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How China Cornered The Fed With Its "Worst Case" Capital Outflow Countdown

Tyler Durden's picture




 

Last week, in "What China’s Treasury Liquidation Means: $1 Trillion QE In Reverse," we took a look at the potential size of the RMB carry trade, noting that according to BofAML, the unwind could, in the worst case scenario, be somewhere on the order of $1 trillion. 

Extrapolating from that and applying Citi’s take on the impact of EM reserve drawdowns on 10Y UST yields (which, incidentally, is based on "Financing US Debt: Is There Enough Money in the World – and at What Cost?", by John Kitchen and Menzie Chinn from 2011), we noted that potentially, if China were to use its FX reserves to offset the pressure on the yuan from the unwind of the great RMB carry, the effect could be to put more than 200bps of upward pressure on the 10Y yield. 

Going farther, we also said that $1 trillion in FX reserve liquidation by the PBoC would essentially negate around 60% of QE3. In other words, China’s persistent FX interventions amount to reverse QE or, as Deutsche Bank calls is "quantitative tightening." 

Now, SocGen is out with a description of China's "impossible trinity" or "trilemma". Here's the critical passage:

The PBoC is caught in an awkward position: not letting the currency go requires significant FX intervention that will not prevent ongoing capital outflows but which will result in tightening domestic liquidity conditions; but letting the currency go risks more immense capital outflow pressures in the immediate short term, external debt defaults and possibly further domestic investment deceleration. Furthermore, it has to consider the painful repercussions globally that could result from any sharp RMB depreciation.

In other words, because the new currency regime looks to have paradoxically created a situation where the market will play less of a role in determining the exchange rate for the yuan, China will be stuck liquidating its reserves and offsetting that resultant liquidity drain with reverse repos, RRR cuts, and a mishmash of short- and medium-term lending ops which, to the extent they're seen as net easing, will only exacerbate pressure on the yuan, necessitating still more interventions in a very non-virtuous loop until such a time as the PBoC either runs out of assets to sell or else throws in the towel and moves to a free float which would likely trigger an all-out short-term panic. 

Well, that's not entirely true. Everything could suddenly be "fixed", or, as SocGen describes it, "for the RMB to appreciate compared to its current value (6.40) will require a very positive environment for EM coupled with a cessation of capital outflows and a vibrant cyclical growth and an export recovery." 

Since it's difficult to imagine a situation that's further from what's currently playing out across emerging economies, we can rule that out, and because even if China can manage to mitigate outflows by "temporarily tighten[ing] (the implementation of capital controls," solving the puzzle here will, to quote SocGen again, "still entail large-scale FX intervention," we can move straight to a consideration of how dramatic the FX reserve liquidation may ultimately be. Here's SocGen's three scenarios:

Logically, we should first make assumptions about the PBoC’s tolerance for currency volatility and FX reserves drawdown. However, practically, it still helps to envision likely scenarios of capital outflows and reverse-engineer the amount of FX reserves needed. We present a few scenarios over a one-year time horizon to gauge possible reserve usage.

  • Base case: Current account surplus of $280bn over the next four quarters plus capital outflows (FDI + portfolio + other + NEOs) that are 50% greater than the previous year ($560bn) would equate to the PBoC needing to use $280bn of reserves over the next twelve months if it wanted to stabilize the RMB.
  • Moderately bad case: Current account surplus falls by 50% ($150bn) and capital outflows accelerate by a factor of two compared to the previous year ($750bn). The PBoC would need to absorb $600bn in outflows if its goal was no further RMB depreciation
  • Worst case: Foreigners exit all cumulative portfolio investment from the past five years ($260bn), five years worth of cumulative foreign inflows into trade credit/loans/deposits are reversed ($530bn), and locals accelerate outflows by a factor of two ($400bn). There could be $1.2trn in outflows. If the current figure halved over the next year to $140bn, net outflows would be around $1.04trn. There would be hardly any money left to leave after this, and the PBoC would be left with a meagre $2.5trn in reserves (chart 18).

Or, visually:

The chart above is important: what it shows is that not only is the Fed trapped in a corner domestically, on one hand dreading the launch of the tightening cycle (as can be seen by the endless drama and dithering about whether or not to hike rates) which will not only unleash even more asset selling and in the process tighten financial conditions even more, thus limiting what little inflationary impulse exists in the economy, while on the other risking complete loss of confidence if it were to postpone or cancel the tightening cycle, but now it is also trapped internationally, courtesy of China's August 11 announcement of its currency devaluation, which has started a T-minus 365 day countdown on the Fed's successful conclusion of its monetary policy implementation.

Furthermore, as SocGen explains vividly, the potential outcomes for China from this point on, are bad, worse and worst, and since China's recent "success" in effectively controlling its housing, credit, and last but not least, its stock market bubble, has demonstrated a worst case scenario is almost certainly the most probable one, what the above analysis means, is that while the Fed may be hoping for the best and expecting an even better outcome, the "reverse QE" that China launched less than three weeks ago, will make the Fed's job that much more difficult as its presents not only a timing constraint to Fed policy, but a monetary one as well in the form of what Deustche Bank dubs "Quantitative Tightening."

