the president has to worry how China could respond, although the reality is that just like the US, the biggest victim of China’s monetary tightening would be, well, China itself as investors rush to get out of the world’s most financialized economy, whose financial sector is between 2 and 4 times greater than the US, depending on how one accounts for China’s shadow banking.
In other words, the outcome of all this, is that both the US and China are now “threatening each other” by playing Russian roulette with guns that are fully loaded. We fail to see how this has anything remotely resembling a happy ending.
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