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8 November 2016 Multimedia

Abenomics, Zombie Firms, And More

The Outlook for China and Japan

  1. Freya Beamish

In this interview, Freya Beamish, the senior economist at Lombard Street Research with extensive knowledge of China and Japan, answers whether Chinese zombie debt provides a threat to the wider economy, if Abenomics is a success or failure, and offers her insights into the RMB/USD exchange rate.

The Take 15 Series is a series of short interviews with leading practitioners on timely topics focused on the investment profession.



LAUREN FOSTER: Hello and welcome to this episode of Take 15. I'm Lauren Foster, Content Director with CFA Institute. And joining me today to talk about China and Japan is Freya Beamish. Freya is a senior economist with Lombard Street Research where she covers China and Japan. She's also a frequent commentator on TV and in print. It's a great pleasure having you here today, Freya. Thank you so much for joining us.

FREYA BEAMISH: It's a pleasure.

LAUREN FOSTER: There's a lot of talk about the danger of zombie firms in China and into China's corporate debt overload. But some China watchers say aggregate zombie debt's still not large enough to pose a threat to the wider economy. Is this true?

FREYA BEAMISH: Well, OK I'll give you my conclusion up front. I'd probably say yes, that statement is correct, that probably zombie firms, or whatever we want to call them, are a huge portion of the Chinese economy. But there's still an even greater portion that can clear up the mess that's been made by those zombie firms. So it's a big problem, but it's not yet so much of a problem that the Chinese have to worry about it in terms of kind of an Armageddon-type of scenario.

LAUREN FOSTER: OK. A two-part question. Foreign bankers in Shanghai suggest the RMB dollar exchange rate might reach 7 or 7.2 by early next year. So the first part is do you agree? And then if the US raises interest rates, where will the RMB head?

FREYA BEAMISH: Well, I think probably the RMB is going to continue on the depreciation path. We've had a kind of a lull in that. But the first question and the second question are very related, because the reason why they need to get a depreciation of the currency is to get that net trade portion contributing to GDP so that doesn't have to be such a huge run up in debt in order to meet those growth targets and keep people employed. So yes, I would agree that the RMB is on that kind of depreciation path. Maybe another 10% over the next year or so.

In terms of against whom, that's quite an important question, and it plays into your question of the rise of US interest rates. There is a greater focus globally at the moment on the dollar and the renminbi has started to depreciate against that bilateral. That's much more difficult for Beijing to contain, because the majority of their foreign liabilities are priced in dollars. So there's much more of a focus on that. And it's more liable to lead to the market turmoil that we saw in 2015 and that the downward spirals. But ultimately, Beijing will kind of step in and counterbalance any outflows that arise.

LAUREN FOSTER: China's policymakers, though, say they don't want to weaken the RMB. Should we believe them?

FREYA BEAMISH: I don't think they want a kind of a rout in the RMB. That doesn't really fit with their aims of internationalizing currency, and it could touch off some issues with regard to foreign liabilities. But really, the foreign liabilities that China faces are sort of the thin end of the wedge, and if you're a corporate treasurer-- that's a Chinese corporate treasure and you're sitting there still with exposure to one-way appreciation bets, then perhaps you want to consider a new career path, because there's been some quite obvious indications that we're not on a one-way appreciation path now.

So I think they want to avoid that kind of route, but they've learned from previous experience, and so has the private sector. So they probably do need to allow the currency to continue to depreciate from here.

LAUREN FOSTER: OK. Naysayers have been predicting a debt-induced crisis in China for years, but until China opens its capital account, is this likely to happen?

FREYA BEAMISH: Well, in terms of the rest of the world and the exposure of the rest of the world has, whatever happens over the next few years, it's not going to be a type of a Lehman event or a subprime crisis type of event, because China's an excess savings country, so they've actually been exporting their capital. Whereas in the US, it was a question of the rest of the world really being leveraged up and exposed to the subprime crisis across the financial markets in pretty much every advanced economy. So even if there is a debt blow-up in China, then it's not going to have the same kind of financial market repercussions as a subprime-type of event.

LAUREN FOSTER: Why is China selling US treasuries and buying Japanese government bonds?

