China may face Japan-like slump unless yuan weakens, KKR says


China could be facing the same kind of anemic growth that Japan did in the 1990s unless it moves to weaken the yuan to alleviate the country’s debt burden and fend off deflation, according to KKR & Co., one of the world’s largest private equity firms.

The country’s currency interventions have drained cash from the financial system, tightening liquidity further at a time when money is already leaving the country in droves, Henry McVey, head of KKR’s Global Macro & Asset Allocation team, said in a research note Tuesday. The tightening of money supply and falling inflation are making it more expensive for companies to repay their debt, ultimately hurting economic expansion, he said.

“China cannot ignore the one-two punch of deflation and capital outflows without having to ultimately realign its currency strategy,” said McVey. “If it does choose to ignore these items, then we believe GDP growth could stagnate further the way it did in Japan during the 1990s (i.e., high real rates restrain growth amidst too much debt).”

KKR, which oversees $99 billion in assets as of September, estimates that the “fair value” of the yuan is about 7 per dollar, or 7.1 percent weaker than Tuesday’s close. With volatility as much as 10 percent, the yuan could weaken to 7.5 per dollar in an “overshoot” scenario, McVey said.

China doesn’t need to devalue the exchange rate to boost trade, because its companies have already grabbed export market shares even when the currency was strengthening over the past few years, he said. Instead, the argument for a weaker yuan stems from the need to offset capital outflows.

“The reality that capital account outflows are now bigger than current account inflows is quite significant, in our view, as it represents somewhat of a sea change in terms of how China must think about financing itself versus the flexibility and stability it enjoyed in prior years,” he said.

A weakening yuan will likely lead to “more dislocation” in countries such as South Korea, Japan and Singapore, than China itself, he said. As the yuan declines and Chinese companies compete “aggressively” in high-end export markets, long-term bond yields should stay low for longer than investors may anticipate, McVey added.

The Chinese government has set the growth target for this year between 6.5 percent and 7 percent after the economy expanded 6.9 percent in 2015, the slowest in a quarter century.

Japan’s debt-fueled housing and stock market bubble burst in the late 1980s, leading to sluggish economic growth in the following years, a period commonly referred to as the country’s lost decade.