A key figure just presented China with a nasty choice for its economy
Choosing the former would be an act of desperation. Choosing the latter, at least in the short term, could unleash untold amounts of pain on the country.
Here's what happened. This week, someone very important to China told the country to knock it off with the capital controls and allow the free flow of money in and out of its economy. That person is Henry Fernandez, the Chairman and CEO of MSCI - a company that makes stock indexes.
For years China has wanted to be included in the MSCI Emerging Markets Index ETF. Inclusion could mean trillions of dollars pouring into China's A-share domestic stock market, and offer proof that China is in fact a modern, global economic power house.
So to secure this, over time the country has been trying to show the world that its economy is open, transparent, and safe enough to participate. According to Reuters, as of last June, MSCI told the country (in so many words) that it was close, but not quite there yet.
Rock, meet the hard place
Fast forward to the last few months in which the yuan has declined at a record pace, falling at its fastest rate since 1994. The yuan's value is declining because the Chinese economy is slowing, and because people are taking money out of the country. In December, $82 billion left China.
This is not in the country's interest. China's leaders want their people to be able to buy things - to have a consumption based economy like the one in the United States. And so the government has installed a bunch of capital control measures to stem outflows and used its vast store of foreign exchange reserves to buy back yuan and prop up the currency's value.
MSCI is now asking China to stop doing part of that - to loosen the capital controls or, as Fernandez told Reuters, to stop restricting "the out door." Indeed, what investor would want to put money into an economy without having the ability to pull it out at will?
Of course, getting rid of these capital controls could spur more outflows, and more outflows would pull the yuan down farther. This is the vicious cycle China has been trying to prevent.
On the other hand, China needs to attract money, not just keep it within its borders. It can't do that without the confidence of individuals and institutions like MSCI. China must choose to either continue a losing battle of stopping money from going out, or risk the volatility of having an economy that could possibly attract some money in.
Meanwhile, foreign direct investment (FDI) in the country is declining. Foreign investors are sending more money back home once it's been made, according to Societe Generale. Eventually, China won't be able to make a choice. The ebb and flow of the global economy will make the choice for it.
Face it
All of this said, everyone knew this day was coming. Charlene Chu, one of the world's most brilliant China analysts, said in a recent note that China would only be able to prop up the yuan with its foreign exchange reserves for a few quarters before something happened.
Analysts also knew that capital controls would eventually hurt the Chinese economy.
"Beyond a certain level, capital controls cannot be stepped up without hurting trade flows and thus the real economy," Societe Generale economist Wei Yao said in a note to clients this week.
Yao also shared this chart. It shows that the farther the yuan falls, the more net errors and omissions in China's balance of payments (or most simply, China's national checkbook).
Yao politely calls this a "coincidence." Another polite word to add might be "convenient." It is a coincidence that there are more errors and omissions in the balance of payments when the yuan falls and it would be convenient for people to get money out of the country.
This couldn't come at a worse time for China when it comes to optics. President Xi Jinping just made history as the first Chinese leader to speak at the World Economic Forum in Davos Switzerland.
There, he urged the world to continue opening up to free trade.
"Whether you like it or not, the global economy is the big ocean you can't escape from," Xi said.
This is a short term problem with a long term solution. The yuan will continue to weaken as long as Chinese growth is fueled on debt. Changing that involves deleveraging massive companies, some of which employ millions of people (especially in industries like steel and coal). It is a painful process that could take years.
And it seems increasingly clear that China doesn't have that much time. Not if its going to practice what Xi is preaching, at least.