The Chinese economy produced much better results in the second half of 2016 than many people expected. We continue to think that this is largely because of the stimulative steps taken by the Chinese authorities, but we continue to be troubled by China’s economic outlook.

Uncertainty is bad, but uncertainty plus tension is worse

We expect Trump to take a very different approach than Obama did to China, which we think will raise geopolitical and economic risks. But, even if U.S. trade policy with China does not change, it will not be clear for some time. As a result, we will probably have to get used to living with uncertainty over U.S./China relations.

In the meantime, China’s economic challenges remain. Reducing the economy’s dependence on credit, modernizing the production base, shifting the economy to focus on domestic consumption of goods and services, and preserving central control have proven to be difficult in a tolerably benign external environment. These challenges will not be any easier against a backdrop of an increasingly tense relationship with the United States.

Questions of currency

It is also important to note that the Chinese private sector is increasingly nervous about the economic outlook. As a result, capital outflows have continued. In addition, the authorities are dangerously close to running into a classic problem with a pegged exchange rate. What do you do with a peg when the private sector begins to question its credibility? Defending the exchange rate by raising interest rates threatens harm to the domestic economy. But breaking the peg may cause damage, too, since it harms domestic balance sheets, especially of those actors who had treated the peg as though it were credible. When you peg to a currency that is appreciating for exogenous reasons, maintaining the peg creates other difficulties.

The Chinese authorities would like the yuan to depreciate at a slow and steady pace against the dollar, but Trump’s election has pushed the dollar up quite significantly. The authorities thought they could diffuse some of the pressure by changing the basket against which they manage the yuan. They also have the longer-term goal of introducing some flexibility into the bilateral exchange rate with the dollar. The new basket has a lower weight for the dollar, but the announcement of the new basket had the effect of making investors nervous that further reduction in the dollar weight would be forthcoming, which would cause the dollar value of their assets to decline further. The problem is that basket weights matter for thinking about trade, but investors tend to care more about bilateral exchange rates.

The Chinese authorities would like the yuan to depreciate at a slow and steady pace against the dollar, but Trump’s election has pushed the dollar up quite significantly.

Faced with this pressure, the authorities are reverting to the playbook they know best. They are reluctant to allow price adjustment — this would mean either freeing the currency to float or devaluing sharply and pushing up interest rates. So they are considering two quantity adjustments: to reduce the quantity of demand for dollars and to increase the quantity of supply.

Reducing the quantity of demand without the price mechanism means tightening restrictions. This is happening quite aggressively now, and Beijing is trying to offset the unpopularity of related measures by linking them to China’s ongoing anti-corruption campaign. It is as if the leadership was saying: “We are only good patriots who are trying to stop corrupt officials from sending offshore their ill-gotten gains.” Increasing the supply without adjusting price means making public sector supply available, which means selling reserves and leaning on state-owned entities to supply more dollars to the market.

We continue to think that the Chinese have the tools to control these issues, and that any worsening of Chinese troubles is unlikely to trigger a global financial crisis. But the underlying pressures are for continued outflows, and the economic risks are to the downside. As we have seen in the past couple of years, the Chinese growth outlook matters for global growth prospects, if only because the Chinese economy is now so large.

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Despite geopolitical pressures, China continues to deploy numerous tools to manage a steady decline in its currency.