FREYA BEAMISH: It's a very interesting question because at the moment, there's a lot going on. We could talk about this for a long time. But the most obvious way of approaching this is to say that when the Chinese currency is depreciating against the yen, it sort of goes under the radar a lot more, and that's why 2016 has had a lot less of financial market volatility that's been touched off by any depreciation of the Chinese currency has achieved. So they are continuing to experience capital outflows, and the PBOC is having to lean against that through the use of its foreign exchange reserves and US treasuries.

But there's also a kind of intra-Asian flow into Japan that is, in a sense, probably touching on some of these issues of the REPACS. If you have dollars, then you can bring them into Japan, hold them, into a forwards contract, and you can actually make a profit on that, which is the the reverse carry trade. I don't know if that's exactly what the Chinese authorities have in mind, but in terms of their policy and slipping these kinds of depreciations on the radar a little bit more, it makes much more sense for them to be appreciating against the yen.

LAUREN FOSTER: And how much rebalancing of China's economy has occurred thus far, and how much is left to go?

FREYA BEAMISH: A lot is still left to go, but there have been some moves in the right direction. If you look on the demand side of the economy, then investment is falling as a share of GDP and consumption is rising as a share of GDP. But actually, it's a sort of a rebalancing by default, just because private consumption is that kind of is the part of the economy, which can still increase its leverage.

LAUREN FOSTER: So at some point, financial problems come home to roost. At what point will China's banking system come clean with its bad loans and purge them from the system?

FREYA BEAMISH: I'm not sure they necessarily will ever. It might just be a question of having a big rug in the middle of China and shoving a whole bunch of bad debt under it in a Japan-type style. So we're not necessarily looking for it or not expecting a massive debt blow up, but we're not really expecting full benign transition-- going back to your rebalancing question-- to private consumption-led growth, because that would need them to actually clear out this bad debt and move on. But they still have the space to halfway house for those halfway house options, and it doesn't really get you the full way to rebalancing.

LAUREN FOSTER: Speaking of Japan, what advice do you think Japanese policymakers have been giving their Chinese peers?

FREYA BEAMISH: I'm not sure the Japanese policy makers really learned the lessons of their own history, in the sense. I probably would have said the same structural imbalances persist in Japan as some of the structural imbalances that China is facing, chief among which is that too much of the income flows into the corporate sector and get stuck there, and that's something that Japan continues to struggle with today.

LAUREN FOSTER: So sticking with Japan, Abenomics has been in place since 2013, but it's produced neither growth nor inflation. Do you consider it a success or failure?

FREYA BEAMISH: I'd say if you think of the main operative arrow of Abenomics, it was yen depreciation. Over the course of this year, we've seen yen appreciation, so in that sense, it's a failure. But actually, because we always thought that-- Lombard Street Research anyway-- we always thought that Abenoics was the wrong prescription for the Japanese economy. The failure of Abenomics has actually potentially turned out to be quite useful to the Japanese economy.

LAUREN FOSTER: The Bank of Japan is not only buying JGBs, but also corporate bonds and ETFs. At what point do we stop buying assets other than JGBs and how much is enough?

FREYA BEAMISH: Well, I think if you take ETFs, this is basically a problem that's just expanding to accommodate the BOJ. So they can continue for a certain degree. I don't know exactly when it stops, but it is an expandable pond. It's more actually with JGBs that they need to start to taper purchases, and I think the yield curve targeting was intended to be a way for them to do that without actually using the word taper.

LAUREN FOSTER: OK. I guess a final question. The obligations of the state are growing, but the economy is shrinking. How much longer can Japanese government continue its current strategy?

FREYA BEAMISH: It's a question of when inflation does actually arise in Japan, and why it's arisen. So they want to get rid of deflation. But actually, if you have an upwards trajectory for debt to GDP, deflation is quite useful to you to be able to service that very low costs. So the budget the Japanese government is running is very much focused on the demographics of the past, and the consumption tax hike was an was aimed at updating it for the demographics of today, but it hasn't really worked. So they continue to have this upwards spiral of debt-to-GDP government-debt-to-GDP. It's just a question of when they start to face difficulty with inflation in the economy and actually have to pay for that debt.

LAUREN FOSTER: It's been a fascinating conversation. Thank you so much for joining us. And thank you for watching.

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