What Next For China?

China appears to be flailing.  Its stock market stabilization efforts have failed miserably.  It looks as if it has botched another attempt to let market forces have greater sway over the yuan's exchange rate yet.  

The 25 bp cut in key one-year lending and deposition rates and the 50 bp cut in reserve requirements announced today after the local markets closed represents a new phase in damage control.    Chinese stocks have fallen by a little more than a fifth over the past four sessions.  However, the rate cut will likely snap the four-day slide.  Chinese stock futures and ETFs on Chinese stocks that trade outside of China have rallied.  Some, like the iShares large cap China Index ETF (FXI), are up around 5%.  

This likely points to a further decline in the yuan.  The fix was at CNY6.3987 early today, a 0.20% change from the prior day's fix and 0.16% above the previous day's close in Shanghai.  The dollar briefly poked through CNY6.42 before finishing the session at CNY6.4128.  This was the highest level for the dollar since August 13.   Since the close of local markets, the dollar has traded higher against most of the major currencies.  The dollar has moved higher against the offshore yuan (CNH) as well.  

The setting of the central reference rate in such narrow ranges in recent days has threatened to make a mockery of China's announcement on August 11 ostensibly giving market forces greater influence in setting the exchange rate.  The rate cut underscores that China's monetary policy is moving in the opposite direction of US rates, even many are pushing out expectations for the Fed's lift off.  This could justify a weaker yuan.  Indeed, it seems like a needless expenditure of capital to avoid the weakening of yuan now.  

It is noteworthy too that the cut in rates was coupled with the liberalization of deposit rates for one-year and longer money.  It was similar to the devaluation coupled with the announcement of a new (though still a block box) mechanism to set the central reference rate.   China's efforts to join the SDR, like its WTO ascension, are helping overcome some domestic resistance to much-needed reforms.  

Policy disputes often involve personalities and reflect power struggles.  Reports suggest that President Xi has consolidated power like few other officials have since Mao.  The rise of the imperial presidency in China has meant the downgrading of the prime minister.  Premier Li is said to have designed the intervention in the stock market in early July.  The drop in share prices, especially over the past few days, is apparently being blamed on Li.  

While the Communist Party has a monopoly on political power in China, there are different factions within it.  One faction, associated with the sons of earlier Communist leaders, are thought of as the princelings.  The other faction is associated with the Communist Youth League.  The fissure between the two is so fundamental that the President is from one and the Prime Minister is from the other. Moreover, they rotate back and forth.  Xi is a princeling while Li has deep roots in the Communist Youth League (tuanpai).    

Xi's concentration of power, and the anti-corruption campaign that appears to have been partisan as well appears to have frozen Li out.  Li has not helped his case very much.  The equity market intervention ill-conceived, not on the grounds of market fundamentalism, but that the shock and awe wore off quickly, and the effort was seen as half-hearted.   Li failed to offer reassuring words in the face of yesterday's slide in prices. Instead, the only public statement appears to be about developing a 3D printing industry in China.  

In any event, reports suggest that there was no intervention on Monday or Tuesday in the equity market.  It seems then that the reason that today's adjustment in monetary policy was not delivered over the weekend was to ensure the defeat of Li.     Some in the media speculate about whether Li can be forced out of office.  The office may have been rendered impotent, which means it does not matter if Li is the Premier or not.  What is really being played for is the 19th People's Party Congress and the new configuration of the Politburo Standing.  Five of the seven that were named at the 18th Party Congress in 2012 were from the princeling faction.  Li and Liu Yunshan (leads the party's ideology and propaganda efforts) were the exceptions.    Liu responsibilities regarding party organization have been weakened by Xi's parallel organization of "small leading groups" who oversee policy.  

Meanwhile, the spread between the onshore and offshore yuan has grown.  The offshore yuan is quoted near CNY6.5020, while the onshore yuan finished at CNY6.4128. In the second half of June, the dollar was often stronger onshore than it was offshore.  The offshore yuan has been hit harder because that is where the leveraged positions were placed.   Over time, China this gap needs to close, as the IMF's recent staff reported anticipated.  This may prove difficult to manage, but it will likely involve a weaker onshore yuan.  

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