In fact, one can argue that since there is no way resolve China's "impossible trinity" of pursuing a stable exchange rate, an open capital account and an independent interest rate policy all at the same time, the worst case scenario is very likely an optimistic one. This means that as the Fed debates whether or not to hike, and how much, the acceleration in Chinese capital outflows starting on August 11 has set the path for the Fed, and at this point any incremental delay in hiking merely adds more to the already vast cross-capital and currency confusion around the globe. However, no longer is the Fed's quandary open ended: with every passing day, China is suffering incremental tens of billions in capital flight, in reserve liquidation, and thus, tighter global financial conditions, as can be expected from the unwind of the world's largest depository of USD-denominated reserves.

Finally, what all of this really means, is that having pushed China to the point of dissociating itself from the USD peg officially, the more the Fed tightens, the more China will have to push back through devaluation or otherwise, and the more capital outflows it will be subject to, thereby amplifying the Fed's tightening posture around the globe. In this very unstable arrangement, suddenly the smallest policy error will reverberate exponentially, and result in the only possible outcome: the Fed's admission of policy failure by adopting a tightening bias, and ultimately launching another phase of monetary easing, be it QE4 or perhaps even the long-overdue and much anticipated Friedmanesque "helicopter money" episode.

In even simpler terms: China has just cornered the Fed: not just diplomatically, as observed when China's PBOC clearly demanded that Yellen's Fed not start a rate hiking cycle, but also mechanistically, as can be seen by the acute and sudden selloff across all asset classes in the past 3 weeks. Now Yellen has about 365 days or so to find a solution, one which works not only for the US, but also does not leave China a smoldering rubble of three concurrently burst bubbles. Good luck.   

 

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Mon, 08/31/2015 - 19:39 | 6492625 buzzsaw99
buzzsaw99's picture

as long as cohen, corzine, et al can afford to overpay for some crappy painting the fed couldn't care less and in fact is as happy as a pig in slop.

Mon, 08/31/2015 - 20:52 | 6492915 Perimetr
Perimetr's picture

So sorry, Fed, we must dump Treasuries to protect our domestic markets

By the way, we will only be accepting yuan or gold-backed trade notes for our products starting next year

Mon, 08/31/2015 - 22:04 | 6493270 BoNeSxxx
BoNeSxxx's picture

Why 365 days?

Tue, 09/01/2015 - 00:02 | 6493762 BuddyEffed
BuddyEffed's picture

Helicopter money will never happen. It was a ruse from Bernake all along that the 99% had a safety net too. A convenient psychological ploy to calm the masses.

Tue, 09/01/2015 - 04:02 | 6494159 Element
Element's picture

It already has, direct bank account injections occurred in the US in early 2008, just not enough to avoid subprime default and foreclosures.

Mon, 08/31/2015 - 19:41 | 6492632 Tinky
Tinky's picture

Sounds like a recipe for an explosive response.

Tue, 09/01/2015 - 04:39 | 6494189 Oracle 911
Oracle 911's picture

Anybody doubting about the fact: the last explosion was retaliation for the Chinese fire-sale. And the Chinese response for that bombing will be disastrous for the US.

Mon, 08/31/2015 - 19:42 | 6492636 techstrategy
techstrategy's picture

ZH has a complete blind spot.  The world's producers are de-financializing.  Conditions in EM and elsewhere will ease dramatically as we pass the tight USD phase into the gold phase... The greatest glut in the world by MANY orders of magnitude is that of essentially if not inherently fraudulent accumulated, compounded and derived phantom debt claims arising from fractional reserve banking...

Tue, 09/01/2015 - 04:40 | 6494190 Oracle 911
Oracle 911's picture

You sir are spot on.

Mon, 08/31/2015 - 19:46 | 6492653 q99x2
q99x2's picture

Xi +1 Blankfein 0

Tue, 09/01/2015 - 07:06 | 6494334 J J Pettigrew
J J Pettigrew's picture

Blank***n and D*mond and Pauls*n and Bernan**e can all line their pockets having profited from the

crisis they created.  CDS and the subprime mortgages and all the gimmickery..... and no one served time and we still dont know where the money went. 

It is tragically poetic that in a nation that boasts of Democracy that its demise will be at the hands of a cabal of the unelected

Mon, 08/31/2015 - 19:49 | 6492656 Atomizer
Atomizer's picture

Like a sexually frustrated whore. Bank of International Settlements has launched a flurry email announcements this morning. I'll cherry pick my favorite.

 

31Aug/Benoît Cœuré: Drawing lessons from the crisis for the future of the euro area

Bonus:

31Aug/Stanley Fischer: US inflation developments

 

Copyright © 2015 Bank for International Settlements, All rights reserved. 

Our mailing address is:

Bank for International Settlements
Centralbahnplatz 2

Basel 4002
Switzerland

Keep up to date. IMHO. 

