Ray Dalio, founder and co-chief investment officer of Bridgewater Associates, highlights the basic forces that drive an economy and explains why economic cycles occur by breaking down concepts such as credit, interest rates, leveraging, and deleveraging. The need for deleveraging, or reducing debt, arises when debt rises faster than income, and this is precisely the situation in China. With the weakening of export demand, China’s income is getting squeezed, and debt repayments are rising.
Four ways to reduce leverage or debt
According to Ray Dalio, the following are four ways to reduce debt:
- Austerity, also know known as spending cuts, is a debt-reduction measure taken by government, businesses, and individuals. However, austerity is painful and deflationary, and debt may even rise due to lower income.
- With debt restructuring, lenders get paid back less or receive payment over a longer timeframe or at lower interest rates than initially agreed upon. This measure is also painful and creates deflation.
- Through redistribution of wealth, the government raises taxes on wealthy individuals. However, over time, wealthy people get squeezed by the weak economy and higher taxes.
- A country’s central bank can also print new money and use it to buy government bonds, which in turn allows the government to increase spending through its stimulus programs and unemployment benefits. A central bank can also devalue its currency, which can boost exports and raise inflation in the long term.
China matters to the global economy because it’s a huge market for various products and a large manufacturing hub. Most smartphone sales come from Asian countries, and these sales directly impact the revenues of tech giants like Apple (AAPL), Microsoft (MSFT), and Alphabet (GOOG). Moreover, social media companies like Facebook (FB) and Twitter (TWTR) generate large advertisement revenues from emerging markets.
Increases in online sales benefit China-focused mutual funds such as the Clough China Fund Class A (CHNAX) and the John Hancock Greater China Opportunities Fund Class A (JCOAX), which invest in Chinese e-commerce giants such as Alibaba Group Holding Limited (BABA) and Baidu (BIDU).
Renminbi devaluation: the most probable path
At Market Realist, we think currency devaluation is the most probable path for China, although it would create tremors in global financial markets in the short term and would bring down China’s foreign reserves drastically. However, China’s foreign reserves are still large enough to support the renminbi.
Kyle Bass, a US hedge fund manager, is of the opinion that the People’s Bank of China will be forced to devalue its currency further to boost the economy. Similarly, David Tepper, president and CEO of Appaloosa Management, believes the renminbi will be devalued further in the short term.
In the next article in this series, we’ll analyze China’s foreign exchange reserves.