“Practically boundless” future capital outflows.
“Beneath all of the financial turbulence there lurks, in my view, a credit crisis; I fear the worst now,” UBS economic adviser George Magnus told Bloomberg TV today. The reform agenda “has stalled,” he said, and “things are looking much bleaker for China going forward.”
And so on Monday, we got another flavor of it.
The Shanghai Composite index plunged 5.3%, to 3016, down 15% so far this year. The Shenzhen Composite fell 6.6%. Hong Kong’s Hang Seng fell 2.8% to 19888, below 20000 for the first time since June 2013, and down 30% from its April high.
Everyone had hoped that China’s “National Team” would jump into the fray and bail everyone else out, but it didn’t. And the People’s Bank of China didn’t offer any big new remedies either. But it did stabilize the yuan after it had dropped 1.5% against the dollar last week, and about 6% since mid-August.
In Hong Kong, interbank yuan lending rates broke all records since the Treasury Markets Association started compiling the data in June 2013, with the overnight Hong Kong Interbank Offered Rate spiking 939 basis points to 13.4%.
And copper did it again, ratting on China’s real economy. Copper goes into anything from skyscrapers to smartphones. China is the world’s largest copper consumer, accounting for over 40% of global demand. And on Monday, copper dropped 2.6% to $1.97 per pound, the lowest level since May 2009.
Buffeted by, among other things, fears about slowing demand from the industrial sector in China, oil plunged – with WTI down 6.1% to $31.13 a barrel
To prop up the yuan and counter the impact of capital flight, China had dumped $510 billion of foreign exchange reserves last year, drawing them down to a three-year low of $3.33 trillion. And that was just the beginning.
According to estimates by BofA Merrill Lynch, that $510 billion of sales included:
- $292 billion of US Treasuries
- $92 billion of US stocks
- $3 billion of US agency debt
- $170 billion of non-US paper.
But China also increased its purchases of US corporate bonds by $44 billion, bringing the total to $415 billion.
So what is China going to dump next? The New York Times cites Shyam Rajan, rates strategist at BAML: “In the next two months I would still say Treasuries. But if the pressure continues beyond that, it’s non-US assets, and in the US space it’s definitely corporates and agencies.”
In the report, BAML estimated that China still holds:
- $1.29 trillion of Treasuries
- $1.15 trillion of non-US assets (mostly short-dated euro-denominated bonds)
- $212 billion of US agency debt
- $415 billion of US corporate bonds,
- $266 billion of stocks.
Selling a significant part of its $415 billion of US corporate bonds and $266 billion of stocks will likely leave an imprint on the markets. And selling $500 billion or more in assets a year when the total stash is down to $3.3 trillion, well, pretty soon it becomes apparent that this cannot be done for a long time before markets realize that it cannot be done for a long time, and then, when confidence collapses, things could get a little hairy.
It’s getting complex already. By dumping its FX reserves, China is trying to counteract the impact of capital flight. Fitch Ratings reported today that capital flight since the second quarter of 2014 is by now “likely to have exceeded” $1 trillion. In light of that kind of number, those $3.3 trillion of foreign exchange reserves don’t look that huge.
Analysts at JPMorgan Chase reported that the causes of these capital outflows have grown more numerous and “have entered a new phase” in the second half last year, “broadening to include foreign direct investment and portfolio instruments, something that could make future capital outflows practically boundless.”
And this, according to Fitch, is getting China’s policies tangled up in some unsavory contradictions:
China is facing a sharpening dilemma between a perceived need to keep interest rates low to help the economy manage its debt burden, and downward pressure on the Chinese yuan and foreign reserves.
The authorities have reduced interest rates steadily since November 2014 in a bid to help the economy manage its debt burden – which is high and still rising – at a time of slowing growth. However, lower rates are helping to drive capital outflows, weakening the yuan.
So China is selling its FX reserves to prop up the yuan. But….
A country cannot simultaneously allow free capital flows and control its exchange rate and domestic interest rates. This is at the core of the policy dilemma China faces between the imperative of keeping rates low for domestic stability against pressures on external stability as exemplified by the exchange rate and reserves data. China still operates capital controls, but the scale of flows suggests that these have become porous.
And that coming massive yuan devaluation everyone is talking about? Maybe not. Because it might just be the trigger that would set off a nasty chain of events:
Fitch does not expect the authorities to resolve the dilemma with a large trade-weighted yuan depreciation, as this would risk creating additional uncertainty and further undermining policy credibility….
Because “policy credibility” is sacrosanct. Losing it would be the nightmare scenario. It would signal to the markets that the authorities have lost control entirely over the currency, the credit markets, the stock markets, and all the things they’ve been trying to keep from unraveling. And this would start the unraveling in earnest.
“Now is the right time for us to sell this investment,” Deutsche Bank’s co-CEO John Cryan said to justify the sale of Deutsche’s stake in Hua Xia Bank in China. He couched the deal in all the right terms. Other megabanks too have been dumping their stakes in Chinese banks. Read… What Secret Do Global Banks Know about Chinese Banks?