 

 

 

Mon, 08/31/2015 - 19:52 | 6492673 Supernova Born
Supernova Born's picture

Little did they know, Wall St and the Fed sold themselves down the river along with the outsourced American middle class worker.

Mon, 08/31/2015 - 20:12 | 6492764 jcaz
jcaz's picture

Oh,  they understood that very well, actually....

Mon, 08/31/2015 - 20:30 | 6492824 RopeADope
RopeADope's picture

The ones that went to work for Citadel at least. The naive academics left at the FED, not so much.

Mon, 08/31/2015 - 19:59 | 6492708 KashNCarry
KashNCarry's picture

'A Parable for Our Dangerous Times' by Pepe Escobar http://sputniknews.com/columnists/20150831/1026393243.html

Mon, 08/31/2015 - 20:00 | 6492716 DaVinci
DaVinci's picture

That will teach the Fed...

Mon, 08/31/2015 - 20:03 | 6492730 reader2010
reader2010's picture

It's the other way around. The true owners of the Fed have cornered China.

Mon, 08/31/2015 - 20:22 | 6492802 Atomizer
Atomizer's picture

Until they sell off bonds and UST. Then the rats will be corned. 

Tue, 09/01/2015 - 05:08 | 6494211 CHX
CHX's picture

Especially if the proceeds are used to buy gold. 100B US$ is worth roughly 2.7k metric tons (at current "price" of ~1140 per ounce) or simply current yearly global mine output. Now they could do this with 1 T US dollars, aye ? Then what ??? That's a golden gun against the U$ temple (pun intended). Tick tock tick tock...

Mon, 08/31/2015 - 20:35 | 6492846 asteroids
asteroids's picture

If you were China and were holding a massive stinking pile of US debt. Backed by the "Full Faith and Credit" of people like Hillary and Obozo, wouldn't you look into the crystal ball and decide to dump everything as quickly as possible?

Mon, 08/31/2015 - 20:39 | 6492861 Caviar Emptor
Caviar Emptor's picture

Such short-sighted thinking from all around!
What's at stake? The Nixon junkodollar system is failing.
Can't export inflation anymore via vendor-financing.
Can't roll the debt overseas.
Nope.
Printing and higher rates are coming

Mon, 08/31/2015 - 21:31 | 6493104 Stormtrooper
Stormtrooper's picture

So, when will the report on MH-17 be published?

Mon, 08/31/2015 - 21:56 | 6493224 Illegal
Illegal's picture

Trade UST for oil

Mon, 08/31/2015 - 22:42 | 6493456 thebestlackallc...
thebestlackallconviction's picture

finally mention of the trilemma or impossible trinity. now zh has to do an article debunking the fallacy that china is not important because they only take 1 percent of our exports. this is the same argument bernanke made when he said subprime was not important because at 500 billion it was a small percent of gdp. i guess i'm asking zh to flesh out the thesis that credit crises elicit non-linear responses.

Tue, 09/01/2015 - 01:07 | 6493947 Atomizer
Atomizer's picture

Obama plans to sanction China for cyberbullying.

This numnuts writes daily comedy. He should've been a standup comedian instead of the POTUS.  

Tue, 09/01/2015 - 04:07 | 6494164 Element
Element's picture

moved

Tue, 09/01/2015 - 08:08 | 6494215 CHX
CHX's picture

With the "globalization meme" that outsourced all the productive US jobs to China et al. the US elites and cronies sold out the country. What will remain of this once great and proud country is not pretty. What a pity.  

Tue, 09/01/2015 - 05:43 | 6494253 Jersey_Mountaineer
Jersey_Mountaineer's picture

Don't worry.  Yellen's got a plan.

She'll raise interest rates.  Or maybe she won't.  No, she will, if unemployment keeps improving.  Just not in the winter.  Well, maybe this winter's OK, because it couldn't possibly be as cold as the last one.  As long as there's no uncertainty in Greece.

Tue, 09/01/2015 - 07:07 | 6494340 J J Pettigrew
J J Pettigrew's picture

Yellen's got a plan?  No, that's the bag Bernanke handed her.....and she is a stoop for "holding the bag"

Tue, 09/01/2015 - 06:48 | 6494311 Raul44
Raul44's picture

"China's PBOC clearly demanded that Yellen's Fed not start a rate hiking cycle..." << I am pretty sure thats a biggest wish FED want,rather than China and this could be their excuse. 

Tue, 09/01/2015 - 07:10 | 6494343 J J Pettigrew
J J Pettigrew's picture

It is never good when those to whom you owe Trillions (China and Japan) suddenly need the money.

Where are those who said the trade imbalances didnt matter?  Mattering soon......

Tue, 09/01/2015 - 09:07 | 6494643 Koopa
Koopa's picture

Question, as I am not very familiar with this topic:

What's this T-365 about ? What's supposed to happen on August 11 2016 ?

Tue, 09/01/2015 - 11:11 | 6495162 JenkinsLane
JenkinsLane's picture

RTFM

Tue, 09/01/2015 - 11:10 | 6495161 JenkinsLane
JenkinsLane's picture

Great article, thanks Tyler.

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