China is opening the door a bit more to foreign investors, but that's not a reason to rush in. Perhaps just the opposite.
On Monday, Chinese regulators said that registered institutional investors will be able to invest certain amounts above previously agreed quotas into renminbi-denominated assets without having to ask for approval.
Before this announcement, foreign investors had to apply to get permission from the State Administration of Foreign Exchange (SAFE) if they exceeded their pre-agreed quotas by any amount. The change in regulation means that institutions such as pension funds, hedge funds or insurance companies can get more exposure to Chinese assets.
The world's second-largest economy has had a long tradition of keeping its capital markets closed to foreign investors while investing heavily in other nations' markets. Among other things, this has cost Beijing the European Union's coveted "market economy" status, which would allow China to be on a par with capitalist countries such as the United States when it comes to trade.
The European Union's five criteria to consider a country a market economy are: 1) the elimination of barter trade in the economy; 2) non-intervention by government over the allocation of resources and companies' decisions; 3) transparent and non-discriminatory corporate law; 4) a functioning property law and bankruptcy regime; 5) a genuine and state-independent financial sector.
China is so far from meeting the last four of these criteria that the EU decided in July to sidestep the issue altogether, saying that it would no longer debate whether to grant Beijing market-economy status or not. Instead, the EU will draw up plans to defend itself from Chinese dumping of steel and other products.
So, why would a country that isn't a market economy try to pretend that it is one? Well, it's no secret that China's economy has been slowing relatively dramatically, with continued credit the main factor that's still underpinning it. However, it's come to the point where taking on new debt has fewer and fewer positive effects on the Chinese economy.
In fact, it looks like it's just a matter of time before the whole structure comes crashing down. In a recent paper about China, experts from the International Monetary Fund warned that "after decades of fast expansion, many sectors have started to exhibit severe overcapacity, declining profit, and alarmingly high leverage."
How alarming is China's debt problem? Well, Michael Pettis, an expert on China, recently wrote on his blog that no matter what China does, it will be virtually impossible for it to simply grow out of its debt burden.
Hard data are difficult to obtain from China, but it is assumed the country's debt is at around 240% of gross domestic product and growing by 15% to 20% a year. It is also assumed that debt servicing capacity is rising at around the same rate as GDP, somewhere around 6.5%, according to Pettis. Because debt servicing capacity is growing more slowly than the debt itself, Beijing must implement reforms that improve productivity a lot in order to dig itself out of debt.
China only has two ways to service its growing debt through productivity gains alone. First, Chinese productivity should grow so much that each new unit of debt generates 5x to 7x as much GDP growth as it does now. Or, all assets backed by the total stock of debt should suddenly generate 25% to 35% more GDP growth than they do now. Both of these are highly unlikely.
The pace at which various types of debt has been increasing is breathtaking. For example, the IMF paper cited data from the National Audit Office of the People's Republic of China as showing that local-government debt soared to 24 trillion yuan ($3.6 trillion) at 2014's end from just 10.72 trillion yuan in 2010. That's more than double in four years. Domestic bond issuance likewise grew to 11.9 trillion yuan in 2014 from only 7 trillion in 2011, a 70% increase in three years.
So, if China can't grow out of its debt burden, how can it deal with it? It could, of course, follow the example of such fine "champions" of capitalism as the United States, United Kingdom and the eurozone, which all have artificially low interest rates and central-bank asset buying. China is already trying to do just that up to a point, with monetary easing ensuring that at least its debt-servicing costs remain manageable.
But a more certain way to fix things would be to shift some of the debt burden on to someone else, like foreign investors. After all, domestic investors can only do so much, while hyperinflating China's debt away would be extremely unpopular in an economy where a lot of people still live hand to mouth.
So, the classic way that over-indebted countries deal with debt is to shift part of the burden to foreign investors via capital markets, then weaken the local currency to deliver "debt restructuring by stealth." Those eager to buy renminbi-denominated assets should be aware that China's recent warmth towards foreign investors might have something to do with that.