China devaluation risk is rising as capital outflows reach danger level

21/12/2016 22:37

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China devaluation risk is rising as capital outflows

reach danger level
AMBROSE EVANS-PRITCHARD

21 DECEMBER 2016 7:45PM

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Chinese media have been mocking China bears such as George Soros, but his predicted 'hard-landing' may come
soon

s the Dow flirts with Trumpian heights of 20,000 on Wall Street, the Shanghai
Composite in China has been drifting down for sev en consecutiv e weeks.

It is hard to construct a case that reconciles this split, giv en the tightly intertwined
nature of the world's financial sy stem and the trans-Pacific sy mbiosis that we call
Chimerica. One of these two markets must rev erse.

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If y ou are waiting for the nex t Chinese boom, y ou hav e already missed it. The latest
1 8-month mini-cy cle has peaked. The authorities are being forced to tighten. China's $9
trillion bond market is seizing up.
Forty companies hav e had to cancel or postpone bond issuance this month. Nomura say s
24 large firms are in default negotiations, ranging from steel and construction to
shipbuilding, chemicals, tex tiles, and solar.
Beijing let rip earlier this y ear with a fiscal deficit of 4pc of GDP - a one-off loosening of
two to three percentage points that y ou would ex pect only in an emergency - and it
deliberately stoked a housing bubble in the cities of the Eastern seabord.

The stimulus was comparable in scale China's post-Lehman blitz, but the effects hav e been
far less because the efficiency of credit has collapsed. It now takes four y uan of loans to
generate one y uan of growth. Since there has been almost no underly ing reform, this has
merely bought time at the cost of greater imbalances.
"The game is getting long in the tooth. Beijing's reflationary tactics are subject to
diminishing returns, and the risks are accumulating," said Konstantinos V enetis from
Lombard Street Research.
The Communist Party has now lost its room for manoeuv re. Net capital outflows
accelerated last month to the highest lev el since the currency panic a y ear ago. That
panic - nota bene - led to an 1 2pc fall in the Dow.
Capital Economics estimates that outflows reached $80bn. The Institute of International
Finance say s it may hav e been as much $1 1 5bn, three times the lev el in October.
This occurred in spite of draconian capital controls. Foreign foray s by Chinese companies
hav e been put on hold. Corporate pay ments abov e $5m must be cleared (or rationed?).
The French group Saint-Gobain complains that it is hav ing trouble getting its money out
of the country .

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The Nov ember outflows also occurred before the US Federal Reserv e raised interest rates
and signalled a hawkish path of monetary tightening in 201 7 , sending the dollar index to
1 4-y ear high.
Rocketing bond y ields in the US hav e become a magnet for Chinese money . This is
combining with dev aluation fears as the y uan weakens almost daily against the dollar the only peg that matters in the Chinese collectiv e mind. The ex change rate is fast
approaching the sy mbolic line of sev en to the dollar.
The central bank has slowed the currency slide by burning through a trillion of dollars of
foreign reserv es. But within a month or two the reserv es will drop below $3 trillion,
another sy mbolic line.
Ha Jiming, former v ice-chairman of Goldman Sachs, say s the key "psy chological
threshold" is $2.8 trillion, the minimum safe lev el for a country like China with a managed
ex change rate under the metric used by the International Monetary Fund.

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He also warns that China is more deformed than it was during Mao Zedong's Great Leap
Forward or than Japan was at the end of the Nikkei bubble in the late 1 980s. Beijing risks
being "forced into a corner" if debt woes metastasize and lead to a v icious circle of capital
flight and a sliding currency , each feeding on the other.
Professor V ictor Shih from the Univ ersity of Southern California say s the Chinese central
bank (PBOC) is in a bind. It cannot easily raise interest rates to slow capital outflows
because this cry stallizes stress in the banking sy stem.
"Giv en the growth target and the enormous amount of debt that needs to be rolled ov er, I
dont see how the PBOC can tighten in any meaningful way ," he told Bloomberg.
This has become clear ov er the last ten day s. A slight tap on the brakes by regulators led
to a liquidity crunch, sending a shock wav e through the bond market. The 1 2-month
Hibor rate in the Hong Kong money markets - the gauge of funding stress - has doubled to
almost 7 pc and is back to the danger lev els seen last January .

Funds hav e been borrowing on short-term money markets to buy bonds, and then using
these bonds as collateral to borrow more, buy ing further bonds, and on and on with
escalating lev erage - and all bey ond the scope of regulators.
These bonds underpin much of the $3.6 trillion industry of wealth management products,
the most frothy part of the shadow banking sy stem. It is a nex us of counter-party
ex posure linking banks, brokers, and funds. As the PBOC has discov ered, the chainreactions are fissile.
"We see a clear risk that global markets hav e become too complacent about Chinese risks
and that financial turmoil in China could resurface in 201 7 ," said Allan v on Mehren from
Danske Bank.
Professor Y u Y ongding, a former rate-setter for the PBOC and now the country 's leading
currency guru at the Chinese Academy of Social Sciences, say s it is futile to keep
defending the y uan. The reserv e loss is too damaging. "Once we get towards $2 trillion the

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markets will start to panic," he said.

His v iew - gaining credence in the Politiburo - is that it would be better to lance the boil
and let the ex change rate find its natural lev el. The initial slide could be as much as 25pc
but the y uan would soon recov er. "Hav e y ou ev er in history heard of a country with a
current account surplus of 3pc of GDP suffering a currency collapse? It is unthinkable," he
said.
Prof Y u told me earlier this y ear that he learned a v aluable lesson observ ing Britain's
ex change rate crisis while study ing at Ox ford in 1 992, and v iv idly remembers the two
desperate rate rises in one day by the Bank of England. Y ou cannot buck the market.
As for Britain then, the issue for China is not the ex change rate as such but rather the
danger that defending it against the dollar - when the monetary cy cle is out alignment
with the US - will squeeze the money supply and trigger defaults.
"Corporate debt in China is $1 4 trillion - larger than in the US - and they hav e not ev en
begun to delev erage. This is a dangerous situation for the banking sy stem. A lot of debt is
being rolled ov er and non-performing loans are much worse than they look," he said.
Indeed they are. Fitch Ratings estimates that bad debts are ten times the official figure,
and that the denouement could cost 30pc of GDP. It is much more serious than the
banking crisis of 1 998 when debt ratios were far lower and China was still in its booming
catch-up phase, about to enjoy the one-off windfall from joining the World Trade
Organisation. This time it is grappling with the onset of demographic decline. The work
force is shrinking by three million a y ear.
China must now pick its poison. For President Xi Jinping sitting in Beijing, dev aluation
may appear the less tox ic option.
Whether the world could absorb the deflationary shock of a sudden y uan dev aluation is
an open question. It would undoubtedly set off may hem in the East Asian currency
sy stem - a 1 998 crisis writ large - and would enrage Donald Trump in Washington. He has
already v owed to label China a currency manipulator "from day one".
The official news agency Xinhua mocked the "scary prophecies" of perennial China critics
in a prominent end of y ear comment, reminding George Soros and an army of foreign
hedge funds that China's long-foretold debt reckoning had y et to materialize. "It is an easy
game, and these China bears hav e been selling imaginary fears for their own fame and
fortune for a long time," it said.
Xinhua has a point. The speculators misread the boom-bust stimulus cy cle and launched
their short positions at least fifteen months too early . But then Xinhua - the v oice of the
Standing Committee - giv es its own hostage to fortune.
"The odds of a Chinese economic hard landing are so tiny that China economy skeptics
would do well to rethink their betting," it said.
Hubris alway s ends badly .

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